The origins of ‘responsible provincial government’ can be traced back to the Government of India Act, 1919 (also popularly called Montagu-Chelmsford Reforms). In 1933, the Australian Commonwealth appointed the Commonwealth Grants Commission (CGC). This was not gone unnoticed by the wide-ranging consultative process, that went into the formulation of the Government of India Act, 1935. Sir Otto Ernst Niemeyer, a British civil servant, had been invited by the British Government in India to advise it on the reduction of fiscal imbalance.
While the envisaged federation in Government of India Act, 1935, didn’t operationalise, it did usher in ‘provincial autonomy’ through the following steps:
(a) It separated the revenues and finances of the Provincial Governments from the Federal Government; and
(b) It detailed the distribution of financial resources and grants-in-aids to provinces.
N.K. Singh, the Chairman of the 15th Finance Commission has noted that ‘the Government of India Act, 1935, established the basic structure of fiscal federalism in India, one that survives even today’.
Post-independence, the Indian Constitution, a product of the anti-colonial struggle , established the Indian Republic as a federal polity. Given the then persisting tremors of partition, the pattern of tax assignments in the Constitution weaved the newly born republic into a ‘common economic space unhindered by internal barriers.’ The Seventh Schedule to the Indian constitution spells out the coterminous division of legislative & financial powers and duties. The basis for this transfer of responsibilities to sub-national levels is rooted in the belief that better information flow at the operational level will enable citizens to establish greater accountability mechanisms through civic vigilance. (Jacob n.d.)
Waris (2019) shows the spectrum of financial decentralisation models available to us, ranging from complete fiscal autonomy to assigned tax revenues and fiscal transfers. Given that most post-colonial states tend to have fragmentation and security concerns, a hybrid of the assigned tax revenue system and fiscal transfers is observed in linguistically and ethnically diverse countries. This system tries to take into account the needs and capacities of the provincial levels to deliver an acceptable standard of goods and services to their populations. Due to revenue dependency and possible political (mis)alignment, Mr K. Santhanam, the Chairman of the 2nd Finance Commission (FC), aptly described financial relations as “the Achilles’ Heel of every free federation” (Chapter-7 The Finance Commission).
Role of the Finance Commission
India can be described as a federal welfare state with a unitary bias. The Centre handles provision of nationally important services (defence, foreign affairs, currency) while the States handle provision of agriculture, industry, health, police etc. Due to the difference in the nature and base of taxes collected, the Union collects nearly two-thirds of combined revenue, while States make two-third of combined expenditure (Manoj Panda et al 2019: 6). This results in vertical imbalances, necessitating fiscal transfers.
Keeping these vertical (Centre-States) and horizontal (inter-state) imbalances in mind, the Indian Constitution embodies enabling and mandatory resource transfer provisions. Further, to insulate the process from narrow political considerations, it establishes an institutional mechanism – namely the Finance Commission, to facilitate these resource transfers. This also assures the states against arbitrary exercise of discretion. Dr. B.N. Rau, the Constitutional Adviser to the Constituent Assembly of India, described the Finance Commission as “a quasi-arbitral body whose function is to do justice between the Centre and the States” (Chapter-7 The Finance Commission: 236).
Article 280 (1) mandates the President of India to constitute a five-member Finance Commission (FC) every 5 years or earlier. The most important constitutionally mandated responsibility of the Finance Commission is to determine the quantum of vertical and horizontal devolution.
Structure of Tax Devolutions
Vertical Devolution implies the sharing pattern between the Centre and the ‘States’ as a whole. Horizontal devolution implies the sharing pattern between States (not UTs) of the vertically devolved pool. Before proceeding, it’s essential to fully understand the meaning of ‘net proceeds of divisible pool of Union taxes.’
The above two figures tell us the layer by layer contribution of the tax revenue receipts of the Union government.
Now, a combined look at the Tax Revenue Receipts of Union Budget 2020-21 and the Statement Showing State-Wise Distribution of Net Proceeds of Union Taxes and Duties for Budget Estimates (BE) 2020-21, tells us that the divisible pool of Union taxes comprises only of Corporation Tax, Income Tax, Wealth Tax, Central GST, Customs, Union Excise Duty and Service Tax.
Items like cesses, surcharges, taxes in UTs, National Calamity Contingency Duty, and National Disaster Response Fund are excluded from the divisible pool.
Further, the Commission can’t recommend alterations to the constitutional division of tax resources between the Centre and the States. Like many other constitutional bodies, the reports of the FC also have to undergo parliamentary scrutiny. Barring a few instances, the Union government has generally accepted the recommendations of the Finance Commission.
At this juncture, it is pertinent to analyse two contemporary changes that have reshaped the fiscal federalism landscape in India. While the introduction of Goods and Services Tax (GST) represents a paradigm shift in Indian tax administration, the increasing deployment of cesses and surcharges as a revenue tool presents unforeseen challenges to the legal landscape of federal finances.
Pooled Sovereignty – The Goods and Services Tax (GST)
The 101st Constitutional Amendment Act, 2016, which constitutionalised GST, fundamentally altered the balance of revenue collection rights and established a statutory council (GST Council) to make recommendations on the apportioning of taxes between the Union and the States.
To begin with, GST has changed the tax administration structure of the country. Earlier, the states would levy their own taxes like State VAT, Entry Tax, Entertainment Tax, etc. Parallelly, the Centre would levy its own taxes like Central Excise Duty, Additional duties of excise and Service Tax.
GST essentially taxes the value addition made at each stage of the supply chain. Hence, when someone pays a tax on a final product, they pay for the price inclusive of all value additions made in the previous stage. However, the producer, distributor or retailer would have paid certain tax already at that respective stage of the product. We can call this input taxes. In GST, those taxes will be subtracted from the tax paid on the final product or service. This is called Input Tax Credit. The balance amount is the tax liability to be paid to the government.
Pre-GST, input tax credit was available within the chain of central taxes and state taxes respectively. Input tax credit was not available between these verticals. If a commodity would attract both state and central taxes, the tax would be calculated on the basis of the price at the previous stage, and not just the value addition at the stage. This effectively increased the price for everyone in the supply chain, leading to a cascading effect of taxes.
However, considered in terms of cash-flow, the introduction of GST implies a reduction in tax revenues of the central and state governments, on account of tax rationalisation. In other words, governments had foregone revenue that was being collected on unsound taxation principles.
Secondly, GST aimed to weave India into one market. This required the establishment of a representative body (the GST Council) to set uniform tax rates for commodities within GST. This also meant that states lost control of adjusting tax rates to suit their revenue needs. Post GST, the combination of tax rates on different commodities decided by the GST Council would determine the impact on revenues for each state, depending on the state-wise consumption baskets. Invariably, for most states, this led to net reduction in own tax revenues (OTR).
Based on the above two factors, GST initially failed to draw support. To circumvent this hesitance of the states, the concept of ‘protected revenue’ and ‘compensation cess’ was invented.
The 101st Constitutional Amendment Act, 2016, along with The Goods and Services Tax (Compensation to States) Act, 2017, provided for ‘protected revenue’ by assuming a 14% year on year growth of revenue foregone due to implementation of GST. The last pre-GST financial year (FY 2015-16) has been taken as the base year for this purpose. This revenue protection was envisioned to be in operation for 5 years from the implementation of GST. The preferred revenue instrument for this revenue compensation was that of a GST Compensation Cess – a charge on items mentioned in the schedule to the Act. The proceeds of the GST Compensation Cess would form the GST Compensation Fund, which would be used to compensate the states.
The Cess Mess
Our Constitution provides for Union revenues to be raised through various instruments – taxes, fee, cess, and surcharges. Ashrita Prasad et al (2018: 5) show that from the 3rd FC to the 10th FC, various recommendations were made about sharing more buoyant taxes with the States to balance the needs of Centre and States.
The 80th Constitutional Amendment Act, 2000, substituted the erstwhile Article 270, for a new one. The substituted Article 270 allowed for sharing exceptions with respect to statutory cesses and surcharges under Article 271.
This amendment to Article 270 gave Constitutional sanction to the practice of keeping Union cess taxes and surcharges outside the divisible pool, a practice which was previously based only on the recommendations of the Finance Commissions (Ashrita Prasad 2018: 5).
The use of this constitutional discretion by the Union in its total tax kitty is explained by Figure 3.
N R Bhanumurthy et al (2019: 6) and Ashrita Prasad et al (2018: 1) highlight the growing share of cesses and surcharges as revenue sources in the past few years. This can be seen in Figure 3 through the widening gap between FC mandated divisble pool shares (red) and aggregate State shares in Union Gross Tax Revenue (blue). The general trend of increasing share of cesses and surcharges towards the Union GTR can also be seen in grey below.
Thus, the argument of larger devolution to States must be examined critically. The past 3 annual fiscals transfers seem to suggest a declining share of states in Union GTR, something the states have repeatedly argued against. As stated earlier, it is outside the purview of the FC to recommend either on (1) increasing the size of the divisble pool as a share of the GTR or (2) prescribing limits on cess and surcharge revenues.
Issues regarding Cess and Surcharges
Ashrita Prasad et al (2018: 18-20) shed comprehensive light on the various legal and constitutional issues that arise in this regard.
Dilution of specificity
Specificity is recognised as a core aspect of cesses. The Supreme Court in Maru Ram v. Union of India (1981) interpreted the word ‘specific’ to be “precise, exact, definite and explicit”. A simple comparison of the post-independence phase (Salt Cess Act, 1953 or Iron Ore Mines Labour Welfare Cess Act, 1961) with the current phase (Swachh Bharat Cess or Krishi Kalyan Cess) illuminates the loss of specificity in these cesses. There has been a tendency to impose cess for financing of national highways, basic education, environment, etc. These essentially constitute broad expenditure heads and not specific heads.
Provisions in various Finance Acts (2004, 2007, 2016) have used the terms cess and surcharge interchangeably. While both augment revenue, a cess is said to be purpose-specific, while a surcharge is essentially a tax on a tax. However, both are excluded from the divisible pool.
Besides the confusion, it also creates transparency and accountability issues. Accurate accounting is essentially a check on the executive for effective utilisation of funds for specific purposes. There have been instances where the Comptroller and Auditor General has noted that cess proceeds were used for financing revenue deficits, like in the instance of Research and Development Cess.
The imposition of cesses for subjects that fall within the State list is a fiscal subversion of the Seventh Schedule. Examples of such subjects include agriculture, hygiene, health, and education.
Further, the GST Cess is a misnomer, and hence, an anomaly. Section 8 (1) of The Goods and Services Tax (Compensation to States) Act, 2017, provides for levy and collection of GST Cess. This cess is to be used for compensating the states for the revenue shortfall for the first 5 years from the implementation of the GST. There are two points that arise for consideration: (1) The purpose of ‘Compensating State Governments’ doesn’t seem to pass the specificity test and (2) As discussed earlier, the proceeds of a cess aren’t shared with the states. However, the GST Cess is shared with the States.
A Utopia – Sharing is Caring
As a matter of fact, after the dismantling of the Planning Commission, the Finance Commission directly deals with the largest quantum of public money, only second to the Parliamentary dealing of the Union Budget. This indicates the significance of the Finance Commission as an agenda-setting body – which has various ‘nudges’ and ‘incentives’ at its disposal.
The increasing share of general and non-specific cesses and surcharges amounts to a reduction in the total role of the Finance Commission in the federal finance and can be looked at as an attack on the federal structure of fiscal relations envisaged by the Constitution. While both – the Union and the states – need to have fiscal options for various objectives, the use of these tools must be bound by rules of constitutional propriety. In the same spirit, two main recommendations emerge: –
Besides respecting constitutional propriety, two core recommendations are as given below: –
- Utilisation Review of Cess: Ashrita Prasad et al (2018: 30) suggest a 3-5 year review cycle for all cesses. Subject to proof of underutilization and diversion, the cesses should be treated as part of the divisible pool. Further, if the cess proceeds continuously yield below estimates or below an absolute figure, their abolition must be expedited in view of increasing the efficiency of tax administration.
- Scheduling Surcharges and Cesses separately: Legislations concerning the levy of surcharges and cesses should clearly distinguish between the terms cess and surcharge. Preferably, separate schedules spelling out the surcharges and cess levied, their procced estimates, and utilisation must be annexed to these Acts.
The Indian fiscal finance landscape has become more unitary than it did before. With the revenue dependency of states on the Centre now increasing, it will be interesting to see how India’s political landscape manages the aspirational demands of the electorate. The age-old dictum – ‘Sharing is caring’ – bodes ever so true, for the future of the Indian Union of States.
(Rajat Asthana is a Master of Public Policy (MPP ‘21) candidate at the National Law School of India University, Bengaluru. He has a Bachelor’s degree in Electronics and Communication Engineering. Rajat, a current affairs enthusiast, is interested in issues related to public finance, financial decentralization, and the transformative potential of technology. He can be reached at firstname.lastname@example.org
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