1. Tax Sharing:
Under this method, the proceeds of certain selected taxes, imposed and realised by the Centre, are apportioned between the Centre and the different states. In India, the income tax and some union excise duties are taxes which are shared.
This method of sharing the tax yield is, however, confronted with various difficulties such as, what should be the criteria for determining the share of states out of the total tax yield of the Centre? What portion of the total national share should be assigned to each state? Basically, the share of the Centre should be reasonably large to meet its nationwide functions.
The share of each state can, however, be determined on the basis of actual yield from a particular state, its population, total revenue and its total expenditure needs.
Nevertheless, adjustments to the complete satisfaction of the different states may not be possible and states are bound to feel a sense of frustration. Arbitrary decisions are thus inevitable. In India, for instance, a Finance Commission is appointed every five years by the President to determine the share of each state in the division of taxes.
2. Reallocation of Functions:
Sometimes, when it is found that certain functions, though assigned to the state government, can very well be carried out by the central government with the same efficiency, it is desirable for the Centre itself to take over such functions, thus, relieving the state governments of the administrative burden.
3. State Contribution:
There may be a provision for contribution or payment from state governments to the Centre, when the latter is in need of large resources. This was practised in the U.S.A., at the time of its first Constitution when the national government had no powers of taxation and was solely dependent on the states’ assistance.
Such a system had been discarded in modern times, for it will not only make the Centre weak and subordinate to the states, but hinder the progress of national wellbeing and create immense difficulties for the Centre in meeting emergencies.
4. Supplementary Levies:
Supplementary levies may be of two types: (i) imposition of additional levies by the Centre on state taxes. However, as the states have their own rates of taxation, the latter method may not be a practicable proposition. The first method is more desirable and practicable, because in all federations, it is the states which need additional revenues to meet their growing commitments and as such, they should be authorised to impose supplementary levies on federal taxes.
For making the necessary adjustments in state resources, the central government has the constitutional power to make grants to the state governments in most federations of today. Undoubtedly the grants-in-aid from the Centre constitute a more definite and dependable source of revenue to the state governments than the method of sharing tax yields of the Centre.
Further, the grant may be regarded as an effective instrument for bridging the gap between fiscal capacity and financial needs of the state governments. While allocating grants, the Centre takes into account the economy and need of the states. It generally decides to give more financial help to backward states as compared to the rich and advanced states.
Federal grants should not be arbitrarily determined. They must be based on some specific criteria as suggested above. In India, a finance commission is appointed every five years to recommend to the Centre the allocation of grants.
Moreover, the allocation of federal grants should be determined well in advance and should be valid for a period of time; otherwise, a great deal of uncertainty and dissatisfaction may be caused to the states.
Conditional and Unconditional Grants:
Federal grants may be conditional or unconditional. Conditional grants are made for certain specific purposes. Therefore, the state governments have perforce to use such funds only for the purposes for which they are allocated.
Conditional grants are provided on the basis of expenditure needs of each state, irrespective of its financial capacity. For instance, educational grants may be made according to the number of students in school-going age in each state.
Although, under conditional grants, the states lose their freedom of action, such grants are justified on the grounds that the receiving states are made conscious of their financial responsibilities and functions and observe financial discipline and check unwise spending.
Unconditional grants are generally made on the basis of per capita income and relative poverty of the different states. They are devised to bridge the gap between revenues and expenditures of the state governments.
Such grants are also known as equalising grants. Since under unconditional grants, there is no check or supervision by the Centre, the receiving states have full authority to use them in any way they like. However, the state governments do not use them for projects which benefit the nation as a whole; they are used only for local purposes.
It will be observed from what has just been said that conditional and unconditional grants have their own merits and demerits. However, a combination of both the systems seems to be desirable and practical.