KOCHI : The reduced divisible tax pool and low tax devolution, which disregards the recommendations of the Finance Commission (FC) is a matter of concern for fiscal federalism, says a new report by India Ratings and Research (Ind-Ra). The study by the Fitch Group company indicates that an analysis of Union budgets over the years reveals consistent underperformance in tax devolution provided to states compared to levels recommended by the FC.
According to the study, in FY25, the Centre has budgeted to share 35.5% (BE) of the divisible tax pool with states, lower than the 15th FC’s recommended 41%. The divisible tax pool is gross tax revenues net of cess & surcharges -- excluding GST compensation cess -- and taxes of Union territories. The share of states averaged 35.4% of the divisible pool during FY21-25, down from 39.8% during FY16-20.
Paras Jasrai, senior analyst at Ind-Ra, said a lower divisible tax pool constrains states’ fiscal capacity to undertake desirable expenditure in priority areas. “Since states are responsible for over 60% of general government expenditure, the reduced divisible tax pool and low tax devolution will remain an important issue before the 16th FC. Had the cesses and surcharges (excluding GST compensation cess) been included in the divisible pool of taxes, then states would have received roughly 4.2% more, thereby taking the tax devolution to states to nearly 40% in FY25BE,” he said.
According to Ind-Ra estimates, Kerala would have received approximately Rs 2,600 crore more per annum, on average, during FY21-25 if the central government had adhered to the guidelines set by the 15th FC.
This issue was also highlighted by the RBI in its latest ‘Study of State Finances’, which points out that due to increase in cesses and surcharges, the divisible pool has shrunk from 88.6% of gross tax revenue in 2011-12 to 78.9% in 2021-22 despite the 10 percentage point increase in tax devolution recommended by FC.
The ‘Medium Term Fiscal Policy and Strategy Statement’ of the Kerala government highlights a concerning liquidity crunch arising from a vertical fiscal imbalance and arbitrary cuts in the borrowing limit.
According to the report of the 15th FC, the relative share of states in the combined revenue expenditure is 62.5%, compared to just 37.5% for the Centre. Conversely, the relative share of states in the combined revenue receipts is 37.5%, with the remaining 62% allocated to the Centre. The budget document highlights that while states bear 62% of public expenditure, they receive only 37% of tax revenue.
“It was known that the Union government has increased cesses and surcharges and kept them out of the divisible pool, and this had led to total transfers to states falling below 30% in many years,” said Dr R Ramakumar, professor with Tata Institute of Social Sciences and part-time member of the Kerala Planning Board.
“However, if the Fitch report is correct, it now turns out that the Union government has not been giving states 41% of even the already shrunk divisible pool. All Union governments after independence have sworn by the sanctity of the recommendations of finance commissions. But the report tells us that even this sacred feature of fiscal federalism is being grossly violated under the present regime,” Prof Ramakumar told TNIE.
Tax share given to states from the divisible pool*
FY17 41.1%
FY18 39.3%
FY19 43.3%
FY20 35.3%
FY21 32.9%
FY22 37.4%
FY23 35.1%
FY24(RE*) 36%
FY25(BE**) 35.5%
*RE- Revised estimate
**BE- Budget estimate
*Divisible tax pool is gross tax revenues net of cess & surcharges and UT taxes
Source: Union budget and Ind-Ra