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Centre-State FinancialRelations in India

1870 to 2010

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0)LJLc

A Comprehensive Introduction on Centre-State Financial Relations inIndia during the Pre- and Post-Independence Periods with Summaryand Commentary on each of the Reports of the Finance Commissions

from First Finance Commission to Twelfth Finance Commission

M.M. Sury

/ \ INDIAN TAX FOUNDATION/ l C F \ New Delhi, India

NEW

NCCENTURY

in association with

New Century PublicationsNew Delhi, India

Contents

Preface viii-xi

1. Centre-State Financial Relations: Theoretical Framework 1-111.1 Federal Polity: Meaning and Essential Features

1.1.1 Dual Government1.1.2 Distribution of Powers1.1.3 Supremacy of the Constitution1.1.4 Authority of Courts1.1.5 Doctrine of Harmonious Construction1.1.6 Doctrine of Pith and Substance1.1.7 Rule of Repugnancy

1.2 Economic Basis of Decentralisation1.3 Advantages of Decentralised Decision-making

1.3.1 Tiebout Hypothesis1.4 Problems of Multi-level Finance: Vertical and Horizontal

Fiscal Imbalances1.5 Financing Pattern

1.5.1 Taxes1.5.2 Transfers1.5.3 Borrowings

1.6 Earmarking of Revenue1.6.1 Conditions for Successful Earmarking

1.7 Nature of Indian Federation

2. Pre-Independence Developments and Post-PartitionFinancial Adjustments 12-302.1 Mayo Scheme, 18702.2 Government of India Act, 1919

2.2.1 Meston Settlement, 19202.3 Indian Taxation Enquiry Committee, 1924-252.4 Indian Statutory Commission, 19302.5 Peel Committee I, 19312.6 Percy Committee, 19322.7 Peel Committee II, 19322.8 White Paper on Indian Constitutional Reforms, 19312.9 Joint Parliamentary Committee on Indian Constitutional

Reforms, 1934

Contents xiii

2.10 Government of India Act, 19352.10.1 Indian Financial Enquiry Report, 1936

2.11 Financial Adjustments after the Partition: Deshmukh Award2.11.1 Income Tax2.11.2 Grants-in-aid in Lieu of Jute Export Duty

2.12 Expert Committee on Financial Provisions of the Constitution, 19472.13 Financial Integration of Princely States2.14 Indian States Finances Enquiry Committee, 1948

3. Financial Relations under the Constitution and the Rolesof Planning Commission and Finance Commission 31-663.1 India: A Federal Polity3.2 Centrally Biased Constitution and its Justification

3.2.1 Supremacy of Union Legislative Power3.2.2 Union Control over State Legislation3.2.3 Emergency Provisions3.2.4 Restrictions on Taxation Powers of the States3.2.5 Restrictions on Borrowing Powers of the States3.2.6 President's Rule

3.3 Constitutional Provisions Pertaining to Taxes3.3.1 Distribution of Taxation Powers3.3.2 Restrictions on the Taxation Powers of the States3.3.3 Rationale for Constitutional Arrangements3.3.4 Sharing of Central Taxes3.3.5 Philosophy of Articles 268 and 2693.3.6 Taxes and Duties in the Union List not being Levied at Present3.3.7 Freedom as to Payment of Taxes for Promotion of any

Particular Religion3.4 Centralisation of Revenues and the Need for Transfers3.5 Mechanism of Central Transfers to the States3.6 Transfer of Resources through the Finance Commission

3.6.1 Finance Commission3.6.2 From Itemised Sharing to Global Sharing

3.7 Economic Planning in India3.7.1 Establishment of the Planning Commission3.7.2 Establishment of National Development Council3.7.3 Objectives of Economic Planning in India3.7.4 Financing of the Plan

3.8 Transfer of Resources through the Planning Commission

xiv Centre-State Financial Relations in India: 1870 to 2010

3.8.1 Gadgil Formula3.8.2 Nature of Plan Transfers

3.9 Centrally Sponsored Schemes3.10 Size and Pattern of Central Transfers3.11 Commission on Centre-State Relations, 1988

4. Trends in Combined (Centre and States) Tax Revenues 67-724.1 Trends in Tax-GDP Ratio4.2 Trends in the Relative Significance of Direct and Indirect Taxes

4.2.1 Reversal of Roles4.2.2 Equity Implications

5. Trends in Central Taxes 73-785.1 Central Taxes as Per Cent of GDP5.2 Direct and Indirect Taxes5.3 Composition of Direct Taxes

5.3.1 Income Tax5.3.2 Wealth Tax

5.4 Composition of Indirect Taxes5.4.1 Union Excise Duties5.4.2 Service Tax5.4.3 Customs Duties

6. Trends in State Taxes 79-866.1 State Taxes as Per Cent of GDP6.2 Direct and Indirect Taxes

6.2.1 Composition of Direct Taxes6.2.2 Composition of Indirect Taxes

6.3 Local Finance

7. Sales Tax and State Level VAT 87-1127.1 Different Forms of Sales Tax

7.1.1 Multi-point Sales Tax7.1.2 Single-point Sales Tax

7.2 Pre-Constitution Developments7.2.1 Initial Legal Hurdles7.2.2 Beggar-my-neighbour Policies

7.3 Constitution of India and the Provisions for the Regulation ofTaxation of Inter-State Sales7.3.1 Consequences of Constitutional Restrictions on Sales Tax

Contents xv

7.3.2 Essential Goods Act, 19527.4 Constitution (Sixth Amendment) Act, 19567.5 Central Sales Tax (CST) Act, 1956

7.5.1 Main Provisions of CST Act7.5.2 Working of CST Act

7.6 Additional Duties of Excise (Goods of Special Importance)Act, 1957

7.7 Constitution (Forty-sixth Amendment) Act, 1982 andConsignment Tax7.7.1 Issues Related to Consignment Tax

7.8 Present Nature of Sales Tax7.9 Problems Created by Sales Tax7.10 Alternative Remedies

7.10.1 Sales Tax as Central Levy7.10.2 Complete Substitution of Sales Tax by Excise Duty7.10.3 Partial Substitution of Sales Tax by Excise Duty7.10.4 Minimum Rate Agreement among States7.10.5 Single-Point VAT7.10.6 Agreement of November 19997.10.7 Empowered Committee of State Finance Ministers, 20017.10.8 Agreement of January 23,20027.10.9 Task Force on Indirect Taxes, 20027.10.10 Agreement of June 20047.10.11 Salient Features of the State-level VAT Design7.10.12 Progress of VAT Implementation7.10.13 Towards National Goods and Services Tax (GST)

8. Taxation of Agricultural Income 113-1218.1 Constitutional Provisions8.2 Committee on Taxation of Agricultural Wealth and Income, 1972

8.2.1 Views of the State Governments8.3 Tax Reforms Committee, 19918.4 Task Force on Direct Taxes, 2002

8.4.1 Critical Comments

9. Sharing of Revenue from Certain Central Taxes:Arrangements Prior to the Recommendations of theEleventh Finance Commission 122-1399.1 Sharing of Income Tax Revenue

xvi Centre-State Financial Relations in India: 1870 to 2010

9.1.1 Determination of the Share of States9.1.2 Distribution of the Share of States Inter Se9.1.3 Controversies over Distribution of Income Tax Revenue

9.2 Sharing of Excise Revenue9.2.1 Nature of Revenue Sharing9.2.2 Determination of the Share of States9.2.3 Distribution of the Share of States Inter Se9.2.4 Varying Emphasis on Criteria Adopted9.2.5 Areas of Controversy

10. Constitution (Eightieth Amendment) Act, 2000 and theSharing of Revenue from All Central Taxes 140-14710.1 History of Constitution (Eightieth Amendment) Act, 200010.2 The Constitution (Eightieth Amendment) Act, 200010.3 Eleventh Finance Commission: New Tasks

10.3.1 Impact of Constitution (Eightieth Amendment) Act, 200010.3.2 Impact of Seventy-third and Seventy-fourth Amendments

to the Constitution10.3.3 Share of States

10.4 Share of States Determined by Twelfth Finance Commission

11. Additional Duties of Excise in Lieu of Sales Tax 148-15611.1 Rationale of the Scheme11.2 Views of the State Governments11.3 Decisions of the National Development Council11.4 Role of the Finance Commission

11.4.1 Guaranteed Amount11.4.2 Procedure for Guaranteed Amount11.4.3 Basis of Distribution

11.5 Expert Committee on Replacement of Sales Tax byAdditional Excise Duty, 1983

11.6 Present Position

12. Grant in Lieu of Railway Passenger Fares Tax 157-16012.1 History of Railway Passenger Fares Tax12.2 Recommendations of Successive Finance Commissions12.3 Constitution (Eightieth Amendment) Act, 2000 and

Changes in Article 269

13. Grants-in-aid of Revenues 161-16513.1 Principles of Grants-in-aid of Revenues

Contents xvii

13.1.1 Budgetary Needs13.1.2 Tax Effort13.1.3 Economy in Expenditure13.1.4 Standard of Social Services13.1.5 Special Obligations13.1.6 Broad Purposes of National Importance

13.2 Approach of Various Finance Commissions

14. State-Local Financial Relations in India 166-18214.1 Functions of Local Bodies

14.1.1 Essential Civic Functions14.1.2 Regulatory Functions14.1.3 Agency Functions

14.2 Financing of Local Bodies14.3 Constitutional Provisions14.4 Decentralisation Initiative, 199214.5 Constitution (Seventy-fourth Amendment) Act, 1992

14.5.1 Salient Features14.5.2 New Status of Municipalities14.5.3 Desirability and Feasibility of Uniformity in

Municipal Functions14.5.4 Role of State Finance Commissions

14.6 Municipal Commercial Borrowings14.6.1 Rationale for Municipal Commercial Borrowings14.6.2 Limitations14.6.3 Factors Determining Success of Municipal Bonds

14.7 Privatisation of Municipal Services14.8 Tenth Finance Commission on Local Bodies14.9 Eleventh Finance Commission on Local Bodies14.10 Twelfth Finance Commission on Local Bodies

15. First Finance Commission 183-19615.1 Financial Assistance to States: Approach of the Commission15.2 Distribution of Income Tax

15.2.1 Determination of the Share of States15.2.2 Distribution of the Share of States Inter Se

15.3 Division of Union Excises15.3.1 Determination of the Share of States15.3.2 Distribution of the Share of States Inter Se

xviii Centre-State Financial Relations in India: 1870 to 2010

15.4 Grants-in-aid in Lieu of Export Duty on Jute15.5 Grants-in-aid of Revenues15.6 Permanent Secretariat for the Finance Commission

16. Second Finance Commission 197-21316.1 Distribution of Income Tax16.2 Division of Union Excises16.3 Grants-in-aid in Lieu of Export Duty on Jute16.4 Grants-in-aid of Revenues16.5 Distribution of Estate Duty16.6 Union Loans to States

16.6.1 Loans for Rehabilitation of Displaced Persons16.6.2 Interest-free Loans

16.7 Distribution of Additional Duties of Excise16.8 Distribution of Tax on Railway Passenger Fares16.9 Miscellaneous

17. Third Finance Commission 214-22917.1 Determination of the Budgetary Needs of the States17.2 Distribution of Assigned Taxes

17.2.1 Estate Duty17.2.2 Grant in Lieu of Tax on Railway Passenger Fares

17.3 Devolution of Union Taxes/Duties17.3.1 Income Tax17.3.2 Union Excise Duties

17.4 Distribution of Additional Duties of Excise17.5 Grants-in-aid of Revenues17.6 Finance Commission versus Planning Commission

18. Fourth Finance Commission 230-25118.1 Views of the Commission on Taxation Provisions

in the Constitution18.2 Plan versus Non-Plan Expenditure18.3 Estate Duty18.4 Grant in Lieu of Tax on Railway Passenger Fares18.5 Income Tax18.6 Union Excise Duties18.7 Additional Duties of Excise in Lieu of Sales Tax18.8 Principles Governing Grants-in-aid of Revenues

Contents xix

19. Fifth Finance Commission 252-26719.1 Income Tax19.2 Union Excise Duties19.3 Additional Duties of Excise in Lieu of Sales Tax19.4 Grants-in-aid of Revenues under Article 275 of the Constitution19.5 Taxes and Duties under Article 269 of the Constitution

19.5.1 Duties in Respect of Succession to Propertyother than Agricultural Land

19.5.2 Terminal Taxes on Goods or Passengers Carried byRailway, Sea or Air

19.5.3 Taxes on Railway Fares and Freights19.5.4 Taxes other than Stamp Duties on Transactions in

Stock Exchanges and Future Markets19.5.5 Taxes on the Sale or Purchase of Newspapers

and on Advertisements Published Therein

20. Sixth Finance Commission 268-28820.1 Income Tax20.2 Union Excise Duties20.3 Additional Duties of Excise20.4 Grant in Lieu of Tax on Railway Passenger Fares20.5 Estate Duty20.6 Grant on Account of Wealth Tax on Agricultural Property20.7 Financing of Relief Expenditure20.8 Grants-in-aid of Revenues20.9 Rescheduling of Central Loans

21. Seventh Finance Commission 289-30521.1 Financing of Relief Expenditure21.2 Estate Duty21.3 Additional Duties of Excise21.4 Grant in Lieu of Tax on Railway Passenger Fares21.5 Grant on Account of Wealth Tax on Agricultural Property21.6 Sharing of Income Tax21.7 Sharing of Union Excise Duties21.8 Upgradation of Standards of Administration21.9 Non-Plan Capital Gap of States

22. Eighth Finance Commission 306-32222.1 Approach of the Commission on Financial Transfers

xx Centre-State Financial Relations in India: 1870 to 2010

22.2 Reassessment of the Revenue and Expenditure Forecasts22.3 Sharing of Income Tax Revenue22.4 Sharing of Union Excise Duties22.5 Additional Duties of Excise22.6 Estate Duty in Respect of Property other than Agricultural Land22.7 Grant in Lieu of Tax on Railway Passenger Fares22.8 Grant on Account of Wealth Tax on Agricultural Property22.9 Financing of Relief Expenditure22.10 Upgradation of Standards of Administration22.11 Grants-in-aid of Revenues22.12 Non-Plan Capital Gap of the States22.13 Taxes and Duties Mentioned in Articles 268 and 269

of the Constitution22.14 General Observations

23. Ninth Finance Commission 323-34923.1 Normative Approach23.2 Alternative Terms of Reference23.3 First Report (for the year 1989-90)

23.3.1 Sharing of Income Tax23.3.2 Sharing of Union Excise Duties23.3.3 Additional Duties of Excise in Lieu of Sales Tax23.3.4 Grant in Lieu of Tax on Railway Passenger Fares23.3.5 Financing of Relief Expenditure23.3.6 Special Problems of Debt Relief23.3.7 Grants-in-aid of Revenues

23.4 Second Report (for the years 1990-91 to 1994-95)23.4.1 Sharing of Income Tax23.4.2 Distribution of Additional Excise Duties in

Lieu of Sales Tax23.4.3 Grant in Lieu of Tax on Railway Passenger Fares23.4.4 Union Excise Duties23.4.5 Financing of Relief Expenditure23.4.6 Grants-in-aid of Revenues23.4.7 Debt Relief

24. Tenth Finance Commission 350-36524.1 Alternative Formula of Devolution24.2 Sharing of Income tax

Contents xxi

24.3 Sharing of Union Excise Duties24.4 Distribution of Divisible Amounts24.5 Distribution of Additional Duties of Excise24.6 Grants in Lieu of Tax on Railway Passenger Fares24.7 Upgradation Grants24.8 Financing of Relief Expenditure24.9 Grants for Local Bodies24.10 Grants-in-aid of Revenues24.11 Debt Relief24.12 National Security

25. Eleventh Finance Commission 366-38425.1 Devolution of Central Taxes/Duties to the States

25.1.1 Share of States25.1.2 Distribution of the Share of States Inter Se

25.2 Grants-in-aid of Revenues of States25.2.1 Grants-in-aid to Cover Non-Plan Gap on

Revenue Account25.2.2 Grants-in-aid for Upgradation of Standards of

Administration and Special Problems of States25.2.3 Grants to States for Financing Local Bodies

25.3 Financing of Calamity Relief Expenditure25.3.1 National Calamity Contingency Fund

25.4 Debt Relief to States25.5 Ceiling on Total Revenue Account Transfers

26. Twelfth Finance Commission 385-39926.1 Sharing of Union Tax Revenues

26.1.1 Vertical Sharing26.1.2 Horizontal Sharing

26.2 Local Bodies26.3 Calamity Relief26.4 Grants-in-aid to States26.5 Debt Relief and Corrective Measures26.6 Restructuring Public Finances26.7 Permanent Secretariat for the Finance Commission

27. Issues in Centre-State Financial Relations 400-42027.1 Centralisation of Revenues and Certain State Functions

27.1.1 Centralisation of Revenues

XXII Centre-State Financial Relations in India: 1870 to 2010

27.1.2 Centralisation of Certain State Functions27.2 Inter-regional Inequalities and Transfers27.3 Public Borrowings and Indebtedness of States

27.3.1 Instruments of Government Borrowings27.3.2 Constitutional Provisions Pertaining to

Public Borrowings27.3.3 Indebtedness of States

27.4 Taxation of Services27.4.1 Constitutional Provisions

27.5 Constitution (Forty-sixth Amendment) Act, 1982 and theConsignment Tax

27.6 Financial Autonomy for States27.7 Towards Co-operative Federalism

AppendicesAppendix 1: Pre-Independence History of Income Tax in IndiaAppendix 2: Pre-Independence History of Excise Duties in IndiaAppendix 3: Indian Taxation Enquiry Committee, 1924-25Appendix 4: Committee on Sales Tax, 1964Appendix 5: Committee on Taxation of Agricultural Income and

Wealth, 1972Appendix 6: Committee on Replacement of Sales Tax on

Vanaspati, Drugs and Medicines, Cement, Paperand Paper Board and Petroleum Products byAdditional Excise Duty, 1983

Appendix 7: White Paper on State-Level Value Added Tax, 2005Appendix 8: Thirteenth Finance Commission

Glossary of Fiscal Terms

Time-series Public Finance Data on IndiaTable 1 Combined Tax Revenue, Breakdown between Direct

and Indirect Taxes with Percentage Shares, and Tax-GDP Ratios: 1950-51 to 2006-07

Table 2 Gross Central Taxes, Breakdown between Direct andIndirect Taxes with Percentage Shares, and Tax-GDPRatios: 1950-51 to 2006-07

Table 3 Share of States in Central Taxes, Breakdown betweenDirect and Indirect Taxes with Percentage Shares, andTax-GDP Ratios: 1950-51 to 2006-07

421-427428-432433-455456-482

483-495

496-507508-520521-524

525-548

549-584