Southern states urge 16th FC to address cess and surcharge impact

As the 16th Finance Commission, headed by Arvind Panagariya, takes feedback from stakeholders, some states have complained to it that the Centre is increasingly taking recourse to cess and surcharge to circumvent its recommendations on tax devolution. Southern states have again raised the issue of giving more weight to the criterion of population control in deciding the transfer of central taxes to the states or else revert the population yardstick to the 1971 Census against the 2011 one considered by the 15th Finance Commission.

 

The southern states also wanted to reduce the weight given to the income distance criterion and, instead, consider the contribution of states to the national economy as one of the yardsticks.

 

Finance commissions use different yardsticks to recommend transfer of funds from the Centre to the states. These generally are income distance, population, area, etc. A few commissions considered additional criteria, such as demographic change, population control, tax efforts, fiscal discipline, forest cover, and index of infrastructure.

 

The 16th Finance Commission would give its recommendation for the five-year period from 2026-27 to 2030-31. 

 

Divided over divisible pool

 

Tamil Nadu Chief Minister M K Stalin says the commission should devolve at least 50 per cent, if not more, of the divisible pool to states. Karnataka Chief Minister Siddaramaiah supports this line of thinking.

 

The divisible pool consists of all Central taxes — income tax, customs duty, excise duty, and goods and services tax — but does not include cess and surcharge.

 

Tamil Nadu’s representation flagged this issue, saying cess and surcharges, which constitute 16.83 per cent of the Centre's gross tax revenue (GTR), were not shared with states, diminishing their "rightful" share. The state suggested a mechanism to curb the indiscriminate levy of cess and surcharges, with a recommended cap of 10 per cent of the Centre’s GTR.

 

“Any excess collections should be merged into the divisible pool,” Stalin suggested. 

 

Increasing use of cess and surcharge by the Union government reduces the divisible pool and therefore the transfer of funds to states, according to the representation.

 

As can be seen from the chart, devolution of Central taxes never met the finance commissions’ recommendations in the last 15 years and the gap has widened.

 

Similarly, Siddaramaiah told the 16th Finance Commission team that cess and surcharges were not part of the divisible pool. “Over the years, the Union government has increased its reliance on cesses and surcharges. This has led to the divisible pool not growing in the same proportion as the gross tax revenue. This has caused substantial loss to all the states,” he said.

 

The Chief Minister said the loss to Karnataka on account of the non-sharing of cess and surcharge from the divisible pool is Rs 53,359 crore during the period 2017-18 to 2024-25. He wants the cess and surcharge to be capped at 5 per cent of GTR above which they should be made part of the divisible pool.

 

The Tamil Nadu and Karnataka representations said the commission should recommend including all non-tax revenues in the divisible pool of taxes through a Constitutional amendment.

 

As an alternative, Tamil Nadu suggested an increase in the states' share of the divisible pool. 

 

Dramatic rise 

 

Govinda Rao, member of the 14th commission, says the proportion of cess and surcharge has risen dramatically in the last 10 years. “That is why the states ask for reducing cess and surcharge, or giving more devolution to them,” he says.

 

Cess and surcharge are about vertical devolution — transfer of funds from the Centre to states. Then comes horizontal devolution — transfer of funds among states within the overall recommendation by the commission.

 

Tamil Nadu says its share has declined significantly. As can be seen from the charts, its share has declined from 5.3 per cent during the period of the 12th Finance Commission — 2004-05 to 2009-10 — to 4.08 per cent during the period between 2021-22 and 2024-25, the period of the 15th Finance Commission (Report 2).

 

The state wants the 16th commission to reduce the weight given to income distance criterion, which measures how much a particular state is behind the top state on per capita income. The poor state gets more devolution.

 

Weighting given to this criterion has come down to 45 per cent during the period of the 15th Finance Commission (Report 2) — 2021-22 to 2025-26 —from 60 per cent in the 10th Finance Commission period.   

 

Four states and Union territories had higher per capita income than Tamil Nadu's out of the total 25 for which data is available for 2023-24. The state's representation says the commission should reduce the weight given to income distance. Alternatively, it wants the income distance to be adjusted to purchasing power parity (PPP) basis. PPP measures incomes by adjusting to price level differences between the states.

 

Karnataka’s representation wants the commission to strike a balance between equity and efficiency. It recommends that 60 per cent of the contribution of a state to the divisible pool should be given to that state.

 

Sunil Kumar Sinha, professor of economics at the Chandigarh-based Institute of Development and Communication, says the commission needs to redistribute income in favour of the laggard states as well as incentivise those which have performed well.

 

Southern say they have performed well on the parameters which are of concern to the entire nation, such as education, health, and population control, but they are being penalised for that success. Sinha says parameters such as distance from income and population need to be there to help those left behind, but they need to be expanded in a way that gives a boost to states that have worked well on economic and social indicators.

 

The demand for 50 per cent devolution is not new. It creeps cropping up from the states, depending on who is in power. Rao points out that Prime Minister Narendra Modi, when he was the chief minister of Gujarat, raised the same demand to the 14th Finance Commission.

 

It is for the commission to accept or reject these demands.