The 16th Finance Commission so far visited 16 states; visits to 12 more will be completed in the next few months. The commission has covered most of the Northeastern and Himalayan states as well as smaller states.
The information from news reports on these visits show that all states have raised two issues. One, increasing the combined share of states in the divisible pool of Union tax revenue to 50 per cent and including cess and surcharges in the divisible pool. Two, change the horizontal distribution formula to protect each state’s interests.
Gujarat and Southern states have argued to give efficiency a greater weight, and other smaller states have argued based on their specific fiscal problems. This is the opportune moment for states to argue for a transformative change in the horizontal distribution formula.
Basics of a horizontal distribution formula : The formula is to address the budget deficits or fiscal gaps in states’ budgets. The differences in fiscal gaps is because states differ in terms of population, revenue capacity, area, other specific problems and efficiency factors. Finance commissions recommend a distribution formula assigning different weights to these indicators and the indicators are also defined variously by them.
Because finance commissions change these complex formulas, the states cannot easily predict how their fiscal behaviour will be assessed by future commissions. But the overall analysis suggests that ultimately a state’s share in tax revenue increases with its population and declines with its income, as the Finance Commission prefers equity to efficiency.
Population and income: For the 15th Finance Commission, the Centre stipulated to use the 2011 census population in the distribution formula. This has directly affected the shares of states that have drastically reduced fertility rates since the 1960s. Population control is a behavioral change effected through democratising education and health care, and consequent social change to accept fertility control. This has not been adequately rewarded.
‘Income distance’ is another important indicator with more than 45 per cent weight in the distribution formula. The distance of the real per capita income of a state from the highest per capita income of all states is calculated and scaled up by the 2011 population of the state. As a result, we find states smaller in terms of population growth and larger in terms of size of the economy have received lower shares in the Union tax revenue compared to states with larger populations and smaller economies. Thus, equity is a major factor in the distribution formula.
Predictable formula to incentivise fiscal behaviour: The Finance Commission is constituted once in five years; the real concern then is to incentivise the fiscal behaviour of states on the desired path based on their recent behaviour. This requires the distribution formula to be simple with a few economic indicators. Such a formula would signal the states that their future fiscal behaviour will be evaluated based on their impact on a few economic variables.
The area of a state has been a part of the distribution formulas recommended by many commissions. The 15th Finance Commission also gave 15 per cent weight to it and had to do a balancing act by adjusting the area to scale up small states. 12 states were identified as small states by the 15th FC. Those smaller states had 10 per cent of the 2011 population and got a share of around 12.5 per cent of the tax devolution.
Smaller and larger states are not comparable by many indicators, therefore treating them as equals is not fair. Alternatively, we can think of assigning 10 to 12.5 per cent of the Union tax revenue to these smaller states and a formula-based set of comparable indicators should be used to derive the inter se shares for horizontal distribution. The remaining 85 per cent of Union tax revenue can be distributed among larger states.
In the last 75 years, every state ought to have internalised its area in its fiscal policies. This indicator can be dropped from the distribution formula. Some of the previous finance commissions have used forest cover, infrastructure index, and tax effort. Now there are demands to include indicators of urbanisation, old-age population, SC/ST population and poverty ratios.
Increasing the number of indicators and assigning weights to each of them will make the distribution formula complex. As we mentioned already, a finance commission’s recommendation is for a brief period of five years, therefore, it has to be simple and predictable to influence the fiscal behaviour of states. Continuity between finance commissions is also necessary. Therefore, too many indicators should be avoided in the distribution formula.
Alternatively, for larger states, the distribution formula should have only two variables—population and state’s income. Fiscal policies that help reduce population and increase state’s income shall concomitantly reduce the fiscal gap and improve the fiscal responsibility of states.
This simple two-variable distribution formula—with changing weights in successive finance commissions—will incentivise performing states and motivate the others to reduce population and develop their economies. The natural outcome of this will be reduced fiscal gaps in the states. Thus, the desired objective of the distribution formula will be achieved.
R Srinivasan
Member, Tamil Nadu State Planning Commission
S Raja Sethu Durai
Professor, BITS-Pilani, Dubai
(Views are personal)