The State of The Fiscal Union
Part-2
-Ashwath Damle, BSc. ‘24
estimated reading time: 5-7 minutes.
As I mentioned in the previous article, in my view, the primary failing of our fiscal federation is the system by which union taxes are devolved. The formula as it stands today is almost entirely need based. The addition of demographic performance as sop to the southern states simply obfuscates the real issue facing the faster growing states. The faster growing states receive cents on the dollar ( or paisas on the rupee) of their payment in direct taxes. This fundamental imbalance is at the heart of both the devolution and delimitation question. After all, for 50 years India has not just allowed but actively created malapportionment and even today continues to seriously consider allowing the malapportionment to continue. This strangely anti-democratic consideration occurs because explicitly or implicitly most people recognize the imbalance in our fiscal arrangements and are trying to find ways to compensate for it.
Now all federations the world over engage in some form of fiscal transfers between wealthier and poorer states. But what N.S Nilekantan points out is that India may be the only country where it is the smaller states subsidising the larger states. This places a higher degree of fiscal strain on the wealthier states in India.
This is not the only way in which India differs from other federations. The nature of the current formula does not just create an imbalance between wealthier and poorer states but it also warps the incentives facing the states. The purely need based formula weakens the state government’s incentives when it comes to growth. Now I must be careful, I am by no means suggesting that the current framework has created a situation where the states are indifferent to growth. But direct taxes, unlike consumption taxes, do not have a component that is distributed on the basis of collection.
Income growth does not lead to an increase in direct tax revenue for the states as they are not allowed to levy their own direct taxes nor are they awarded a percent of direct tax collections that happened within the state. That is not all. A rise in a state’s income level means a decrease in the income distance, a measure that makes up nearly half of the finance commission formula.
This means that state governments are not just indifferent to, but actually harmed by income growth that is not accompanied by consumption growth. Given India’s recent economic condition, income growth without consumption growth is far from a hypothetical.
As mentioned earlier this purely need based allocation of direct taxes makes India an outlier among federations. Both in the developed and developing world.
Germany and China for example have federation wide direct tax that is split between the centre and the states. With a state’s share being determined purely on the basis of collections. Much like how the GST functions in India. The US on the other hand has no formal tax sharing arrangement but rather allows the states to levy their own income tax.
Interestingly, India was not always such an outlier. In the pre-independence era, there was no stability in the fiscal arrangements, with expert committees being regularly set up to make reforms. Yet broadly speaking, direct taxes were almost consistently distributed on the basis of collection.
The first major shift to a need based framework came with the interim C.D Deshmukh award. Following the partition adjustments had to be made to the state’s share to redistribute the shares of the states that had gone to pakistan. And to reduce Punjab’s and Bengal’s share to bring it in line with their new reduced size. C.D Deshmukh, who was tasked with making these adjustments, redistributed the share of the states that left the union purely on the basis of population. He argued that including any consideration for collections would only serve to slow down the process of convergence among the states. The 1st Finance Commission broadly concurred with this reasoning. It drew up a formula that was 80% population and 20% collection.
Whatever critique one may have of an alternate fiscal arrangement, it is worth noting that after 75 years this convergence has not yet occurred. And there are no signs that it will occur in the near future.
It is also interesting to look at the representations made by the states to the 1st finance commission. Unsurprisingly states like Bihar and Orissa argued for population and special needs to be given a higher weightage. While states like Bombay and Madras argued for a collection to be given a higher weightage. However the only truly interesting submission was the one made by Bengal. Bengal argued that the constitution only gave the finance commission the power to decide the split between the centre and the states. According to Bengal’s reasoning the constitution required that taxes be divided among the states purely on the basis of collection.
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