Cess and Surcharges in India

Cess and Surcharges in India

Arvind Panagariya, Chairman of the 16th Finance Commission, recently termed the increasing reliance of the Centre on cesses and surcharges as a "complicated issue." This has raised debates on the fiscal implications and fairness of such tax measures in India’s federal structure.

What are Cess and Surcharges?

Cess:

• A cess is an additional tax imposed on top of an existing tax (e.g., income tax, excise), earmarked for specific purposes. It is a "tax on tax."

• Cesses are generally intended for temporary use to fund a particular cause, like education, cleanliness, or infrastructure development.

• Cess revenues are excluded from the divisible pool, meaning the states do not share in the revenue, according to Article 270 of the Indian Constitution.

• Examples: Education Cess (for financing primary education), Swachh Bharat Cess (for sanitation programs), Fuel Cess (for road development).

Surcharge:

• A surcharge is an additional levy imposed on existing duties, often targeting specific income brackets or sectors. It is also known as a "tax on tax."

• Surcharges are designed to be progressive, meaning higher-income individuals or businesses pay more, thus promoting social equity.

• Funds collected through surcharges go into the Consolidated Fund of India (CFI) and are used for general purposes, such as financing infrastructure projects or social welfare programs.

• Examples: Income Tax Surcharge (imposed on high-income earners), Corporate Tax Surcharge.

Cess vs. Surcharge

• Cess: Funds must be spent on specific purposes (education, cleanliness, etc.), and are excluded from the divisible pool, i.e., they are not shared with states.

• Surcharge: Revenue is used like other taxes, for general governmental purposes, and also excluded from the divisible pool.

What are the Concerns Regarding Cess and Surcharges?

1. Centre’s Fiscal Constraints:

   • With states' share in the divisible pool increasing from 32% in the 13th Finance Commission to 41% in the 15th Finance Commission, the Centre's share has reduced, leaving it with less fiscal space.

   • To compensate, the Centre has increasingly relied on cesses and surcharges, which are not shared with states. What started as a temporary measure has now become a permanent feature of the tax system, raising concerns about its long-term impact on fiscal federalism.

2. State Concerns:

   • The share of cesses and surcharges in total tax revenue increased from 10.4% in 2011-12 to 20% in 2021-22, shrinking the pool of taxes shared with states.

   • States' fiscal flexibility is limited, and their ability to fund critical programs (e.g., health, education) is compromised.

   • States have consistently demanded a cap on cesses and surcharges and that any excess collections be included in the divisible pool for a fairer revenue distribution.

3. Lack of Transparency and Vagueness:

   • Cesses are earmarked for specific purposes, but there is a lack of transparency regarding their allocation and use.

   • Cesses like the Swachh Bharat Cess and Krishi Kalyan Cess are often broadly defined, and many are not subjected to the same parliamentary oversight as other taxes.

   • For example, the Research and Development Cess was partly used to finance the Union’s revenue deficit, deviating from its intended use.

   • Criticism: This bypasses the principles of equitable revenue sharing between the Centre and states.

4. Inequitable Taxation:

   • Cesses and surcharges disproportionately affect wealthier segments of society, as they are the primary contributors.

   • Critics argue that this creates fairness issues and could lead to capital flight, where businesses and high-income individuals relocate to tax-friendly jurisdictions.

What is the Divisible Pool of Taxes?

The Divisible Pool of Taxes refers to the share of central tax revenues that the Union government distributes to states. This pool is a key part of fiscal federalism.

• Key Taxes in the Pool: Taxes like Corporation Tax, Personal Income Tax, and Goods and Services Tax (GST) form part of the divisible pool.

• The Finance Commission is responsible for recommending the share of the divisible pool that each state receives. The 15th Finance Commission recommended 41% of the divisible pool be allocated to states for the period 2021-2026.

Vertical and Horizontal Devolution:

• Vertical Devolution: Allocation of the divisible pool between the Centre and the States.

• Horizontal Devolution: Distribution among states based on factors like population, income disparity, and tax effort.

International Practices on Cess and Surcharges:

1. Surcharges:

   • Germany: The solidarity surcharge was introduced in 1991 to fund German reunification and Gulf War expenses. It has continued since, despite its initial temporary nature.

   • France: Imposes temporary surcharges to address fiscal challenges.

2. Cess Taxes:

   • United States: States like Alabama earmark substantial tax revenue for specific purposes like infrastructure.

   • Australia: The Medicare Levy, a personal income tax introduced in 1984, funds the national healthcare system. Other temporary taxes have been short-lived.

What Can be Done to Address Concerns Regarding Cess and Surcharges?

1. For Cesses:

   • Avoid levying cesses for issues that fall under the State List (e.g., health, education), as this undermines federal principles.

   • Set a ceiling on cess collection and ensure it is not exceeded.

   • Transparency: Allocate cess funds clearly and ensure regular audits to evaluate their necessity and effectiveness.

   • Abolish ineffective cesses that generate minimal revenue or create complexity.

   • Introduce sunset clauses: Cesses should only be imposed for a fixed period (e.g., 5 years with one possible extension).

2. For Surcharges:

   • Rationalize income tax: Instead of relying on surcharges to impose progressive taxes, restructure the income tax itself.

   • Temporary nature of surcharges: Surcharges should be used only in times of fiscal distress, with clear sunset clauses to prevent their indefinite continuation.

Conclusion:

The increasing reliance on cesses and surcharges has raised concerns regarding efficiency, equity, and transparency in India’s taxation system. A balanced approach, with clear guidelines, periodic reviews, and sunset clauses, is needed to prevent their perpetual use and ensure a fair and transparent tax system. The Centre should also ensure that surcharges and cesses are used only for their intended purposes and in exceptional circumstances.