Vishleshan for Regulatory Exams, 10 July 2025: Tax Devolution & the Inflation Paradox

To get ready for the UPSC, RBI, SEBI, or NABARD exam, you have to stay updated about key economic and regulatory updates. In today’s edition of Vishleshan, we delve into Tax Devolution Beyond Standard Parameters and Inflation Paradox. These issues are highly relevant for competitive exams and offer valuable insights into India’s evolving economic scenario. Keep reading to stay ahead with a clear understanding of these current updates.

Also, know why RBI Grade B Phase 1 Exam: The Silent Eliminator of 99% Aspirants & What is the Finance and Management Syllabus for RBI Grade B Exam?

Tax Devolution Beyond Standard Parameters

Context: The Finance Commission, which completed its state visits recently, is now going through detailed memoranda submitted by states and departments to shape its recommendations for the 2026–31 period.

Source: Mint

India’s Sixteenth Finance Commission, currently in its deliberation phase, faces the complex challenge of recommending a new formula for revenue sharing between the Centre and states for the 2026-31 period. A key debate has emerged from wealthier states, particularly in the western and southern regions, demanding a larger share of the national revenue kitty, arguing that current distribution formulae do not adequately reward their disproportionate contribution to national GDP and tax collections. This delicate balancing act is central to ensuring fiscal federalism and equitable development across the diverse Indian states.

Finance Commission: Constitutional Mandate, Role, and Brief History

The Finance Commission is a constitutional body in India established under Article 280 of the Indian Constitution. It plays a pivotal role in maintaining fiscal federalism and ensuring equitable distribution of financial resources between the Union government and state governments.

Constitutional Mandate (Article 280): Article 280 mandates the President of India to constitute a Finance Commission every five years (or earlier if deemed necessary).

Role and Mandate: The primary role of the Finance Commission is to make recommendations on:

• The distribution of net proceeds of taxes between the Union and the States (known as vertical devolution).
• The allocation of shares of such proceeds among the States themselves (known as horizontal devolution).
• The principles that should govern the grants-in-aid of the revenues of the States out of the Consolidated Fund of India.
• The measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats and Municipalities in the State on the basis of the recommendations made by the State Finance Commission.
• Any other matter referred to the Commission by the President in the interests of sound finance.

Brief History: Since its inception in 1951 (First Finance Commission), successive Finance Commissions have played a crucial role in evolving India’s fiscal federal structure. Early commissions, like the Second FC, recommended “Margin Money” for states to cope with calamities, initially a symbolic ₹6 crore annually, later scaled up to ₹240 crore by the 8th FC. The 9th FC introduced the Calamity Relief Fund, marking a shift towards state-level autonomy. The 13th FC institutionalized the National and State Disaster Response Funds (NDRF and SDRF) following the Disaster Management Act of 2005, introducing rule-based disaster financing.

15^th Finance Commission: Formation and Devolution Criteria

The 15th Finance Commission, chaired by N.K. Singh, was constituted in 2017 and its recommendations covered the period from 2020-21 to 2025-26.

• Vertical Devolution Criteria: The 15th FC recommended a 41% share for states and 59% for the Centre out of the divisible pool of central taxes. This 41% share was a slight adjustment from the 42% recommended by the 14th FC, primarily due to the creation of the Union Territories of Jammu & Kashmir and Ladakh.
• Horizontal Devolution Criteria: For distributing the states’ share among individual states, the 15th FC used several “standard parameters”. These criteria and their approximate weights were:
  • Population (15%): Using the 2011 Census population, which often penalizes states that have successfully controlled population growth.
  • Area (15%): To reflect the cost of administering larger areas.
  • Forest and Ecology (10%): To incentivize states with larger forest cover.
  • Income Distance (45%): Measures disparities in per capita Gross State Domestic Product (GSDP). States with lower per capita income (higher income distance) receive a larger share to address inequalities.
  • Tax and Fiscal Efforts (2.5%): To reward states that have performed well in mobilizing tax revenues and maintaining fiscal discipline.
  • Demographic Performance (12.5%): To reward states for their efforts in controlling population growth (a new criterion introduced by the 15th FC).
• Shift to Resilience Mindset: The 15th FC proposed a significant financial architecture for disaster management, allocating ₹1.60 trillion for states and ₹68,000 crore for the Centre, including ₹45,000 crore specifically earmarked for mitigation. It adopted a Disaster Risk Index (DRI) to guide allocations based on actual vulnerabilities, marking a “transition from a welfare mindset to a resilience mindset”.

16^th Finance Commission:

The 16th Finance Commission, chaired by Arvind Panagariya, has completed its state visits and is currently in the deliberation phase.

• Current Status: It has “just completed its round of state visits” and is “entering the deliberation phase”. It is reviewing “detailed memorandums submitted by various states and departments”.
• Recommendations Period: Its recommendations will cover the five years from 1 April 2026 to 31 March 2031.
• Key Tasks: Like its predecessors, it is tasked with recommending:
  • Vertical devolution (how central tax revenues should be divided between the Centre and states).
  • Horizontal devolution (how that share should be distributed among states).
  • Assessing funding needs for disaster management.
  • Assessing funding needs for strengthening local governments.
• Deadline: The panel is working to an official deadline of 31 October, with no anticipated delay.
• Member’s Insight: Manoj Panda, a member of the commission, stated that the commission “may have to go a bit beyond the standard parameters” in its computation, hinting at changes to the criteria.

Fiscal Federalism:

Definition: Fiscal federalism is the study of how expenditure and revenue assignments are divided and shared between different levels of government (e.g., central, state, and local governments) in a federal system. It aims to achieve both efficiency in resource allocation and equity in distribution, recognizing that different levels of government are better suited to provide certain public goods and services.

How Finance Commission Ensures It: The Finance Commission is the primary institution ensuring fiscal federalism in India by:

• Addressing Vertical Imbalance: Bridging the gap between the revenue-raising powers of the Centre (which are generally higher) and the expenditure responsibilities of the states (which are also substantial, especially for social sectors).
• Addressing Horizontal Imbalance: Reducing fiscal disparities among states, as some states are economically weaker or have lower revenue-generating capacities. This is done through horizontal devolution criteria that favour less developed states.
• Grants-in-Aid: Recommending grants-in-aid to states, often conditional, to support specific state needs or to encourage fiscal reforms.
• Promoting Fiscal Discipline: Through its recommendations and assessments, it encourages states to maintain fiscal prudence, adhere to FRBM norms, and manage their debt sustainably. Manoj Panda observed that “capital expenditure-related borrowing remains sustainable if managed within the prudential norms outlined in the Fiscal Responsibility and Budget Management (FRBM) framework”. States are generally expected to maintain fiscal deficits within 3% of GSDP.

Analysis of the Article: Decoding the Challenges for the 16th Finance Commission

The 16th Finance Commission faces the complex and politically sensitive task of balancing the demands of fiscally stronger states with the needs of weaker ones, all within an evolving economic landscape.

1. The “Penalization” Debate from Richer States:

• Core Grievance: “Developed states in western India as well as southern India” argue that they “are contributing more to the overall tax kitty of the country, but they are not getting adequate returns”.
• Argument for Recognition: These states urge the 16th FC to “take into account their contribution to national growth and tax revenue while recommending horizontal allocations across states”.
• Feeling “Penalized”: They feel “penalized” because existing distribution formulae (e.g., income distance, population) disproportionately favour states with lower income levels or higher populations from older census data, without adequately rewarding economic performance or population control efforts. “They don’t want to feel ‘penalized’—a word that is often being used,” said Manoj Panda.
• Tax-to-GSDP Ratios: State’s tax-to-GSDP ratios for many western and southern states have remained stuck at 6-7% levels, and future tax collections will “primarily hinge on GSDP growth”.

2. The Balancing Act (“Zero-Sum Game”):

• Give and Take: “In any federation, there has to be some give and take. The weaker states have to be supported, but developed states are saying that the low-income states can’t be supported beyond a point,” said Panda.
• Horizontal Distribution Challenge: In horizontal distribution, where “the total is 100,” giving “more to one, somebody else will suffer”. This highlights the inherent “zero-sum game” nature of horizontal devolution.
• Diverging Growth Trajectories: The debate is further complicated by “diverging growth trajectories among states,” with some traditionally weaker states (e.g., Uttar Pradesh) showing improvement, while others lag. Convergence of average income levels would eventually reduce resource needs based on equity.

3. Potential Changes to Standard Parameters:

• Panda hinted that the Commission “may have to go a bit beyond the standard parameters” used by the 15th FC. This suggests a possible re-evaluation of the weights or introduction of new criteria in the horizontal devolution formula to address the concerns of richer states while ensuring equity.

4. State-Level Fiscal Challenges and Demands:

• Tax Enforcement: There is “some scope to improve tax enforcement at the state level,” but states have “little room to manoeuvre on indirect tax rates, which are governed by the GST Council”.
• Rising Social Sector Commitments: States are demanding a higher share of central revenues due to “rising social sector commitments”.
• Reliance on Cesses and Surcharges by Centre: The Centre has “increasingly leaned on cesses and surcharges, which fall outside the divisible pool, to meet its spending obligations,” even after raising states’ share by 10 percentage points a decade ago. This reduces the share of funds available for unconditional transfer to states.

5. Fiscal Discipline and Collaboration:

• State-level Debt: Capital expenditure-related borrowing remains sustainable for states if “managed within the prudential norms outlined in the Fiscal Responsibility and Budget Management (FRBM) framework” (fiscal deficits generally within 3% of GSDP). During the pandemic, this threshold was relaxed by an additional 0.5%, and the Centre provided 50-year interest-free loans.
• Centre-State Collaboration: The Finance Commission “can only suggest states keep their debt within a limit.” Beyond that, “the Centre and states will need to work together to keep expenditure, particularly subsidies, within bounds”.
• Avoiding Competitive Populism: There should be “some kind of broad consensus among the governments to avoid competitive populism”.

In conclusion, the 16th Finance Commission is navigating a complex terrain of inter-state fiscal equity, balancing the demands of economically advanced states for greater recognition of their contributions with the constitutional imperative to support weaker states. The challenge is to devise a devolution formula that is perceived as fair, promotes sustainable growth across all regions, and ensures fiscal prudence at both Centre and state levels, without succumbing to the pressures of competitive populism.

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Inflation Paradox

Context: Contrary to expectations, the US President’s tariff hikes are yet to show up in America’s cost-of-living data. Puzzling as this is, these are early days yet and trade shocks still risk setting off shudders of price instability.

Source: Mint

Following US President Donald Trump’s April 2 edict imposing a 10% tariff on all imports, a puzzle has emerged: the remarkably subdued effect on inflation in America. Despite initial prognoses of stagflation and the US now having its highest average tariff since the 1930s, coupled with a significant dollar depreciation, retail prices have shown only a minimal increase. This phenomenon calls for a closer look at the underlying economic dynamics, suggesting that various temporary factors may be masking the expected inflationary impact.

Impact of Imposing Tariff and Non-Tariff Barriers:

When a country imposes tariffs (taxes on imported goods) or non-tariff barriers (NTBs) (non-tax restrictions like quotas, import licenses, strict regulations) on goods from other countries, it can have several impacts on its own economy:

On Inflation (Direct & Indirect):

• Direct Impact (Price Increase): Tariffs directly increase the cost of imported goods. If these goods are consumed directly by the public, their retail prices are likely to rise, leading to higher inflation.
• Reduced Competition: Tariffs protect domestic industries from foreign competition. This can allow domestic producers to raise their prices, further contributing to inflation.
• Supply Chain Disruptions: NTBs can make it difficult or costly to import goods, leading to supply shortages and higher prices.
• Retaliation: Imposing tariffs often leads to retaliatory tariffs from other countries, making the imposing country’s exports more expensive and potentially reducing demand for its goods. This can disrupt global supply chains and lead to higher input costs for domestic industries.
• Currency Impact: Increased trade protectionism can influence currency values. A weaker currency (like the dollar’s recent drop) makes imports more expensive, adding to inflationary pressures.
• Initial Prognosis: The article notes that the “general consensus—not limited to doomsayers—was that growth would fall and inflation rise as a direct outcome,” leading to a prognosis of stagflation (slower growth amid higher inflation) for the US and global economies.

On Economic Growth:

• Reduced Trade: Tariffs reduce both imports and exports (due to retaliation), leading to a contraction in overall trade volume.
• Higher Input Costs: Domestic industries that rely on imported raw materials or intermediate goods will face higher costs, which can reduce their profitability and competitiveness.
• Reduced Consumer Spending: Higher prices due to tariffs can reduce consumers’ purchasing power, leading to lower overall demand.
• Uncertainty and Reduced Investment: Trade wars and protectionist policies create economic uncertainty, which can disincentivize domestic and foreign investment. The article notes that “what we have seen instead is a slowdown for sure—US output contracted 0.5% in the first quarter of 2025“.

Current Inflation Level in Countries with the Most Liberal Trade Agreements:

Countries with highly liberal trade agreements typically benefit from increased competition, access to cheaper imports, and greater efficiency, which can help mitigate inflationary pressures. While the article on US tariffs doesn’t explicitly provide current inflation data for such countries, we can look at commonly recognized examples of economies with very open trade policies:

• Singapore: Known for its open economy and numerous free trade agreements (FTAs). As of May 2025, Singapore’s core inflation (excluding accommodation and private transport) was 3.1% year-on-year, while headline inflation (CPI-All Items) was 2.8% year-on-year.
• Switzerland: A highly globalized economy with a strong emphasis on free trade. As of May 2025, Switzerland’s CPI inflation was 1.4% year-on-year.
• Netherlands: A major trading hub within the European Union, with extensive international trade. As of May 2025, the Netherlands’ harmonized CPI (HICP) was 2.7% year-on-year.
• South Korea: A highly export-oriented economy with a strong network of FTAs. As of May 2025, South Korea’s CPI inflation was 2.7% year-on-year.

These examples generally show moderate inflation levels, often within or close to their central bank targets, suggesting that open trade policies, among other factors, contribute to price stability by fostering competition and providing access to diverse and often cheaper goods and services. This stands in contrast to the potential inflationary risks discussed in the article regarding the US’s increased tariffs.

Analysis of the Article: Decoding the Tariff-Inflation Puzzle

The article highlights a puzzling economic phenomenon: the surprisingly subdued inflationary impact of the US tariffs, despite predictions to the contrary.

1. The Puzzle and Initial Prognosis:

• Trump’s Edict: On April 2, US President Donald Trump issued an edict imposing a 10% tariff on all imports.
• Initial Expectation: The “general consensus” was that this would lead to “slower growth amid higher inflation” (stagflation) for the US and the global economy.
• Observed Reality: Instead, the US has seen a “slowdown for sure—US output contracted 0.5% in the first quarter of 2025”, but “barely a blip on the price front”.
• The Contradiction: This subdued effect on inflation is a puzzle, especially given that the US “now has the highest average tariff since the 1930s, thanks to Trump’s novel approach to trade”. Additionally, the dollar index has fallen by close to 11% since the beginning of this year, making it the “worst first-half for the US currency in almost half a century”. Both these factors (high tariffs and a weak dollar) “should have pushed up retail prices”.
• Current Data: US data shows its Consumer Price Index (CPI) rose just 0.1% month-on-month in May 2025. Annual inflation at 2.4% is above the Fed’s 2% goal, but a New York Federal Reserve survey in early July showed that “earlier fears that Trump’s tariffs would result in a price spike have all but disappeared”.

2. Explanations for the Subdued Inflationary Effect: The article provides four possible reasons for this unexpected outcome:

• Front-Loading of Imports: Importing companies may have “front-loaded their imports and piled up inventory” to beat the tariff deadline. This temporary surge in supply would have mitigated immediate price increases.
• Margin Absorption by Companies: Many companies chose to “absorb the extra paid for imports and let margins take a hit, rather than raise retail price tags”. This strategy allows businesses to retain market share but reduces their profitability.
• Softening Demand Due to Uncertainty: Demand was “driven lower by uncertainty,” which “softened the price impact”. Economic uncertainty often leads consumers and businesses to postpone spending and investment, thus dampening demand-side inflationary pressures. This was also observed in the global oil market.
• One-Off Price Jump Absorbed (Fed’s View): Fed Chair Jerome Powell’s view is that tariffs result in a “one-off price jump” those businesses “appear to have ‘eaten’ for now”. He hinted that the “outlook is for higher inflation over the year,” suggesting this might be “just a lull before the storm”.

3. Future Risks and Conclusion:

• Upcoming Tariffs: The article warns that Trump’s “more threatening country-specific ‘reciprocal’ tariffs” (held off for 90 days) and the latest tariffs notified for 14 countries (enforceable from August 1) mean “we ‘ain’t seen nothin’ yet'”.
• Price Instability Risk: The US “still risks price instability worse than what Trump might expect if his August tariffs kick in”.
• Temporary Factors: The current calm in inflation could be due to “peculiar factors” that “lulled asleep” the “inflation dog”.
• Basic Laws of Economics: The article emphasizes that “The basic laws of economics haven’t broken down. Yet”. This implies that the expected inflationary pressures from protectionist policies are likely to manifest eventually, once these temporary mitigating factors dissipate.

In conclusion, the muted inflationary impact of US tariffs so far is a complex puzzle, likely explained by temporary factors such as front-loaded imports, companies absorbing costs, and softened demand due to uncertainty. While inflation expectations have returned to pre-tariff levels, experts, including the Fed Chair, caution that this might be a temporary lull. The fundamental economic principles suggest that the full inflationary consequences of these protectionist measures are yet to unfold, especially if additional tariffs are implemented.

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