Federalism, Taxation & 14th Finance Commission

Authored By: Shreyas B. T

Taxation powers for the Union and the States; and Revenue sharing between them are two of the key elements in any Federal setup, which directly determines if the most appropriate government layer is involved in public expenditure towards the respective policy items.

It is all the more key for the Indian union, given its geographical size, large & diverse population and hence significantly dissimilar problems among different regions/ States.

 India, being a (quasi) Federal democracy, also has its own setup of taxation power split between various government layers – like Center, State, City Corporation, Village Panchayat et al; and sharing the collected revenue with the other layers of government.

 Is it a most suitable setup? Does it have unnecessary revenue aggregation and segregation steps? Does it harmonize or does it do more harm?

 In this artcile, let’s try and understand the details around these aspects with a reference to the latest (14th) Finance Commission’s recommendations. Let’s first see the basic principles of taxation powers of the various levels of the governments in India, then its segregation to the next levels of governments:

TAXATION POWERS IN INDIA
Centre Cess & Surcharges Not shared with States
Corporation Tax, Income Tax (other than Agricultural), Excise Duty, Service Tax, Customs Duty, STT Shared with States (Divisible Pool)
Central Sales Tax, Duties on property succession, Taxes on railway fares a freights Assigned to States (roughly based on origination; to the “exporter” State in case of CST)
States Stamp Duties & Excise Duties Levied by Centre; collected & retained by States
VAT, Agricultural Income, Agri Land Estate Duty, Capitation Tax, Road & Vehicle Tax Levied, collected & retained by States
Municipalities Property Tax  

 Finance Commission (FC) in India and the 14th FC

Article 280 of the Constitution of India provides for a finance commission as a quasi-judicial body. It is constituted by the President of India every fifth year. It consists of a chairman and four other members to be appointed by the president.

It’s mandate will be to provide recommendations about the following to the President of India:

  1. The distribution of the net proceeds of taxes between the centre and the states and the allocation between the states of the respective shares of such proceeds.
  2. The principles that should govern the grants in aid to the states by the centre.
  3. The measures needed to augment the consolidated fund of states to supplement the resources of the local governments in the states on the basis of the recommendations made by the State Finance Commissions.
  4. Any other method referred to it by the President in the interests of the sound finance.

The recommendations made by finance commission are only advisory in nature and hence, are not binding on the government.

Key Recommendations of the 14th FC:

  • Sharing of Union Taxes
    • Vertical Distribution – 42% of the divisible pool
    • Horizontal Distribution
  • Moving away from the Plan and non-Plan distinctions
    • Reduction in grants, and greater emphasis on devolution
    • Discontinuation of sector specific grants
  • Grants in Aid for Local Bodies
    • 87 Lakh Cr. for 5 year period
    • 90% based on Population
    • 10% on Area
  • Post Devolution Revenue Deficit: Rs. 48,906 Cr. grant for 11 revenue deficit States
  • Others (Public Utility Pricing, Fiscal Deficit Review, Disinvestment, GST, Climate, Disaster Recovery Fund, etc)

Let’s discuss in detail on some of the key recommendations of the 14th FC, particularly around the tax devolution, its formulae and GST effect on State finances.

Vertical Devolution:

The 14th FC has recommended a 42% vertical devolution of the divisible pool of the Centre’s taxes to the States. This was 32% in the 13th and 30.% in the 12th FCs.

As can be seen, this is a big jump from the previous FCs with an underlying theory of reducing Plan transfer (like Centrally Sponsored Schemes) where the States would not have a lot of flexibility on choosing the most relevant areas of expenditure. With an increased tax devolution and reduced dependency for States on the plan transfers, the idea is to promote self sufficiency for the States in the spirit of cooperative Federalism.

Horizontal Distribution:

The 42% share earmarked to be devolved to the States would then follow a Horizontal Distribution formula to arrive at the individual States’ proportionate share.

Horizontal Tax Distribution
  14th FC 13th FC 12th FC
Population (Basis 1971) 17.5% 25.0% 25.0%
Population (Basis 2011) 10%
Fiscal Capacity as Income Distance 50% 47.5% 50%
Land Area 15% 10.0% 10.0%
Forest Cover 7.5%
Fiscal Discipline 0% 17.5% 7.5%
Tax Effort 0% 7.5%
Total 100.0% 100.0% 100.0%

Source: Table 8.1 of Fourteenth Finance Commission report

Based on this horizontal distribution formula, the table below provides an approximate State-specific share of the divisible pool of taxes.

Inter-Se Share of States   Inter-Se Share of States
State 14th FC 13th FC Change

(13th -> 14th FC)

  State 14th FC 13th FC Change

(13th -> 14th FC)

Uttar Pradesh 17.96% 19.68% -1.72%   Telangana 2.44%
Bihar 9.67% 10.92% -1.25%   Jammu & Kashmir 1.85% 1.55% 0.30%
Madhya Pradesh 7.55% 7.12% 0.43%   Punjab 1.58% 1.39% 0.19%
West Bengal 7.32% 7.26% 0.06%   Arunachal Pradesh 1.37% 0.33% 1.04%
Maharashtra 5.52% 5.20% 0.32%   Haryana 1.08% 1.05% 0.04%
Rajasthan 5.50% 5.85% -0.36%   Uttarakhand 1.05% 1.12% -0.07%
Karnataka 4.71% 4.33% 0.38%   Himachal Pradesh 0.71% 0.78% -0.07%
Odisha 4.64% 4.78% -0.14%   Meghalaya 0.64% 0.41% 0.23%
Andhra Pradesh 4.31% 6.94% -2.63%   Tripura 0.64% 0.51% 0.13%
Tamil Nadu 4.02% 4.97% -0.95%   Manipur 0.62% 0.45% 0.17%
Assam 3.31% 3.63% -0.32%   Nagaland 0.50% 0.31% 0.18%
Jharkhand 3.14% 2.80% 0.34%   Mizoram 0.46% 0.27% 0.19%
Gujarat 3.08% 3.04% 0.04%   Goa 0.38% 0.27% 0.11%
Chhattisgarh 3.08% 2.47% 0.61%   Sikkim 0.37% 0.24% 0.13%
Kerala 2.50% 2.34% 0.16%          

Source: Table 8.2 of Fourteenth Finance Commission report

It very clearly shows that a good 40% of the total divisible pool is diverted towards the so-called heartland of India, somewhat infamously referred to as the BIMARU states that yield rich political dividends for parties that can woo those states.

It does obviously follow a set of laid out principles (i.e., the horizontal distribution formula) recommended by the Finance Commission. Yet, a seemingly continued skewed allocation prompts a much closer look at the distribution formula itself.

Population and Demographic Change:

The 14th FC has recommended a weight of 17.5% to the 1971 population and a 10% weight to the 2011 population. Both 1971 and 2011 population figures have been considered to factor in the demographic changes since 1971, like composition of population and migration.

Although going with a more recent population sounds very logical at the outset, a quick look at the population statistics of both 1971 and 2011 demonstrate how the smaller States with much better discipline in population control is at a significant disadvantage.

Population in Crores Population Distance From UP (example)
  2011 1971 Change

(1971 onwards)

2011 1971
Uttar Pradesh 19.9 8.3 239.76%
Karnataka 6.1 2.9 210.34% 0.31 0.35
Kerala 3.3 2.1 157.14% 0.17 0.25
Tamil Nadu 7.2 4.1 175.61% 0.36 0.49
West Bengal 9.1 4.4 206.82% 0.46 0.53
Maharashtra 11.2 5 224.00% 0.56 0.60

The above table illustrates the relative population weights of a State like MH that is perhaps the strongest economic performer, some of the more disciplined States in population control (TN, KA etc) those are also strong economic performers, and a State like UP that has the highest population with no signs whatsoever of slowing down its population.

Although there is a direct correlation between population and the cost to deliver public policies and social welfare schemes to them, and hence it is very logical to allocate more funds to the more populous States, statistics provided above clearly shows that these States have continuously failed in population control for many decades. This naturally continues to skew the fund allocation towards such States, effectively incentivising poor performance and penalizing better performing States (population control in this context).

Fiscal Capacity (as Income Distance):

Fiscal Capacity as Income Distance is a measure to determine the economic backwardness of a state. The more backward the state, the more fund allocation for it! The main intent being harmonization and bringing all states to a comparable level of living conditions.

Successive FCs have used some form of Income Distance (be it, per capita Income or per capita Taxable capacity or per capita GSDP) and with a huge weightage (50% in the 14th FC) in the horizontal distribution split.

The 14th FC has calculated the income distance following the method adopted by the 12th FC. A three-year average (2010-11 to 2012-13) per capita comparable Gross State Domestic Product (GSDP) has been taken for all the twenty-nine States. Income distance of each State has been computed by taking the distance from the State having highest per capita GSDP. Goa has the highest per capita GSDP, followed by Sikkim. However, since both these are very small States, the next highest GSDP State Haryana has been considered as the reference State to arrive at the Income Distance of all the States.

State Average Per Capita GSDP

(Rs. Thousand Lakhs)

(2010-11 to 2012-13)

Indicative

Income Distance

Haryana (Reference) 116.1793
Uttar Pradesh 33.8154 70.89%
Karnataka 76.7809 33.91%
Tamil Nadu 98.3267 15.37%
West Bengal 58.3234 49.80%
Maharashtra 103.0914 11.27%

Source of GSDPs: Annex 8.5 of Fourteenth Finance Commission report

Greater the income distance of a State with the reference State (Haryana), larger is its share in the horizontal distribution. This sounds fair in a Federal setup, where ideally the various levels of governments should collectively ensure and minimize income and regional imbalances.

However, a continued lacklustre performance by the most populous States for many decades, both on the financial and population control fronts again results in a skewed allocation towards such States, effectively incentivising poor performance and penalizing better performing States – to give some quantitative perspective of the effect of Income Distance on the relative weightages, UP gets more than double the weightage than Karnataka!

On one hand a huge population, on the other hand a huge income distance for such a large population says one thing aloud – it’s a huge burden on those who’re having to pay up trying to reduce this gap since decades without a respite!

Fiscal Discipline:

Fiscal Discipline, a measure of the State’s handling of its finances was one of the components in the horizontal distribution formula till the 13th FC (17.5%). The 13th FC had come up with a Fiscal Discipline measure called IFD (Index of Financial Discipline), which is basically a ratio of own revenue receipts of a State to its total revenue or current expenditure. Improvements in IFD are measured as the difference in the ratio between the base period (2001-02 to 2003-04 years by FC-13) and the reference period (2005-06 to 2007-08 by FC-13). Improvements in this ratio are then compared to the average for all States; and States with relatively higher improvement than the average for all States received higher transfers.

However, the 14th FC has done away with Fiscal Discipline as a horizontal distribution component citing inaccurate methodology. This is because, the 13th FC considered the improvement in IFD from the base to the reference year, and the relative improvement (delta) figures would naturally tend to be higher for States having a significantly lower IFD to start with (base year).

So the delta IFD being inaccurate to horizontally distribute revenues has merit, because it would result in a State like Bihar getting a much bigger weightage for  its higher improvement factor (delta), despite being much lower when stack ranked against other better performing States’ IFD. A quick look at the States’ own IFD and their relative IFDs (relative ratio to all States) suggest that States like KA, MH, TN, GJ etc have been consistently maintaining much better financial prudence, yet not being rewarded by means of proportionally higher horizontal devolution by not factoring in their fiscal discipline.

Notwithstanding the current statistics which are arguably inaccurate, it is anybody’s guess on how sensible it would be to include Fiscal Discipline (in some logical form) in horizontal devolution to encourage good fiscal prudence.

Index of Fiscal Discipline
Sl. No. States Own Revenue / Revenue

Expenditure (%)

Relative to all States (ratio)  
Average 2001-

02 to 2003-04

Average 2005-

06 to 2007-08

Average 2001-

02 to 2003-04

Average 2005-

06 to 2007-08

Index of Change

(ratio)

1 Andhra Pradesh 59.58 69.49 1.18 1.11 0.94
2 Arunachal Pradesh 10.99 23.92 0.22 0.38 1.76
3 Assam 34.51 44.99 0.68 0.72 1.05
4 Bihar 24.46 23.4 0.48 0.37 0.77
5 Chhattisgarh 56.88 72.3 1.13 1.16 1.03
6 Goa 78.01 86.98 1.54 1.39 0.9
7 Gujarat 61.97 78.54 1.23 1.26 1.03
8 Haryana 79.24 94.37 1.57 1.51 0.96
9 Himachal Pradesh 22.52 40 0.45 0.64 1.44
10 Jammu & Kashmir 22.83 24.33 0.45 0.39 0.86
11 Jharkhand 52.6 48.5 1.04 0.78 0.75
12 Karnataka 64.1 82.07 1.27 1.31 1.04
13 Kerala 55.33 61.16 1.1 0.98 0.89
14 Madhya Pradesh 46.86 57.29 0.93 0.92 0.99
15 Maharastra 67.24 87.22 1.33 1.4 1.05
16 Manipur 7.54 11.69 0.15 0.19 1.26
17 Meghalaya 21.05 24.08 0.42 0.39 0.93
18 Mizoram 6.62 11.16 0.13 0.18 1.36
19 Nagaland 6.99 9.63 0.14 0.15 1.11
20 Orissa 37.02 52.72 0.73 0.84 1.15
21 Punjab 59.11 71.93 1.17 1.15 0.98
22 Rajasthan 46.94 59.69 0.93 0.96 1.03
23 Sikkim 26.46 29.19 0.52 0.47 0.89
24 Tamil Nadu 67.2 81.88 1.33 1.31 0.99
25 Tripura 15.88 16.91 0.31 0.27 0.86
26 Uttar Pradesh 37.13 49 0.74 0.78 1.07
27 Uttarakhand 37.56 46.54 0.74 0.75 1
28 West Bengal 33.63 37.83 0.67 0.61 0.91
    50.51 62.43 1 1 1

Source: Annex 8.6 of Thirteenth Finance Commission report

Tax Effort:

Tax Effort, a measure of a State’s ability and initiatives undertaken to improve its tax base and hence relative tax generation was one of the components in the horizontal devolution till the 12th FC (with a weightage of 7.5%).

This was discontinued by the 13th FC citing the Fiscal Discipline component anyway captures the States’ tax effort also. This surely sounds reasonable to a degree, but tax effort has been kept out by the 14th FC also despite taking Fiscal Discipline also off the horizontal devolution criteria. This surely is a double blow for States generating higher tax revenues (to the Union’s divisible pool) as well as to the States managing its finances with prudence.

Land Area & Forest Cover:

Land Area has been one of the parameters in the horizontal devolution split since the 12th FC with a view that the greater the land area of a State, higher are the administrative expenses and public expenditure. The 14th FC has retained this and increased its weightage from 10% to 15%. The increase in weightage is debatable, considering other performance related parameters like Fiscal Discipline and Tax Effort have been dropped.

Forest Cover has been included as a new parameter to the horizontal devolution split to factor in the opportunity cost for States having large forest cover. This is with a fair view that the forests can’t and shouldn’t be cleared indiscriminately to make way for industrialization.

GST:

GST subsumes into it a variety of Union and State taxes. The largest among those (in terms of total tax revenue) are the Union’s Excise & Service Tax, and the States’  VAT & CST.

Although most of it, in theory, gets into the Center’s divisible pool and hence would reach the States as per the horizontal devolution formula, States would now lose control over its largest revenue pools VAT and CST (CST was assigned to the “exporter” state pre-GST, whereas will now get subsumed under the “importer” State’s SGST), which otherwise would be in their  direct control.

This is a major impact on the industrialized States. The GST council has suggested a compensation mechanism to address this, but it is in a tapering manner that would eventually cease to exist after 5 years, with theories and assumptions that the introduction of GST would propel the economy to great heights and everything would be normalised by the end of 5 years!

Conclusion:

One of the basic drivers of Cooperative Federalism is for the Center and the States to cooperate and work together on governance and administrative aspects and run a well oiled machine – and one of the key desired outcomes of it (in the context of this paper) being a harmonized and near uniform living conditions across the length and breadth of the Country.

Some of the analyses presented above very clearly show continued skewed allocation of the divisible pool to make up for a continued lack of performance by certain states. There may surely be genuine constraints (like geographical, historical, literacy et al which are outside of the context of this paper) for its backwardness, but decades of mismanagement and hence terribly slow turnaround is clearly hurting everyone.

As if that were not enough, the recent introduction of GST would add to the woes of the “contributing” states due to the tables tilting towards the “importer” states as against the “exporter” states.

It is very clear that decades of diverting tremendous amounts of funds in the guise of harmonization and equalisation isn’t working at all; and the loss to the industrialized States’ revenue stream (VAT and CST) and much higher dependency on Central tax devolution and its policies, the worst fear is if all this would eventually lead the better performing States also to drop the ball which would be the death knell for even Competitive Federalism and killing the cash cows!

Hence, it is anybody’s guess that the need of the hour is for some drastic and bold measures in the interest of the whole Nation.

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