VERTICAL FISCAL IMBALANCE (Syllabus: GS Paper 2 – Polity)

Context: The 16th Finance Commission is tasked with addressing vertical fiscal imbalances in federal relations, particularly when revenue is concentrated with the Union government while states bear significant expenditure responsibilities.

Vertical Fiscal Imbalance (VFI)

• Fiscal Imbalance Definition: It refers to a situation where a government's future debt obligations do not align with its future income streams. This misalignment can lead to increased tax burdens and reduced household consumption both now and in the future.

Types of Fiscal Imbalances: 

• Vertical Fiscal Imbalance: This situation arises when there is a mismatch between revenues and expenditures at different levels of government (e.g., federal vs. state). 

o It is a structural issue that can be corrected by reassessing and redistributing revenue and expenditure responsibilities.

• Horizontal Fiscal Imbalance: This occurs when revenue does not match expenditures across different regions of a country (between states). 

o To address this, equalization transfers or payments from the federal government to various states or provinces may be implemented to balance out monetary discrepancies.

Constitutional Allocation of Financial Duties

• Rising VFI in India: The 15th Finance Commission observed that India experiences a larger and increasing VFI compared to other federations, exacerbated during crises such as the COVID-19 pandemic.
• Distribution of Taxes and Grants: The Finance Commission addresses VFI by distributing Union taxes to States and recommending grants for specific needs. 

Calculating VFI in India

• Methodology: VFI is measured by comparing the ratio of total Own Revenue Receipts and tax devolution to Own Revenue Expenditure. A ratio less than 1 indicates inadequate receipts to cover expenditures, and the deficit in this ratio serves as a proxy for VFI.
• Needed Increase in Tax Devolution: To eliminate VFI, tax devolution should be increased to ensure the ratio equals 1. 
• Between 2015-16 and 2022-23, the average required devolution was 48.94%, while the actual devolution was only 42% and 41% according to the 14th and 15th Finance Commissions, respectively.