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Centre - State financial relations
1.0 Introduction
Devolution of financial powers and distribution of revenues between the Union and the states is an essential part of a federal structure, and is ‘fiscal federalism’. It is one of the characteristics specifically mentioned as an essential nature of a federal system. Indian Constitution contains specific provisions regarding the same. It specifies the distribution of revenues where some exclusive powers are given to the State, to collect taxes and exclusive powers which rest with the Union in relation with taxes. In accordance with this, in the Seventh Schedule of the Indian Constitution, a distinction has been made between central, state and concurrent lists, where distribution of taxes is mentioned in various entries. Overall, the effort is to create processes that can help minimise the three imbalances in the economy - Vertical, Horizontal and Development.
2.0 Concepts and definitions
- Tax Devolution - One of the core tasks of a Finance Commission as stipulated in Article 280 (3) (a) of the Constitution is to make recommendations regarding the distribution between the Union and the states of the net proceeds of taxes. This is the most important task of any Finance Commission, as the share of states in the net proceeds of Union taxes is the predominant channel of resource transfer from the Centre to states.
- Divisible Pool - The divisible pool is that portion of gross tax revenue which is distributed between the Centre and the States. The divisible pool consists of all taxes, except surcharges and cess levied for specific purpose, net of collection charges. Prior to the enactment of the Constitution (Eightieth Amendment) Act, 2000, the sharing of the Union tax revenues with the states was in accordance with the provisions of articles 270 and 272, as they stood then. The eightieth amendment of the Constitution altered the pattern of sharing of Union taxes in a fundamental way. Under this amendment, article 272 was dropped and article 270 was substantially changed. The new article 270 provides for sharing of all the taxes and duties referred to in the Union list, except the taxes and duties referred to in articles 268 and 269, respectively, and surcharges on taxes and duties referred to in article 271 and any cess levied for specific purposes.
- Grants-in-aid - Horizontal imbalances are addressed by the Finance Commission through the system of tax devolution and grantsin-aid, the former instrument used more predominantly. Under Article 275 of the Constitution, Finance Commissions are mandated to recommend the principles as well as the quantum of grants to those States which are in need of assistance and that different sums may be fixed for different States. Thus one of the pre-requisites for grants is the assessment of the needs of the States. The First Commission had laid down five broad principles for determining the eligibility of a State for grants. The first was that the Budget of a State was the starting point for examination of a need. The second was the efforts made by States to realize the potential and the third was that the grants should help in equalizing the standards of basic services across States. Fourthly, any special burden or obligations of national concern, though within the State's sphere, should also be taken into account. Fifthly, grants might be given to further any beneficent service of national interest to less advanced States. Grants recommended by the Finance Commissions are predominantly in the nature of general purpose grants meeting the difference between the assessed expenditure on the non-plan revenue account of each State and the projected revenue including the share of a State in Central taxes. These are often referred to as 'gap filling grants'. Over the years, the scope of grants to States was extended further to cover special problems. Following the seventy-third and seventy-fourth amendments to the Constitution, Finance Commissions were charged with the additional responsibility of recommending measures to augment the Consolidated Fund of a State to supplement the resources of local bodies. This has resulted in further expansion in the scope of Finance Commission grants. The Tenth Commission was the first commission to have recommended grants for rural and urban local bodies. Thus, over the years, there has been considerable extension in the scope of grants-in-aid.
- Fiscal capacity/Income distance - The income distance criterion was first used by Twelfth FC, measured by per capita GSDP as a proxy for the distance between states in tax capacity. When so proxied, the procedure implicitly applies a single average tax-toGSDP ratio to determine fiscal capacity distance between states. The Thirteenth FC changed the formula slightly and recommended the use of separate averages for measuring tax capacity, one for general category states (GCS) and another for special category states (SCS).
- Fiscal discipline - Fiscal discipline as a criterion for tax devolution was used by Eleventh and Twelfth FC to provide an incentive to states managing their finances prudently. The criterion was continued in the Thirteenth FC as well without any change. The index of fiscal discipline is arrived at by comparing improvements in the ratio of own revenue receipts of a state to its total revenue expenditure relative to the corresponding average across all states.
The 14th Finance Commission (FC) gave its report in Dec. 2014 and was accepted by the government. The 15th Finance Commission was constituted in November 2017, under the Chairmanship of Shri N K Singh, and will give the report for 2020-2025.
3.0 Distribution Of Revenues Between Union And States (CONSTITUTIONAL PROVISIONS)
Article 268 - Duties levied by the Union but collected and appropriated by the States
Article 268 defines the duties which are levied by the Union but collected and appropriated by the States.
Article 268 (1) provides that stamp duties and excise on medicinal and toilet preparation which are mentioned in Union List, the collection of duties shall be made by the State which shall be levied by the Union Government. The proceeds of any such duty leviable within any State in any financial year shall not form part of the Consolidated Fund of India but shall be assigned to that State. By the Constitution (Seventh) Amendment Act of 1956, this provisions was extended to the Union Territories.
Article 268A was inserted by the Constitution (Eighty-eigth) Amendment Act of 2003. This introduced provisions relating to the sharing of Service tax between Union and States. This act specifies that Service Tax shall be levied by the Union Of India and appropriated by the Union and States.
3.1Article 269 - Taxes levied and collected by the Union but assigned to the States
This Article was lastly amended by the eightieth amendment in 2000 with effect from 1st April, 1996. This Article specifies that taxes on sales and purchase of goods which take place in the course of inter-state trade or commerce and taxes on consignment of goods shall be levied and collected by the Government of India.
Case: Goodyear India Ltd. V. State of Haryana In this case, the question was in relation with two sales tax acts which speak on consignment of goods. Section 9(1) (b) of the Haryana General Sales Tax Act, 1973 and Section 13AA of the Bombay Sales Tax Act, 1959 relate to the tax on consignment goods and these provisions are beyond the respective State Legislatures as the power vests with the Parliament. And so, it was held to be invalid. Clause 3 of this Article provides that Parliament may formulate principles for determining that when such sales and purchase or consignment takes place in the course of inter-state trade or commerce.
Case: State of Andhra Pradesh v. National Thermal Corporation Ltd. The Supreme Court considered section 3 and 6 of Central Sales Tax Act, 1956. The SC held that a movement of goods after completion of the transaction of sale within the State, does not constitute inter-State sale. The Bench also laid down few principles for considering inter-State trade or commerce:
- Existence of a contract of sale incorporating a stipulation, express or implied regarding inter-State movement of goods;
- Goods must actually move from one State to another pursuant to such contract;
- Such movement of goods must be from one State to another, where the sales conclude.
3.2 Article 270 - Taxes levied and collected by the Union and distributed between Union and States
This Article was lastly amended in eightieth amendment in 2000 and was made effective from 1st April, 1996. This Article specifically provides that taxes on income other than agricultural income and corporation tax shall be levied and collected by the Union and is distributed between the Union and States. The revenue which shall be transferred to the States is unconditional and the States shall have the discretion to use their income as and when they like. In spite of this the States do not make adequate efforts to impose more tax, primarily due to political reasons. The tax proceeds shall not form a part of Consolidated Fund of India but shall be distributed among States.
Case: T.M. Kanniyan v. I.T.O Supreme Court gave a judgment with regard to income tax and said that “the income tax attributable to Union territories forms a part of the Consolidated Fund of India. It is not necessary to make any distribution of income tax with respect to Union territories as those territories are centrally administered through the President”.
3.3 Article 271 - Surcharge on certain duties and taxes for purposes of the Union
This Article corresponds to S. 137 and S. 138(1) of the Government of India Act, 1935. This article empowers Parliament to levy a surcharge from time to time. All proceeds from such surcharges are to form part of the Consolidated Fund of India and are not liable to be distributed among the states. No one can prevent Parliament to impose a surcharge. Also, the Parliament can simultaneously impose more than one surcharge.
3.4 Article 272 - Taxes which are levied and collected by the Union and may be distributed between the Union and the States
This Article has been omitted by the Constitution (Eightieth) Amendment Act.
3.5 Article 273 - Grants in lieu of export duty on jute and jute products
Under the Government of India Act, the net proceeds of the jute export dutywas shared by the Central Government with the jute growing provinces. Under this Constitution, the States are not entitled to any such share.
Article 273 provides that for a period of 10 years from the commencement of the Constitution, the jute growing states of West Bengal, Bihar, Orissa and Assam will receive grants-in-aid from the Union in lieu of the above share of the jute export duty to the extent of sums specified by the President with the consultation of Finance Commission.
3.6 Article 275 - Grants from the Union to certain States
This Article was amended in Constitution (twenty-second) Amendment Act, 1969. Parliament is empowered to make such grants, as and when it is necessary to the States which are in need of financial assistance. Special grants may also be made to promote welfare schemes for Scheduled Castes and Scheduled Tribes.
3.7 Article 276 - States’ power to levy taxes on Professions and Trades
Article authorizes a state or other local authority to levy taxes on professions etc. where List 2, Entry 60 speaks of. Clause 2 of this Article specifies the fixed limit of Rs. 250 per annum for taxes on professions, calling etc. Later, Constitution raised the limit to Rs. 2500.
Case: Quilon Municipality v. H&C. Ltd. Here, Kerela Profession Tax, 1958 was held to be ultra vires because it violated Article 276 and also encroaching upon the Union list of income tax inasmuch as it exceeded the permissible limit which was Rs. 250 at that time.
Case: B.M. Lakhani v. Municipal Committee The following two questions were raise in this particular case
- whether a suit for refund of tax, which was ultra vires the municipality tax, paid to the municipality was maintainable, and
- if the suit is maintainable, whether the levy of tax by the municipality was valid in law.
The Honourable Supreme Court held that the suit for refund of tax in excess of the amount permitted by Article 276 was maintainable. And, for the second question, there was a bar against the levy in excess of the amount specified in the Constitution and not a mere question of levy of taxes under an inapplicable entry.
Criticism: This article has come in for a lot of criticism by the Constitutional experts on the following grounds.
- This Article has overlapping provisions with the Union list. Constitution of India permits such overlapping and makes it clear that in case of conflict, the law of the Union Government shall prevail.
3.8 Article 282 - Expenditure defrayable by the Union or a State out of its revenues
This article gives wide powers to the Union with regard to spending for public purpose. This Article provides that the spending power of the Union or State Legislature is not limited to the legislative powers. For public purpose, the spending can exceed the amount specified by the Legislature. This Article corresponds to (i) Section 150 of the Government of India Act, 1935; (ii) Article 1, Section 8(1) of the Constitution of the United States, and (iii) Section 81 of the Commonwealth of Australia Constitution Act, 1900. This article has been the subject matter of litigations also.
Case: C.F. Narayanan Nambudripad, Kidangazhi Manakkal v State of Madras : The honorable Supreme Court held that the exercise of religion is a private purpose. But, if the States themselves take the management of such religious endowment in the interest of public order, morality, or health, then it is for public purpose.
Restrictions on the States’ power to levy taxes
3.9 Article 286 - State's power to levy taxes
Article 286 empowers the State Governments to levy taxes on "sale or purchase of goods other than newspapers". But, there are few Union laws like "imports and exports" and "taxes on sale or purchase of goods, other than newspapers in the course of inter-State trade or commerce." To avoid such overlapping the power granted to State Governments under Article 286 are subject to the following restrictions.
3.10 Article 286 (1) (a)
No State can tax a sale or purchase taking place outside the State.
This Article specifically prohibits a State to impose a tax on the sale or purchase of goods where such sale or purchase takes place outside the State. But, clause 2 of this Article clearly lays down the principles for determining when a sale or purchase takes place outside the State.
3.11 Article 286 (1) (b)
No State can tax a sale or purchase taking place in the course of import and export.
This Article prohibits a State to impose a tax on the sale or purchase of goods when such sale or purchase takes place in the course of import of the goods into or export of the goods out of the territory of India. Parliament may by law formulate principles for determining when a sale or purchase takes place in the course of import and export of goods.
Case: K. Gopinath v. State of Kerala Cashewnuts were purchased and imported by the C.C.I. from African suppliers, which were sold by C.C.I. to local users. The Supreme Court held that the sale by the C.C.I. were not in the course of import and was not covered by the exemption of Central Sales Tax Act, 1956. There being no direct link between transactions of sale and import of goods on account of nature of understanding between the C.C.I. and purchasers as also be the reason of canalizing scheme for import by C.C.I. the sales do not go in exemption.
Entry 92A in the Union List also mentions that no state can tax a sale or purchase taking place in the course of Inter-State trade and commerce:
The power to impose tax on sale or purchase is exclusively vested with the Parliament. Section 3 of Central Sales Tax Act, 1956 provides that: A sale or purchase of goods shall be deemed to take place in the course of Inter-State trade or commerce if the sale or purchase - (a) occasions the movement of goods from one State to another; or (b) is effected by a transfer of documents of title to the goods during their movement from one State to another.
3.12 Article 286 (3)
Taxes on sale or purchase of goods of special importance
The good of special importance in Inter-State trade or commerce are declared in Section 14 of the Central Sales Tax Act, 1956. Section 15 thus, imposes restrictions on taxation of sales of such goods.
Clause 29-A of Article 366 provides for tax on sale or purchase of goods, on transfer of property, in goods involved in execution of a works contract, on delivery of goods on hire-purchase or any system of payment by installments, transfer of right to use any goods for any purpose for cash, deferred payment or any other valuable consideration. Thus, State law is restricted to impose any tax on above things.
3.13 Article 277
This article speaks about any taxes, duties, cesses or fees which immediately before the commencement of the Constitution, were being lawfully levied by the Government shall be continued for the same purposes notwithstanding that above things are mentioned in Union list, unless the contrary law has been provided.
According to Durga Das Basu, the object of this article is to prevent dislocation of the finances of local government and authorities by reason of the coming into force of new constitutional enactments disturbing heads of taxation on lines different from those which existed before the commencement of such constitutional changes.
It is presumed that the taxation is meant for the benefit of the public which results from expenditure incurred or from schemes undertaken by State or local Government authorities. The scope of the Article is limited and it has no application where there has been no shifting in the allocation of power as between the Union and the State under the Constitution.
Case: Amravati Municipality v. Ramchandra The municipality of Amravati, under a law passed before the Constitution came into operation, imposed terminal tax on goods, except gold and silver, imported in or exported outside municipal limits by rail or road. The power to impose this kind of tax after the commencement of the Constitution was given to the Parliament under Entry 89 of List I. after the commencement of the Constitution, an amending notification of the municipality of 1959 made gold and silver also subject to the terminal tax. The Court held that, the action of the municipality is unconstitutional on the ground that Article 277 could neither permit increase in the rate nor could its incidence be altered.
It must be noted that article 372 is a general provision and article 277 is a special provision. Article 372 saves all pre-constitutional valid laws and article 277 is confined to only taxes, duties cesses or fees. Article 372 must be read subject to Article 277.
Case: Hyderabad Chemical and Pharmaceutical Works Ltd. V. State of Andhra Pradesh The appellant were manufacturing medicines in which they had to use alcohol. They were working under licenses granted under the Hyderabad Abkari Act and the rules made there under. They were required to pay certain fees to the State Govt. for the supervision. There after, the Parliament passed the Medicinal and Toilet Preparations Act, 1955 under which they were not required to pay the fee. The petitioner challenged the levy of fees by the State Govt. after the passing of the Central Act, 1955. By virtue of entry 84 of list 1 and Schedule VII and Art. 277, no charge could be levied by the State. It was held that after the passing of the law by the Parliament, the Hyderabad Act must be deemed to have been repealed.
There is also a difference between tax and fee. A tax is an imposition made for public purpose, without reference to any services rendered by the State or any specific benefit. Whereas, fee is a payment levied by the State in respect of services performed by it for the benefit of the individual. It is levied on a principle just opposite to tax. Tax is paid for common benefit conferred by the Government on all tax-payers, whereas a fee is payment made for some special benefits.
3.14 Article 279
Calculation of net proceeds, etc.
This article defines the "net proceeds" of a tax. It means all the proceeds of tax reduced by the cost of collection. The certificate of the Comptroller and the Auditor General of India (CAG) of net proceeds of a tax in a State shall be final.
4.0 Finance Commission
Article 280 of the Indian Constitution provides that a Finance Commission will be appointed by the President if India. The idea of Finance Commission has been adopted from the model of the Commonwealth Commission of Australia. The expert committee on the Financial Provisions of the Constitution recommended the setting up of a Finance Commission. The Finance Commission in India is an innovation of far reaching importance as it attempts to make the Indian fiscal system federal in character. It is worth noting that in assessing the needs of the States and determining the proportions in which the States, individually, should share the central assistance, the Finance Commission has been guided inter-alia by the principle that "the scheme of distribution should attempt to lessen the inequalities between the states". The framers of the Constitution ensured that the transfer of funds from the Centre to the States should be made neither in such a manner as nor to impair the autonomy of the States. Article 280 requires that after the expiration of every fifth year or at such earlier time as the President might consider necessary, the President shall appoint a Finance Commission.
According to the Finance Commission Act, it has all the powers of a civil court for summoning the witnesses, requiring production of any document, requiring any person to furnish information on any point which the Commission regards as useful or relevant to any matter under its consideration.
Constitution of Finance Commission:
According to the Finance Commission Act, 1952, the Commission is to consist of a Chairman and four other members appointed by the President. The Act further says that the Chairman shall be selected from amongst persons with experience in public affairs, and the members shall be selected from the following categories:
- Who are qualified to be appointed as judge of a High Court; or
- Who have special knowledge of the finance; or
- Who have wide experience of financial matters and in administration; or
- Who have special knowledge of economics.
It is capable of settling many complicated financial problems which affect the relationship between the Union and the States. The recommendations of the last 12 Finance Commissions have proved that the Commission has settled many complicated problems and the present system of allocation of finance between the Union and the States is almost the result of these recommendations. While making recommendations, Finance Commission will take all relevant matters into account including the state of finances of Centre.
4.2 Functions of the Finance Commission
Its first function would be of the nature of arbitration, and therefore the Commission’s decision will be final. These are the duties described by Art. 280(3):
- The distribution between the Union and the States of the net proceeds of the taxes which are to be, or may be, divided between them, and the allocation of the respective shares of such proceeds;
- The principles to govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India;
- The measures needed to augment the State Consolidated Fund to supplement the resources of the panchayats in the State on the basis of the recommendations made by the State Finance Commission;
- The measures needed to augment the State Consolidated Fund to supplement the resources of the municipalities in the State on the basis of the recommendations made by he State Finance Commission and
- Any other matter referred to it by the President in the interest of the sound finance.
4.3 Various Finance Commissions
Originally, the Finance Commission was intended to cover all the financial transfers from the Centre to the States under Articles 269, 272, 275, and 282. In fact the First and Second Finance Commission recommended financial assistance to cover both the revenue and the capital requirements of the States, but the establishment to the Planning Commission led to the bifurcation of this function and the Finance Commission's role became limited to the non-plan expenditure. The last Finance Commission was established in 2012 and the Chairman is Y V Reddy. It is only expected that the Finance Commissions shall apply only two yardsticks: one of the tax effort of the State, and another is the efficiency and economy in formulating its recommendations. The Finance Commission has come up to a great help in solving the distribution of revenues, and will be of great help in future also.
4.4 Fourteenth Finance Commission
The Fourteenth Finance Commission (FFC) has radically enhanced the share of the states in the central divisible pool from the current 32 percent to 42 per cent which is the biggest ever increase in vertical tax devolution. The last two Finance Commissions viz. Twelfth (period 2005-10) and Thirteenth (period 2010-15) had recommended a state share of 30.5 per cent (increase of 1 percent) and 32 per cent (increase of 1.5 percent), respectively in the central divisible pool. The FFC has also proposed a new horizontal formula for the distribution of the states' share in divisible pool among the states. There are changes both in the variables included/excluded as well as the weights assigned to them. Relative to the Thirteenth Finance Commission, the FFC has incorporated two new variables: 2011 population and forest cover; and excluded the fiscal discipline variable. Several other types of transfers have been proposed including grants to rural and urban local bodies, a performance grant along with grants for disaster relief and revenue deficit. These transfers total to approximately 5.3 lakh crore for the period 2015-20. The FFC has not made any recommendation concerning sector specific-grants unlike the Thirteenth Finance Commission.
SARKARIA COMMISSION 1983 : Setup in 1983 by the government of India, to comprehensively examine the Centre-State relations (including fiscal), and suggest changes and improvements. Headed by Retd. Justice Ranjit Singh Sarkaria, it give a detailed report (19 Chapters) with 247 recommendations. Most of the suggestions were not implemented in reality.
PUNCHHI COMMISSION 2010 : Appointed in 2010 to review Centre-State relationships, as a lot changed since the Sarkaria Commission report. Headed by Retd. Justice Madan Mohan Punchhi (28th CJI of SC), its report arrived but didn’t attract much attention.
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