Devolution to states: Cess, surcharge help Centre keep major chunk of taxes

Among a few tweaks to surcharges, Sitharaman announced the Centre would reduce the highest surcharge levied under personal income tax from 37 per cent to 25 per cent under the new tax regime

The Union government is projected to share a little over 30 per cent of Central taxes with states during fiscal year 2023-24 (FY24), against the 15th Finance Commission’s recommendation of 41 per cent.

The 14th Finance Commission had recommended the 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.

The states’ share, however, has never been close to 41 per cent due to cess and surcharge imposed by the Centre. According to Finance Commission recommendations, cess and surcharge, which form a part of Central taxes, don't have to be shared with states. 

In fact, states’ share would come down to 30.39 per cent in the coming fiscal year against 31.17 per cent in the current year. This is partly due to the almost Rs 31 crore transferred to states for past adjustments in FY23.

However, even after excluding past adjustments, states’ share in Central taxes stood at 31.16 per cent in FY23.

As such, even as states complain of the Centre resorting to cess and surcharge to sidestep the Commission’s recommendations, their share will come down slightly in FY24 compared to FY23.

In fact, states’ share was a bit higher at 33.16 per cent in FY22.

Among a few tweaks to surcharges, Finance Minister Nirmala Sitharaman announced the Centre would reduce the highest surcharge levied under personal income tax from 37 per cent to 25 per cent under the new tax regime. This would cut the maximum tax rate to 39 per cent. Besides, there were changes to surcharges and cess for some items including toys, bicycles, automobiles, and naphtha imports.

“Historically, there has always been a gap between the amount recommended by the Finance Commission and the amount actually remitted by the Centre to the states, and the gap emerges due to surcharge and cess,” said Abhishek Rastogi, founder, Rastogi Chambers.

The other reason for devolution coming down in FY24 could be the compensation for states that ended in June 2022. It was paid to states making losses due to the introduction of the goods and services tax (GST). The compensation cess imposed would be used for servicing debt that the Centre took on behalf of the states. The debt allowed the Centre to transfer money to states after Covid-induced lockdowns hit their GST revenues.

The compensation cess is pegged at Rs 1.30 trillion for FY24 against Rs 1.45 trillion in the Revised Estimates for FY23.

The states were considered to have incurred losses under GST if they did not record 14 per cent growth in GST revenues compared to the pre-GST regime on the items subsumed into the new indirect tax. The base year for the calculation was considered to be FY17.

Besides tax devolution, the Centre transfers other funds to states, too. One of them is for implementing Centrally-sponsored schemes such as MNREGA or Mahatma Gandhi National Rural Employment Guarantee Act. For FY24, the Centre would transfer Rs 4.76 trillion to states for the same — just 5 per cent higher than the Rs 4.51 trillion in the previous year's Revised Estimates (RE). This would constitute 10.57 per cent of the Centre’s total expenditure in FY24, almost the same as 10.79 per cent in the previous year (RE).

However, these transfers were much higher at 11.98 per cent during FY22. This could be due to the weak financial health of states following Covid-induced lockdowns.

However, the states would get higher special assistance from the Centre for their capital expenditure needs. The Centre is projected to transfer Rs 1.30 trillion to states for this in FY24 — 71 per cent higher than Rs 76,000 crore devolved in the current fiscal year (RE).

However, it should be noted that the Centre has revised this transfer down from Rs 1 trillion in the current fiscal year.

While the Rs 1.3-trillion, 50-year loan has to be spent by states within FY24, states get to decide how to spend most of it. About 30-35 per cent is tied to specific purposes like scrapping old government vehicles, financing reform in urban local bodies to make them creditworthy for municipal bonds, etc.

The Centre has kept the borrowing limit of the states at 3.5 per cent of their respective gross state domestic product (GSDP) against 4 per cent in the current fiscal year. While 3 per cent will be unconditional, 0.5 per cent of the GSDP will be linked to power sector reforms.