Centre-state tax sharing row: No problem with formula, say experts

Based on 15th FC’s suggestion, 41% of Centre’s divisible tax pool allocated to states
Union Finance Ministry
Union Finance Ministry (File Photo)

NEW DELHI: Ahead of the general elections, southern states -- Karnataka, Kerala and Tamil Nadu -- continue to express their dissatisfaction over the allocation of tax revenue by the Centre.

According to them, their share in the central taxes has been decreased by the 15th Finance Commission. Recently, Karnataka Chief Minister Siddaramaiah on an X post said under the 14th Finance Commission (2015-2020), Karnataka received 4.71% of the tax share, which was reduced to 3.64% by the 15th Finance Commission (2020-2025), a decrease of 107 basis points.

Finance Minister Nirmala Sitharman refuted these states’ claims saying the Centre has no discretion in allocating funds to the states and it is done on the recommendations of the Commission, which is a constitutional body.

Currently, based on the 15th Finance Commission’s suggestion, 41% of the Centre’s divisible tax pool is yearly allocated to the states in 14 installments over the span of 2021-22 to 2025-26. The contentious issue, though, is the formula used to distribute this amount among different states.

Among the different criteria used by the Commission, high weightage is given to income distance, the distance of the state’s income from the state with the highest income, and population.

This means that poor and highly populated states of UP (18%) and Bihar (10%) together receive 28% of the devolved tax amount meant for all states. This leaves developed and lowly populated states like Tamil Nadu (4.2%), Karnataka (3.65%), Telangana (2.13%), Andhra Pradesh (4.11%) and Kerala (1.96%) with smaller share of funds received from the Centre.

Experts are divided in their opinion about the current controversy over tax devolution. While some claim politics in distribution of resources to states, others argue that the allocation is fair and logical.

According to Professor Arun Kumar, former economics professor at Jawaharlal Nehru University (JNU), there is no problem in the devolution method. The problem, he says, is elsewhere. “The main grievance of southern states is that they are being punished for controlling their population – population being one of the key criteria for deciding the tax devolution formula. However, developed and industrialized states must realise that we are one market, and industrialised states also benefit from higher devolution to poorer states, which are the consuming states,” says Prof Kumar.

Lekha S Chakraborty, a professor at the National Institute of Public Finance and Policy (NIPFP) argues the intergovernmental fiscal transfers are based on a scientific formula. However, the weightage and the choice of variables in the formula affect the interstate share.“If more weightage is given to distance criterion (per capita income), it can penalise the states that are growing fast. Similar is the case with population criterion, as states which controlled the population get penalised. So the balance between equity and efficiency in fiscal transfers’ formula is very significant,” she says.

The states have also raised the issue of higher tax collection by the Centre through Cess and Surcharge. It must be noted here that the Centre collects nearly 25% of its tax revenue in Cesses and Surcharges, which are not shared with the states. However, the Centre has argued that a large part of the Cess collection comprises GST Compensation Cess, which go entirely to the states.

“While the problem is not Finance Commission devolution, which allows 41% devolution to states, the problem is states are not getting even the 41% as recommended by the Finance Commission because Centre collects a substantial part of its tax revenue through cess and surcharge, which are not shared with the states. Centre is notional and states are real. But states are only getting 32-33% of the taxes collected by the Centre,” said Prof Kumar.

Politics in distribution

Kumar says there is politics in the way the rest of the amount (amount left after devolution to states) that the Centre is using. The BJP-ruled Centre is investing more in BJP-ruled states and non-BJP ruled states are being treated unfairly. Kumar feels the states must get more autonomy and there should be higher devolution of taxes to states. “I think states must get 65-70% of the taxes collected by the Centre,” he says.

However, the Centre has countered the allegation of politics behind distribution of resources. According to it, Karnataka has received revenue deficit grant of Rs 1,631 crore recommended by the 15th FC. Similarly, Kerala, another southern state, has received revenue deficit grants based on the recommendation of the 15th FC. However, other states such as Uttar Pradesh, Madhya Pradesh, Gujarat and Bihar didn’t receive any revenue deficit grant whatsoever – hardly a discrimination against any region or party in power.

According to Professor Charan Singh, CEO, EGROW Foundation, India has a high level of imbalances in economic growth due to varying cultural, institutional, historical and infrastructural developments in different states. The Finance Commission has a difficult task of attempting to address these vertical and horizontal imbalances despite deploying various parametric benchmarks.

Tightrope walk for 16th FC

Amid the latest row over distribution of resources with states, the 16th Finance Commission will have to do a balancing act. The 16th Finance Commission will cover the period from 2026 to 2031.

Chakraborty says the decision by the 16th Finance Commission in terms of choice of variables and the weightage given to the variables matter, and the bargaining power of the states is high, especially South Indian states in this regard.

Key points

41%: The percentage of Centre's tax pool transferred to states

25%: Proportion of Cess and Surcharge in Centre's tax collection

45%: Weightage given to Income distance for deciding the devolution proportion to states

15%: Weightage given to states' population

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