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The Finance Commission recommends the share of states in the divisible pool of central tax revenue. The 14th Finance Commission (2015-20) increased this share from 32% to 42%. The 15th Finance Commission was constituted in November 2017 to give recommendations for the period 2020-25.3 In October 2019, the 15th Finance Commission’s period was extended by one year to also include the financial year 2025-26.4 With 2019-20 being the last year of the 14th Finance Commission period, the Terms of Reference of the 15th Finance Commission and its recommendations will direct a major share of states’ revenue (35% average in 2015-20) during the six-year period 2020-26.

Defence and internal security: The 15th Finance Commission’s Terms of Reference were amended in July 2019 to require it to examine whether a separate funding mechanism for defence and internal security should be set up, and if so, how it could be operationalised. In 2019-20, the central government has estimated an expenditure of Rs 4,31,011 crore on defence and Rs 80,599 crore on internal security (central armed police forces, intelligence bureau, and border infrastructure). This amounts to an expenditure of Rs 5,11,610 crore in 2019-20 on defence and internal security, i.e., 18% of the central government’s budget.

If the 15th Finance Commission recommends a mechanism which involves setting aside funds for this purpose from the divisible pool, it would affect the devolution receipts of states in the future. For instance, if the 14th Finance Commission had recommended the funding of this entire expenditure out of the divisible pool, devolution to states would have been lower by 7% of their 2019-20 revenue. Note that the 15th Finance Commission has not yet made any recommendation in this regard.

Cess and surcharge: The 15th Finance Commission’s Terms of Reference require it to recommend the share of centre and states in the divisible pool, which is made up of net proceeds of taxes required to be, or which may be, divided between them as per the Constitution. Article 270 of the Constitution specifies the taxes which form the divisible pool. It does not include any cess or surcharge levied by the central government. Therefore, the central government is not required to share with states the revenue it gets from cesses and surcharges.

RBI (2019) observed that the share of revenue from cess and surcharge in the central government’s gross tax revenue has increased from 2.3% in 1980-81 to 15% in 2019-20.5 This implies that of the total tax revenue that the central government collects, the part that is not required to be shared with states has increased over the years. As a result, only 85% of the central government’s gross tax revenue in 2019-20 could form the divisible pool. This implies that states’ 42% share in the divisible pool, as recommended by the 14th Finance Commission, effectively comes down to 35.7% of centre’s tax receipts in 2019-20 (for calculating the effective share, we exclude GST components from tax revenue such as integrated GST and compensation cess).

The central government has estimated Rs 3,69,111 crore revenue through cesses and surcharges in 2019-20. If this tax revenue collected by the central government was a part of the divisible pool, it would have increased the devolution receipts of states. On average, states would have received an additional revenue equivalent to 5% of their 2019-20 revenue, if this cess and surcharge revenue was in the divisible pool. Figure 4 shows the state-wise increase as a percentage of their 2019-20 revenue.

14th Finance Commission period (2015-16 to 2019-20) Revenue receipts of states comprises revenue from own sources, and transfers from the centre. During the 2015-20 period, 53% of revenue receipts of states has come from own sources, and 47% from central transfers.