We have to keep certain things in mind while analysing inter-governmental fiscal relations. One, there should be no fiscal overlapping so that the same tax should not be imposed by more than one layer of government.
The Seventh Schedule of the Indian Constitution specifies the manner in which taxes are to be imposed by the central and state level governments. Two, taxation power is assigned to a particular level of government keeping in view the geographical area on which the impact of the tax is felt.
Thus the tax categories assigned to the Centre are generally broad- based and their impact is felt beyond state boundaries. Three, the residual power with respect to taxation remains with the central government. While exercising such power the Centre introduced ‘service tax’ during 1990s on the provision of specific services. Service tax is slated to be an important source of revenue in times to come. Four, imposition of taxes and fixation of tax rates is a matter of political economy.
In order to further political interests governments have many times in the past waived taxes or excluded certain categories from taxation. A widely debated issue in this context is imposition of taxes on agricultural income, which is a state subject and state governments have invariably avoided taxation of rural rich.
It has given rise to widespread tax evasion as individuals take advantage of the concession allowed to farmers and report non-agricultural income as agricultural income. Five, there is a mismatch between the tax base and the responsibilities assigned to different layers of governments.
The states have always complained about inadequate revenue compared to their expenditure. Similarly, there is shortage of funds at local government level compared to the expenditure they carry out. Six, tax base is unevenly distributed across states. For example, rich states have a relatively higher share of people who pay taxes. Similarly, relatively higher amount of excise duties is collected from industrially better off areas.
In order to tackle the problems of inadequate tax revenue at the state level, the Centre transfers fund to the states. Apart from meeting the gap between revenue and expenditure the devolution of funds to subordinate layers of government has the effect of bringing in regional balance in economic development overtime.
There are three modes of transfer of funds from the Centre to the states. First, the centre collects certain taxes (particularly, personal income tax and excise duties) and allocates a share of the tax proceeds to the states. In order to streamline such allocation the constitution provides for setting up of a Finance Commission every five years, which suggests criteria of such sharing between the Centre and the states on the one hand, and amongst different states on the other.
So far twelve Finance Commissions have been set up and each Finance Commission has suggested formulae for devolution of funds. The factors taken into account while suggesting such formulae have been poverty, backwardness, tax effort, fiscal discipline and population.
The second mode of transfer of funds from the Centre to the states is the grants and loans extended to states for implementing development plans. As you know, while preparing the Five Year Plans the Centre sets targets and investments by different sectors of the economy. Against this backdrop the states prepare their annual plan which is approved by the Planning Commission.
The state receives grants and loans from the Centre which supplement the revenue generated at the state level. The Planning Commission allocates funds to .states as per formula devised by the National Development Council.
For major states the ratio of grants to loan is 30:70. The third mode of transfer of funds from the Centre to the states is the grants given by central ministries to their counterparts in different states for specified projects.
Such projects are wholly funded by the Centre (under ‘central schemes’) or the states are asked to contribute a proportion of the cost (in the case of ‘centrally sponsored schemes’). The devolution of finds from the Centre to the states has been a matter of political economy.
The allocation of funds across states, particularly by the Planning Commission and Central Ministries, is riddled with bargaining power of the state government, presence of pressure groups, and political interests rather than balanced economic growth.
The grants extended to local bodies by the states is mostly discretionary and no set rule is formulated so far. The adoption of value added tax (VAT) by states in lieu of sales tax has opened up fresh debates on tax base of the state governments.