Tax devolution not about richer vs poorer states

Tax devolution shares, which threaten to create a north-south divide among states, may have more to do with per capita income, and not so much with population.

The 16th Finance Commission may have to grapple with the issue of addressing the grievances of the southern states, but, contrary to widespread perception, tweaking the population parameter may not be the ideal way to do so.

The share of southern states -- Andhra Pradesh, Telangana, Tamil Nadu, Karnataka, and Kerala -- came down to 15.8 per cent in total devolution of central taxes to the states when the 15th Finance Commission gave its recommendations in the second part of its report for 2021-22 (FY22) to FY26 from 19.78 per cent during the period of the 12th Finance Commission -- FY06 to FY10.

The share was lower than the 16.02 per cent during FY21, the period of the first part of the 15th Finance Commission's report.

The five southern states blamed it on the population parameter. The 15th Finance Commission's terms of reference asked it to base the population parameter on the 2011 census against the 1971 used by the previous commissions.

They alleged that this would go against them since they controlled their population better than many other states.

To address these woes, the 15th Finance Commission gave weight to demographic performance, meaning population control.

The Commission gave 15 per cent weight to population and 12.5 per cent to demographic performance, thus nearly neutralising the bias of the 2011 census against the southern states.

The 15th Finance Commission is not the only one that gave weight to population on the basis of the 2011 census; the 14th Finance Commission, too, had based the population parameter to the 1971 census, as cited above, and gave it a weight of 17.5 per cent.

However, it had another parameter -- demographic change -- which was given 10 per cent weight. It was nothing but a weight to population in terms of the 2011 census.

The 12th and the 13th Finance Commission each gave 25 per cent weight to population in terms of the 1971 census.

As such, the reference to the 2011 census in the 15th Finance Commission played just a minor role.

That role, with tweaks, may remain, since the reference to the 2011 census cannot be reverted now.

Population challenge

A former member of one of the previous Finance Commissions says, on the condition of anonymity, that the population yardstick would be a challenge for the 16th Finance Commission as well as future commissions.

However, to blame the dip in the share of devolution to the southern states on the population parameter alone would be barking up the wrong tree.

The 12th Finance Commission's chairman, C Rangarajan, says this is not an issue specific to southern states, and that the richer-versus-poorer states matters.

A higher share of the divisible pool has been going to the poorer states in successive Finance Commission periods, he points out.

One has to see whether this is the right approach or not, in principle.

"In principle, I don't think anybody can argue that in any form of distribution of funds, the poorer states should not get a higher share," says Rangarajan.

The member of one of the previous Finance Commissions, cited above, wonders aloud, "If a bigger chunk of the devolution does not go to the poorer states, what is the use of that money?"

Rangarajan cautions that people tend to forget that the major criterion that pulls down the richer states is an income distance criterion.

States farther away from the topmost state in terms of per capita income get higher shares in terms of this criterion. This yardstick is the one to look at, he says.

Weight of the income distance criterion hovered around 45-50 per cent in the recommendations of the Finance Commissions.

Income distance

Technically and theoretically, this criterion would mean the state with the highest per capita income will not get anything out of the 45-50 per cent devolution in terms of the 14th and 15th Finance Commission reports, Rangarajan says.

He suggests this is where some rethinking is required to take care of the aspirations of the richer states.

However, all poorer states did not get higher shares in Central taxes in the recent Commission compared to the previous ones, since the income distance criterion is one of the parameters.

For instance, area has 15 per cent weight, forest and ecology 10 per cent, and tax effort 2.5 per cent in the 15th Finance Commission reports, besides population, demographic performance and income distance criteria.

For example, the share of Uttar Pradesh and Bihar, the poorest states in terms of per capita income, saw their shares dipping when the 15th Finance Commission gave its recommendations in both of its reports against the 12th Finance Commission period (see chart).

This is the period after formation of new states out of these two.

Jharkhand, carved out of Bihar, saw its share coming down, albeit a bit, during this period (see chart).

The share of Uttarakhand fluctuated during this period and came to 1.12 per cent in the second report of the 15th Finance Commission, which was the same during the 13th Finance Commission period.

However, it stood lower, at 0.94 per cent, during the period of the 12th Finance Commission.

It is not always the case that the richer states got smaller proportions of devolution in the 15th Finance Commission than the 12th.

For instance, Maharashtra, Goa, and Sikkim got higher devolutions during this period.

New formula

Rajeev Gowda, vice-chairman of the State Institute for Transformation of Karnataka, says the 16th Finance Commission would like to come out with a formula for devolution of Central taxes to the states.

"Formulae can be very tricky because ours is a diverse nation. To balance the needs of each state is a complicated exercise," he says.

To suggest measures one needs a competent formula.

"You need to look at the level of districts too, while deciding devolution between the Centre and the states. For example, we have a very high per capita income at the state level. It is largely because of revenues generated by Bengaluru, but some regions are extremely backward," Gowda points out.

Finance commissions do look at district-level conditions, too, but this needs innovative formulae to provide more weight to backward districts.

"We need to tweak formulae to address the ground situations within the states," he suggests.

The Centre has increasingly resorted to cess and surcharge to bypass Finance Commission recommendations in the past decade or two.

Here, the share of southern states hovered around 5.03-5.20 per cent in most years. However, the share was much lower than what would have accrued to them had there been no cess and surcharge.

The divergence has increased in recent times. For instance, the share of southern states in total taxes stood at 5.2 per cent in FY11 though it should have been 5.94 per cent, had there been no cess and surcharge, according to implications of the 13th Finance Commission report.

The share is projected to come down to 5.03 per cent in FY25 in the Budget Estimates, while it should have been 6.48 per cent without cess and surcharge, according to the 15th Finance Commission.

Feature Presentation: Aslam Hunani/Rediff.com