The Centre’s tax devolution to the States, which has been consistently falling short of the Finance Commission’s recommendation, will hit a five-year low in FY24, according to an analysis of Budget 2023-24 by Emkay Global Financial Services .

According to the report ‘The Centre-States Nexus of Fiscal Imbalances’ authored by Madhavi Arora and Harshal Patel, the tax devolution is estimated to be 36.5 per cent of divisible pool of taxes in FY24 as against the 15th Finance Commission’s recommendation of 41 per cent.

The 14th Finance Commission had recommended a devolution of 42 per cent of Central taxes to States, but after Jammu and Kashmir was carved out into two Union Territories, the final report of the 15th Finance Commission recommended the transfer of 41 per cent.

Central transfers to states include devolution from a divisible pool of taxes, transfers towards Centrally Sponsored Schemes, Finance Commission grants, other transfers and capex loans. Of these, tax devolutions accounts for over 70 per cent . Tax devolved to States are untied funds and hence states are free to spend them as per their discretion.

Increasing cess & surcharges 

Emkay Global report said the decline in tax devolution is largely due to increasing cess and surcharges imposed by the Centre. Cess and surcharges are part of central taxes but not part of the divisible tax pool and do not have to be shared with States. 

In fact, cess and surcharge has grown at a faster pace than gross tax revenues. From 11.4 per cent of gross tax revenues in FY18, cess and surcharges nearly doubled to 19.8 per cent in FY21.  It is however estimated to moderate to 16.4 per cent in FY24.

The 15th Finance Commission highlighted the problematic nature of the growing share of cesses and surcharges in Union revenues. It said the divisible pool, as a percentage of the gross revenues of the Union, has been consistently falling as more and more resources are raised through non-shareable cesses and surcharges.

Discontinuation of GST compensation

Emkay Global’s report said the other reason for the Centre’s devolution coming down in FY24 could be the discontinuation of compensation for States (to be paid to states to meet the shortfall in indirect tax revenue below a specified threshold, due to the introduction of GST) ending in June 2022. Going ahead, the compensation cess will be used for servicing debt that the Centre took on behalf of the States during the Covid-19 pandemic. For FY24, market loans worth ₹78,100 crore are due for redemption.

The report said the way forward to increase the devolution to States is to bring the cess and surcharges collections under a divisible pool, given that these are legitimate revenues and States do not have these additional levers. “By this inclusion, States will get a bigger pie of devolution from the Centre’s net proceeds to meet their expenditure commitments,” the report added.