Cess and surcharge continue to shrink States’ tax share

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Context : Rise in Cesses and Surcharges:

Impact on Divisible Pool: The share of cesses and surcharges, which are not part of the divisible pool, has been consistently rising since 2020-21. In 2021-22, it reached a high of ₹13.5 for every ₹100 collected by the Centre. Although this ratio is expected to reduce to ₹10.97 in 2025-26, it still represents a significant share of tax collections.

Relevance:GS 2(Governance)

Non-inclusion in Divisible Pool: Cesses and surcharges, along with the cost of collection, do not contribute to the divisible pool that is shared with the States. This means the actual share of States from the Union’s tax collection has been reduced.

Since the pandemic year, the divisible pool has fallen to less than ₹90 for every ₹100 collected by the Centre. Historically, the share of the divisible pool was between ₹91 and ₹95 per ₹100. This reduction implies that States are receiving a smaller portion of the tax revenue, undermining their financial autonomy.
The Finance Commission’s recommendation of a 41% share for States (for FY21-26) reflects this shrinking pool, compared to the 42% share between FY16-20. Prior to FY16, States received only 32%.

Southern States’ Declining Share: The share of southern States in the divisible pool has decreased over time. For instance, Kerala’s share dropped from 3.08% in FY02 to an estimated 1.9% by FY26. Tamil Nadu’s share has remained stagnant at 4.02%, while Karnataka’s share is expected to fall to 3.6%.
Growth of Northern and Western States: In contrast, States like Uttar Pradesh, Bihar, and Madhya Pradesh have seen an increase in their share. For instance, Uttar Pradesh’s share is projected to be 17.9% in FY26, though slightly down from 19.15% in FY02. Bihar, too, remains a major beneficiary, with an expected share of 10.1%.

Misuse and Underutilization: Cesses, which are meant to be earmarked for specific purposes (like the oil industry development body for the crude oil cess), are not always used appropriately.
Reports by the Comptroller and Auditor General (CAG) highlight that significant amounts (₹2.19 lakh crore) in cesses between FY20-22 were not transferred to the designated reserve funds or adequately utilized.

The GST compensation cess, meant to compensate States for revenue losses due to the Goods and Services Tax (GST), is also not included in the cesses that impact the divisible pool. This is a unique situation since the cess was introduced to ensure revenue neutrality for States post-GST implementation.

The formula used to calculate the share of States in the divisible pool takes into account various factors like income distance, population, and tax efficiency. However, there are concerns regarding the political bias in the way this formula is applied, with some States feeling that their development and fiscal progress are not adequately reflected.

Revising the Finance Commission Formula: There’s a growing demand from few states to increase their share of the divisible pool to 50% from the current 41%. This is seen as necessary to ensure that financial resources are more equitably distributed, particularly among States that have made significant progress in socio-economic development.

Cess Utilization and Transparency: A stricter mechanism is needed to ensure that the funds collected through cesses are fully utilized for their intended purposes. This would prevent leakage and enhance the effectiveness of these funds in promoting sector-specific development.
Fiscal Reforms: The Union government needs to explore fiscal reforms that would provide States with more financial autonomy while ensuring that the fiscal health of the Union government is not compromised. This could include increasing the proportion of taxes in the divisible pool and reducing the reliance on cesses and surcharges.