Dear Govt of India, Here’s Why a Cess Needs Impact Analysis Report

Taxes create efficiency losses by affecting demand & supply; cesses/surcharges must be preceded by impact analysis.

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Dear Govt of India, Here’s Why a Cess Needs Impact Analysis Report
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During the 2021-22 Union Budget speech, Union Finance Minister Nirmala Sitharaman announced yet another cess — an Agriculture Infrastructure and Development Cess of Rs 2.5/litre on petrol and Rs 4/litre on diesel.

At first glance, this just means that your commute got dearer. But scratch beneath the surface and you’ll realise that cesses such as these are gnawing away at India’s federalism. Here’s how.

The union government’s income from taxes consists of two components: a ‘divisible pool’, and cesses and surcharges.

The divisible pool comprises taxes like corporation tax, taxes on income, customs, union excise duties, etc. It is called so because this pool of money gets ‘divided’ between the Union and the State governments through a formula recommended by the Union Finance Commission.


In contrast, the money that union governments raise by levy of cesses and surcharges is not shared with the states. Cesses are earmarked taxes levied for specific purposes to provide necessary financial impetus to a particular sector/area. Surcharges are additional charges or taxes levied on existing taxes. A surcharge is calculated on payable tax, and not on income generated. Over the last few years, the union government has been increasingly relying on both cesses and surcharges, resulting in lesser resources being transferred to the states.

Cesses: ‘Frustrating’ the 14th Finance Commission Recommendations

The 14th Finance Commission had recommended increasing the states' share in the divisible pool from 32 percent to 42 percent. The rationale was to provide higher resources to the states so that they can spend as per their requirements and socio-economic conditions. After all, spending priorities of a state like Sikkim are likely to be distinct from the requirements of a state like Maharashtra.

But here’s the catch: the total size of the divisible pool itself has not grown much.

On the other hand, the quantum of cess and surcharge has increased five-fold from Rs 92,537 crores (FY 2011-12) to Rs 4,45,819 crores (RE FY 2020-21 excluding GST compensation cesses).

In essence, the union government has gone against the spirit of the 14th FC recommendations by raising increasing sums of money outside the divisible pool.

What’s Happened As a Result of Rising Cesses?

The result of rising cesses has been that states’ share in the overall Gross Tax Revenue has been shrinking. In fact, the percentage of states' share in the Gross Tax Revenue has never crossed 36.6 percent (FY 2018-19).  For FY 2019-20  and 2020-21 (RE), it was even lower at 32.37 percent and 28.94 percent, respectively. Meanwhile, the ratio of cesses and surcharges to the divisible pool resources nearly doubled from 9.71 percent in 2012-13 to 18.03 percent in 2020-21 (Figure 1).

Figure 1 - Trends in cesses and surcharges and divisible pool. 

Impact of Cess Increase on States

Seen from another angle, an increase in the total quantum of cesses and surcharges is indicative of the total revenue forgone by the states. For example, in FY 2016-17, the states’ revenues could have increased by Rs 91015 crores (which happens to be 4.33 percent of the states’ total revenue for the same FY).

Thus, the current devolution mechanism reduces the states’ economic freedom, leading to them being more dependent on the Union Government. Also, the states are being denied their constitutional entitlement.

One example worth mentioning is that of petrol. The Union Government has raised excise duties in the form of cesses. In 2016-17, 56 percent of excise duty on petrol was levied as cess. Now, this figure is expected to be 96 percent. Thus, the Union will only be sharing 4 percent of the excise on petrol with the states. A recent report pointed out that of the Rs 3.46 trillion expected from fuel taxes to the Union, the states may get just Rs 14,000 crore.


Is Union Govt ‘Taking Away Money’ From States To ‘Spend By Itself’?

There’s also a qualitative problem with cesses and surcharges in recent years. On one hand, while newer cess and surcharges have been introduced (road and infrastructure surcharge, social welfare surcharge), on the other the rates of taxation has been increased for some existing cesses.

For example, health and education cess on income tax was increased from 3 to 4 percent in 2018-19. More strikingly, many of the cesses are related to subjects on the State List, for example, cesses imposed for hygiene, agriculture, state and rural roads.

Thus, the union government is taking money away from state governments to spend by itself on areas that are squarely in the states’ constitutional domain. This does not augur well for India’s federal structure. It is in this context that we must view any introduction of a new cess or surcharge like the Agri Cess on Petrol.

Taxes Create Efficiency Losses. Here’s What a Cess Must Be Preceded By

The Union Government should refrain from imposing taxes on subjects on the State List. In case the Union Government imposes any cess/ surcharge, it should explicitly mention the levy's objective. It should include mechanisms to prevent ever-greening of these levies.

Taxes create efficiency losses by impacting the demand and supply for goods and services. So, imposition of any cess/surcharge should be preceded by an economic impact analysis report.

As far as state governments are concerned, they need to fight this battle together, else, they will be reduced to glorified decentralised agents implementing union government schemes.

After all, as Alexis De Tocqueville wrote: “the federal system was created with the intention of combining the different advantages which result from the magnitude and littleness of nations”.

India desperately needs its Union and State governments both doing what they are constitutionally assigned to do.

(Sarthak Pradhan and Pranay Kotasthane research on public finance at the Takshashila Institution, an independent centre for research and education in public policy. Sarthak tweets @PSarthak19. Pranay tweets @pranaykotas. This is an opinion piece and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for them.)

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Topics:  Taxes   Modi Government   Indian Government 

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