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These days there is much hand wringing about the unfair treatment of the southern States in their share of tax resources of the nation. For the moment, leave aside the fact that this controversy gets much of its fuel from the current election and campaign rhetoric. So let’s focus on the economic angle to the debate. Firstly, it is useful to remind ourselves that India is not a union of States, like the United States of America. The States of India are in fact a creation of the Union, and hence it is possible that more States may be created in the future. It is not as if different States came together voluntarily in 1947 and decided to form a Union. India is not a federation of States either. Yet the country is federal in nature, in that the State governments have certain autonomy.
This autonomy of law making is enshrined in the Constitution, in the Seventh Schedule which has the three lists, the Union list, States’ list and the Concurrent list. The lists delineate areas which are the exclusive domains of respective governments (Centre or State) and overlapping areas (Concurrent list). Prime Minister Narendra Modi has repeatedly used the phrase “cooperative federalism” to describe the fact that development requires both an element of competition between States (and hence their respective autonomy) as also cooperation (for instance in river water sharing, or ensuring there is no fiscal race to the bottom in attracting investments).
It is useful to remind ourselves that India is not a union of States, like the United States of America. The States of India are in fact a creation of the Union, and hence it is possible that more States may be created in the future. It is not as if different States came together voluntarily in 1947 and decided to form a Union. India is not a federation of States either. Yet the country is federal in nature, in that the State governments have certain autonomy.
The passage of the Goods and Services Tax Act at the Centre and in all States represents a “grand bargain” and the spirit of cooperative federalism. In this, the Centre has surrendered its right to impose excise and service tax, and States have surrendered their right to impose sales tax and other sundry taxes. Indeed, we collapsed more than 1,500 different rates of indirect taxes into five or six rates (or slabs), making for a uniform nationwide tax regime. The grand bargain has rule-based sharing of the GST collected between the States and the Centre. The benefits of GST are many. It makes India a unified economic market, removes friction in interstate commerce, has interlocking incentives in the production chain, which reduces tax evasion, and eventually reduces the cost of goods and services. The rollout of GST did reduce the tax autonomy of the States, but it also reduced that of the Centre. This was a tax reform which was discussed and debated over 15 years, and its principle is now totally accepted. Its implementation may leave much to be desired but not the principle.
Of the taxes collected by the Centre, which in addition to Centre’s share of GST, include import duties and income tax, there is a divisible pool. This pool is divided among the States of India as per a formula recommended by the Finance Commission (FC). The FC is a constitutional body, appointed every five years, whose recommendations are usually accepted fully. The current FC is the 15th FC, whose recommendations will be applicable for the five year period commencing April 1, 2020. It is the first one in the post-GST regime. The formula that the FC adopts to divide the national pool of taxes is based on considerations like population and backwardness (per capita income). The latter is to ensure balanced regional development across the country. But over several decades it was seen that the developmental gap was not narrowing. That the rich States have to help poorer States is an accepted principle. But for how long? And is the FC ending up rewarding backwardness? The FC takes into account the State’s own fiscal resource raising capacity, and that is subtracted from overall allocation. Thus, if a state is a “laggard” in its own resource raising, it can count on the FC to “bail it out”. This became a big concern, and ever since the 12th FC, an element of “reforms” was introduced. States were encouraged to tap funds directly from the market, which would presumably impose a fiscal discipline on them.
In addition, the backward States are also those whose populations are rising faster. That too makes their share go up. For instance, some States in the South have achieved total fertility rates of close to 2.1, which means zero population growth. Since 1951, the population share of the four southern States has fallen from around 28 per cent to 20.75 per cent in 2011. In the same period, the share of “Northern” Hindi speaking States has risen from around 36 to 39.5 per cent. So if the 15th FC adopts the 2011 census instead of the 1971 census, the share of taxes to the southern States will reduce substantially, and go up for the northern States.
That the rich States have to help poorer States is an accepted principle. But for how long? And is the FC ending up rewarding backwardness? The FC takes into account the State’s own fiscal resource raising capacity, and that is subtracted from overall allocation. Thus, if a state is a “laggard” in its own resource raising, it can count on the FC to “bail it out”. This became a big concern, and ever since the 12th FC, an element of “reforms” was introduced. States were encouraged to tap funds directly from the market, which would presumably impose a fiscal discipline on them.
Other States like Maharashtra, Assam, Bengal, Punjab, Goa and Odisha too stand to lose if the population base is shifted from 1971 to 2011 census. This is one of the main causes of the controversy. Furthermore, imposing uniform rules of fiscal discipline, like a ceiling of three percent fiscal deficit as a percentage of the Gross State Domestic Product also puts backward States at a disadvantage. States like Maharashtra, which have a higher per capita income, tend to lose out. But it has very high intra-State inequality, so some of its districts are as “backward” as some of the very backward States. So that is another factor that needs to be considered.
Further, as we seek more decentralisation down to the third tier of government, the FC is also considering devolving funds directly to village and town councils and municipalities. This may need a constitutional amendment since it impacts States’ autonomy to internally distribute its resources.
Thus “how to divide the national cake fairly?” among States of India, is an increasingly contested question. It needs multiple criteria to be considered, beyond population size, backwardness and intra-state inequality. What is “fair” is ultimately a matter of judgement, but it can become more widely acceptable if based on sound economic logic, wide participative discussion and transparent, measurable criteria.