Vertical Fiscal Imbalance

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Context:

The financial relationship between the Union government and the States in India is asymmetrical, leading to Vertical Fiscal Imbalance.

Vertical Fiscal Imbalance in India

State’s dependency

The ability of the States to incur expenditures is dependent on transfers from the Union government.

Constitutional Division:

• Union collects major taxes, States handle significant spending.
• As per the 15th Finance Commission, States incur 61% of the revenue expenditure but collect only 38% of the revenue receipts.
• Consequently, there is the problem of Vertical Fiscal Imbalance (VFI) in Indian fiscal federalism due to high expenditure by states.

Growing Imbalance:

VFI has increased, especially during crises like COVID-19 where fund requirement was higher and revenue collection was low.

Fiscal imbalance

Fiscal imbalance occurs when a government's future income streams don't match its future debt obligations

Types of Fiscal Imbalances

Horizontal Fiscal Imbalance

• A horizontal fiscal imbalance describes a situation in which revenues do not match expenditures for different regions of the country.
• This type of imbalance is often used to justify payments to a state or province from the federal government to offset monetary imbalances between different parts of the country.
• For example special grants to scheduled areas under article 275(a) and to some north eastern states.

Vertical Fiscal Imbalance

• A vertical fiscal imbalance describes a situation in which revenues do not match expenditures for different levels of government.
• For example, Funding municipalities by collection from local property or other taxes only can create a vertical imbalance unless the state also contributes to the funding.

How to calculate VFI?

VFI in India is calculated after the devolution of taxes to the States.

Calculate the Ratio:

• Numerator: Sum of Own Revenue Receipts (ORR) and tax devolution from the Union government for all States.
• Denominator: Own Revenue Expenditure (ORE) for all States. Compute the ratio: Ratio = ORR + Tax Devolution/ORE
• Determine the Deficit: If the ratio is less than 1, subtract it from 1 to find the deficit: Deficit=1−Ratio
• VFI Calculation: The deficit obtained is used as a proxy for VFI after devolution.

Significance

• VFI leads to reduced fiscal capabilities in different levels and arms of government,
• A vertical fiscal imbalance is a structural issue that can be resolved if revenue and expenditure responsibilities are reassigned.
• Reducing VFI will lead to a fairer and more cooperative fiscal system.

Fiscal Imbalance and Fiscal Deficit difference:

Fiscal imbalances and fiscal deficits are two different concepts.  

Fiscal Imbalance	Fiscal Deficit
A fiscal imbalance occurs when future debts aren't balanced with future revenue streams.	It is the shortfall in a country's revenue stream compared to its spending.
It is due to debt-revenue mismatches.	A country runs a fiscal deficit if it spends more money than it earns.
It includes national debts.	Fiscal deficits don't include a nation's debts.

Constitutional Provisions for Fiscal Federalism ●Seventh Schedule: Taxation powers are divided between the Union and States listing them in the Union List and the State List respectively under Article 246. ●Revenue sharing: Taxes levied and collected by the centre, but wholly assigned to the states-Article 269. Collection and levy of Goods and Services Tax in the course of Inter-State Trade or Commerce- Article 269-A. ■This is distributed to between both Centre and States based on recommendations of the GST council. Taxes levied and collected by the union and distributed between the union and the states- Article 270. ■This is bashed on the recommendation of the Union Finance Commission. ●Grants-in-Aid: Centre provides grants-in-aid to states under Article 275. ●Burrowing powers: The union government has powers to borrow money from both within or outside the country - Article 292 ●Under Article 293, a state government can borrow within India only and not from abroad). ●Finance Commission under article 280 recommends sharing of tax revenue between Union and States.

Conclusion

Increasing States' share of tax revenues is crucial to address VFI. More untied funds for States improve spending effectiveness and responsiveness reducing VFI leading to a fairer and more cooperative fiscal system.

Important articles for reference:

https://www.iasgyan.in/daily-current-affairs/fiscal-federalism

https://www.iasgyan.in/daily-current-affairs/fiscal-devolution-among-states

Sources:

https://epaper.thehindu.com/ccidist-ws/th/th_international/issues/98325/OPS/GPED9V021.1.png?cropFromPage=true

https://www.investopedia.com/terms/f/fiscalimbalance.asp

PRACTICE QUESTION Q. Due to the asymmetrical financial relationship between the Union government and the States in India, there is a rising trend of vertical fiscal imbalance in India. What are its implications for fiscal federalism in India and how should India tackle such a challenge. Discuss. ( 250 words)