LAW OF TAXATION

TEAM -I ASSESSMENT

THE ROLE OF DIRECT TAXES IN FISCAL FEDERALISM IN INDIA

SUBMITTED TO:

ASST. PROF. UDAY SIMHA

SUBMITTED BY:

MOHAMED SALMAN ASHIF

(SRN: 03FL23BLL069)

KLE SOCIETY’S LAW COLLEGE, BANGALORE

CA-2, Sir M. Vishweshwaraiah Layout, V Block,
Ullal, Bengaluru – 560091, Karnataka
 HE ROLE OF DIRECT TAXES IN FISCAL
FEDERALISM IN INDIA

ABSTRACT

This comprehensive paper throws lights on the intricate inter-relationship of direct

taxes and fiscal federalism in India with emphasis on resource distribution
between Centre and States. Direct taxes, which include income tax, corporate
tax, and capital gains tax, play a more central role in revenue generation and
fiscal transfer and hold greater inroads into regional development. This discussion
covers the constitutional structure, the role of the Finance Commission,
implications of the Goods and Services Tax, and issues relating to state autonomy
vis-à-vis central oversight. The book ends with recommendations regarding the
reform of direct taxation to strengthen the purpose of achieving fiscal equity and
stability in the economy.

INTRODUCTION

Indian fiscal federalism is beset by a complex play of financial resources operated at the
Centre and those operated by the states. This relationship holds essential importance for
boosting equitable economic development in the diverse regions of the country. As such,
direct taxes significantly contribute to national revenue, which also serves as critical
instruments in fiscal transfers aimed at redressing regional disparities. Understanding the
dynamics of direct taxes in this federal framework will be very valuable to policymakers,
scholars, and citizens.

This article focuses on the direct taxes of the fiscal federalism of India, and during the
discussion, their significance in terms of tax revenues, distribution of funds, and
macroeconomic stability would be covered. We approach the historical background with a
discussion on problems encountered and the prospects in direct taxes within the complex
fiscal structure of India.
TAX INSTRUMENTS AND ASSIGNMENT

Constitutional Framework

The Constitution of India provides the foundational framework for the distribution of
taxing powers between different levels of government. Article 246 delineates legislative
powers concerning taxation, categorizing subjects into three lists in the Seventh Schedule:

Union List: This list empowers the Centre to levy direct taxes, including income tax,
corporate tax, and capital gains tax. These taxes are essential for generating revenue to
fund national development programs and meet various expenditures.

State List: States have limited authority to impose taxes, primarily on agricultural
income and certain professions. This limited scope reflects the Centre's dominant role in
direct taxation and the need for uniformity in revenue collection across states.

Historical Context

The allocation of taxation powers has its roots in India's colonial past, where a
centralized approach was deemed necessary to maintain uniformity and manage regional
disparities. The Constitution was framed with the intent to empower the Centre while
providing states with limited autonomy, ensuring a balance that could adapt to the
diverse needs of the nation. This historical backdrop is essential for understanding the
current dynamics of fiscal federalism in India.

Finance Commission

The Finance Commission, constituted every five years under Article 280 of the Constitution,
plays a crucial role in recommending the distribution of tax revenues between the Centre and
states. Its recommendations have a significant impact on the allocation of financial
resources, ensuring that states receive adequate funding to meet their developmental needs.
Revenue Sharing Criteria

The Finance Commission bases its decision concerning the share of the states through the
divisible pool of taxes on several factors:

Population: This is one of the most prominent factors that reflect the demand for the
resources in response to the number of beneficiaries. States with a larger population have
traditionally had a bigger share in revenues so as to meet the demands of their constituents.

Income Distance: The criterion measures the relative income of states compared to the
average national income. The idea in this approach is to identify the poorer states and
give them more support in order to enhance equity in revenue distribution.

Geographical Area: This criterion addresses the problem of providing services to sparsely
populated or geographically larger states since it ensures that adequate resources are used to
meet the states' administrative costs.

Fiscal Discipline: States that are characterized by effective fiscal management and sound
financial practices can receive favorable resource distribution. In this respect, the states may
be motivated to make fiscally prudent policies by building up their tax collection capabilities.
The selectivity criteria attempt to balance the revenue sources in terms of both equity and
efficiency in the resource distribution.

VERTICAL AND HORIZONTAL TRANSFERS

Vertical Transfers

The monetary flows from Centre to states are called vertical transfers. Such transfers have
become very important for those states which do not possess adequate revenue generation
capacity. Centre allocates resources through several arrangements:
Tax Devolution: The Finance Commission makes recommendations to transfer a part of the
Centre's tax revenue to states. This devolution is meant to help states enjoy more predictable
revenues so that they may budget for them.

The other categories of grants-in-aid that are allocated include aid in the head of tax
devolution, wherein the Centre provides specific grants to the states for specific
developmental projects or activities.

There are specific reasons for providing special grants to specific areas or for social
welfare programs or infrastructural development plans or poverty alleviation programs.

Significance of Vertical Transfers

Vertical transfers are very vital in promoting fiscal equity among the states. This makes sure
that all of them are capable of continuing to perform other important services such as
education, health, and infrastructure construction regardless of their economic capability.
Moreover, it stabilizes the economic states during financial recession hence making sure that
essential services do not have to rely much on excessive borrowing.

Horizontal Transfers

Horizontal transfers refer to resource allocation among states or between states and local
governments, such as Panchayats and Municipalities. Horizontal transfers are an important
step toward ensuring fair distribution of resources at the grassroots level and encouraging
grassroots local governance and accountability.

Mechanisms of Horizontal Transfers

State Finance Commissions: At the state level, State Finance Commissions have been
constituted to appraise the financial situation of local bodies and make recommendations
regarding the distribution of resources among them. This way, local governments have the
needed funding to address the needs of their communities.
Specific grants: The Centre and state governments can hand over specific grants to the local
development projects. Through such specific grants, every possible tool is given to local
governments to achieve those initiatives that directly and significantly benefit their
communities.

Horizontal transfers are very important to decentralization and enabling local bodies. By
making sure the local governments are properly resourced, the transfers enable the
governing of local specific needs that would subsequently benefit from better service delivery
and local development.

GST AND DIRECT TAXES

Effect of GST

GST, introduced in India in 2017, has ushered a paradigm shift in the country's tax
structure. GST is an integrated indirect tax to be collected on the supply of goods and
services. It aspires to integrate India into a common national market by cutting through the
myriad state taxes, such as GTA, VAT, entry taxes by the states on intra-state supplies,
central surcharges, and the like.

For the Centre and states, the introduction of GST has altered the scene concerning
revenue collection. It has thus altered the fiscal terrain.

Revenue Impact

Reduced Dependence on Direct Taxes: GST has come to be an important source of revenues
for the Centre and the states. It has reduced the dependence of the Centre on direct taxes.
This development dramatically shifts the financial arithmetic between the Centre and the
states. With GST revenues now accounting for a huge proportion of tax collections, the
traditional fund-raising through direct taxation has decreased.
Increased Compliance: The GST structure has a greater potential to rationalize the system
of taxes, hence high compliance and widening of tax base. This, consequently, resulted in the
increased collection of revenues by states that translate into an opportunity for higher
development spending.

Economic Growth and Stability

GST has also promoted economic growth as it reduced the cascading impact of multiples
taxes on goods and services. It has enhanced business competitiveness, which has increased
investment and, therefore, paved the way for greater economic growth rates. The efficient
clearance of tax compliance with minimizing trade barriers will have the potential to enhance
efficiency in the Indian economy.

Continued Relevance of Direct Taxes:

Direct taxes are an essential part of the fiscal federalism structure as their significance has
increased despite the increasing importance of GST. The Centre's revenue is significantly
supplemented by direct taxes, besides becoming a direct source of financial autonomy for
states to engage in development initiatives. Income tax is an important source for the Centre,
and direct taxes, in general, become a tool for wealth distribution.

Direct Taxes and Equity

Direct taxes are normally progressive, meaning that high-income earners pay a greater
proportion of their earnings than low-income earners. This aspect has seen the decrease in
the level of inequality in income distribution and even redistribution of wealth more
equitably within the community. The progressive nature of direct tax is essential when
speaking of balanced struggle against social inequities or social welfare funding programs.
Problems of Direct Tax Administration

Despite its significance, the Indian system of direct taxes faces several challenges, including
the following:

Tax Evasion: Tax evasion occurs in high degrees, consequently leading to ineffective direct
taxation. Multiple individuals and businesses use practices to underreport income or evade it
outright to evade tax payment, and consequently, cause a loss in revenue to the government.

Complexity of Tax Laws: Indian tax system is highly complex and burdens taxpayers to
comply. Deciphering rules and regulations becomes difficult, and hence, unintentionally
contributes to non-compliance.

Ineffective Collection Mechanism: Inefficiency in collecting and administering taxes involves

long-gone processing that increases costs and breeds inefficiency in the tax system.

There is a need for comprehensive reforms in direct tax administration concentrating on

the aspects of compliance, simplification of tax laws, and enforcement mechanisms to
address these challenges.

FISCAL AUTONOMY AND CENTRAL OVERSIGHT:

Balancing Act

The relationship between fiscal autonomy for the states and central oversight is a delicate
balancing act. States need financial independence to address their specific developmental
challenges, while central oversight is essential for maintaining macroeconomic stability. This
dual requirement gives rise to several challenges:
State Autonomy: States need the elbow room to plan and execute fiscal policies in order to
respond appropriately to regional demands. Over-reliance on transfers from the center
defeats their ability to innovate and respond effectively to regional demands. Fiscal
autonomy empowers states to shape development strategies according to contexts and
specific priorities.

Central Control: The Centre has indirect influence over state fiscal policies by controlling
direct taxes so as to bring the same in line with the objectives of macroeconomic policies of
the center. Such control helps the Centre to check inflations, fiscal discipline, and stability in
the economy.

Means of Control

The Centre can exercise control over direct taxes through various means like:

Tax policy Formulation: The Centre prescribes the framework for direct taxes, which is
bound to affect how states should raise income and profit taxes. In formulating tax
policy, the Centre would thus be able to keep all states on the intended national economic
courses, given the coordination of fiscal planning.

Compliance and Auditing: The Centre monitors the fiscal policies of states to ensure that
these are aligned with broader economic objectives, such as control and fiscal discipline of
inflation. Periodic audit and evaluation can help in identifying some possible areas of risk
and improvement.

Impact of Central Oversight

Central oversight is imperative in securing macroeconomic stability, although it can be

inconsistent with state governments. Federal mandates have been seen as imposing an
uncomplimentary constraint on the ability of a state government to respond to the local
needs of its constituents. The balance between oversight and autonomy is the key to effective
governance.
ROLE OF STATE GOVERNMENT

Responsibilities of States

State governments are perhaps critical in ensuring policies that respond to the needs of
the local entities. They provide a number of vital services, such as education, health care,
and public infrastructure. Direct taxes to complement such services are, therefore
important in the running of these governments.

Empowering States

Empowering states to improve their revenues will result in better responsibilities from the
governments. How can this be?

Devolution of Powers: Delegation of more direct tax collection and imposition authority to
the state government can enhance their fiscal autonomy. They will, therefore, have an
opportunity to choose taxation policies that suit their economic situation and current
developmental needs.

Capacity Building: Technical assistance supplemented by capacity-building initiatives can

enhance the administrative capacity of the state governments so that they can efficiently
handle taxation as well as tax compliance

Fiscal Responsibility

State level promotion of budget responsibility ensures that resources are effectively utilized
in their actual fields. States should implement effective mechanisms that enhance
transparency and accountability in their financial management, which may lead to increased
public trust and responsible governance.

Fiscal Responsibility Acts

Most states have enacted FRAs to put a ceiling to borrowing and spending. Rational and
prudent management of funds as well as a long-range view on benefits and costs enhance
stability in an economy. A long-range view of setting fiscal targets will enable the states to
keep their spending within limits of revenue collections so that they are not over-spending
and thus create a situation that cannot be sustained fiscally.
CHALLENGES AND FUTURE DIRECTIONS

Regional Disparities

Regional disparities still remain one of the long-term problems in the fiscal federalism
system of India. Some states are very strong revenue-generating states, and a good number
of others are unable to raise even minimal fiscal requirements. It leads to economic
imbalances as well as a brake on national development.

Redressing Regional Disparities

There are several ways to redress regional imbalances and these may include:

Strong Fiscal Federalism: Building the fiscal autonomy of states will make it easier for
them to formulate and design policies that suit their local conditions and requirements. It
would finally lead to the balanced development of regions and reduce inequalities.

Targeted Grants: The Centre could provide more targeted grants to economically weaker
states. More investment towards infrastructure, education, and healthcare would be
possible. Targeted support can bridge the gap and thus develop the potential of these states.

Capacity Building: Technical assistance to the states could enhance their revenue collection
and tax administration. Augmentation of capacity in state government will enable them
to improve fiscal policies and programs.

Reforms in Direct Taxation

To address these issues, there is a dire need for reforms in the direct taxation system. The
solutions may include:

Improving State's Taxing Authority: It could make the state a more empowered taxing
authority. This may allow the state to vividly tax some economic activities and, on top of
that, wealth and property.

Improved Tax Compliance: Investment in Technology and Infrastructure Most likely to

Broaden Tax Base and Enhancement of Revenue Collections at both Centre and state
level. Administrative Simplification through Data Analytics and Digital Platforms Likely
to Streamline Tax Administration, Improve Transparency, and facilitate proper
compliance and other reforms.
Decentralization of Tax Powers: Encourage the breadth of tax powers for states so that they
could have more flexible structuring of taxation systems, in accord with local economic
conditions. This could encourage innovation in tax policy and improve responsiveness to
local needs.

Simplification of Tax Structures: Simplifying the mechanism in tax would improve

compliance and will benefit taxpayers as well. Simplification of tax laws and procedures can
make it easy for all to understand and fulfill their obligation.

Role of Technology

Introduction of technology can help streamline the processes, reduce evasions and bring
more efficiency in tax administration. Tax collection and compliance through digital
platforms will increase transparency and accountability to the Centre as well as to states.

Digital Initiatives

e-filing Systems: Proper e-filing systems can make the whole process of tax filing smooth
for an individual and business entities. User-friendly online platforms may allow businesses
and individuals to pay their taxes on time while giving better history.

Data Analytics : Data analytics can reveal patterns of tax evasion and noncompliance. Thus,
the enforcement actions can be properly targeted. Advanced data analytics will enhance the
risk assessment and boost the strategies for taxes collection.

Environmental Considerations

The environment has been the critical challenge currently faced by India; environmental
considerations within the tax system may prove to promote sustainable growth. Fiscal policy
could be aligned with the environmental goals by adjusting direct taxes to encourage
practices from which environmental damage is reduced and pollution is avoided.

The introduction of a green taxation framework should encourage investment in renewable

energy and other sustainable practice patterns. This would be positive, for example, to offer
some tax exemptions to companies adopting environment-friendly technologies.
Fiscal Responsibility

Fiscal responsibility is a principle that needs to be promoted both at the Centre and at the
state level for sustainable economic growth. Fiscal rules, which enunciate transparency and
accountability, are necessary to enhance the credibility of fiscal policies and command public
trust.

Fiscal Responsibility and Budget Management

Presentation of fiscal responsibility legislation that bars borrowing as well as current and
capital expenditures by the states would ensure the undertaking of prudent financial
management as well as long-range planning, which implies economic stability. Regular
review and audit can ensure the implementation of fiscal rules; therefore, states would be
accountable to answer to any of the fiscal acts.

CONCLUSION

Direct taxes, therefore, are an integral part of the fiscal federalism structure in India. They
raise a sizeable portion of the total tax revenues and are used both for transfers to the center
as well as between the states. The erstwhile central control over direct taxes ensures that
states can enjoy fiscal autonomy while simultaneously ensuring macroeconomic stability.

In the future, India's fiscal federalism has to look ahead towards both structural upgradation
regarding regional imbalances, state autonomy promotion, and the implementation of new
technologies in tax collection. Direct taxes will remain central for the proper distribution of
financial resources and ensuring the effective working of the system of federalism.