No State has ever been satisfied with the Finance Commission’s awards either on the aggregate States’ share in the Central tax revenue or on the inter se distribution formula—the two purposes for which Finance Commissions are constituted every five years. However, in recent times, Finance Commissions have been successively increasing the aggregate States’ share in the Central tax revenue, thus the more focussed debate on the distribution formula.
Every State’s share in the Central tax revenue should fill the deficit between its ideal revenue and expenditure so that one can ensure minimum standards and adequacy of public services across States. This fiscal gap of a State arises from the difference in its revenue capacities and expenditure needs. Filling the actual fiscal gap every year will create adverse incentives for States to reduce revenue effort and increase expenditure commitments in the ensuing years. Therefore, Finance Commissions use a set of proxy indicators in the distribution formula to address this issue.
The indicators in the distribution formula are categorised as equity and efficiency ones. The fact that ensuring equity in public services in all States is the prime objective of this effort takes us towards assigning a greater weight to equity indicators. However, giving excessive importance to equity will discourage States from being fiscally efficient, and that will cost the country very dearly. Therefore, the trade-off between equity and efficiency factors in the distribution formula has to be addressed objectively.
Equity and efficiency in distribution formula
Financial Commissions discuss the indicators in the distribution formula and explain how each one represents the equity and/or efficiency aspects of States’ fiscal situation. They also discuss the weightage given to these aspects and the desirability of trade-offs. The general equity factors, represented by various numerical indicators, are population, area and size of the economy. The efficiency indicators are mainly fiscal measures such as revenue effort and expenditure prudence. Of late, Finance Commissions have been hinting at the desirability of rewarding the fiscal efficiency of States but have given more than three-fourths of the weight to equity indicators as the open acknowledgement of preferring equity to efficiency in the distribution formula (Table 1).
Further, comparing the last four Finance Commissions, it is seen that the shares of some of the major States (Table 2) in the aggregate States’ share in the Central tax revenue have been declining, even in bifurcated States after adding the shares of the new States—Andhra Pradesh, Bihar, Madhya Pradesh and Uttar Pradesh. These States cannot be categorised as a homogeneous group in terms of either size and structure of economies or fiscal behaviour. Shares of other States have been fluctuating in successive awards of Finance Commissions. The differences in the numerical nature of indicators and weightage for each indicator together change the absolute shares of States. Therefore, the cumulative effect of Finance Commission awards has neither brought about equity nor promoted the efficiency of fiscal and economic situations of States. It shows that the primary objective of ensuring minimum standards of adequate public services in all States is still elusive.
The hue and cry of States whenever a Finance Commission is established is because of this subtle efficiency consideration. Hence, there is an immediate need to change the distribution formula that can directly address this elusive objective of Union-State financial transfers in India.
Reassign tax powers
The problems of the vertical fiscal gap and the efficiency aspect in the distribution formula can be addressed with the single move of assigning the entire commodity taxation to States. In 2017-18, the States’ share in the Central tax revenue was Rs.6.73 lakh crore. The goods and services tax (GST) collection by the Central government (Central GST (CGST) + Integrated GST (IGST) + cess) was Rs.4.43 lakh crore, and the Union excise duty collection was Rs.2.59 lakh crore. By assigning these two taxes to States, they would get additionally Rs.7.02 lakh crore, which is slightly higher than the States’ share mentioned earlier. If the entire commodity taxation is assigned to the States, then the resultant distribution of such tax revenue will reflect differences in tax efficiency and economic endowments. This distribution will be totally different from the existing distribution because the existing distribution has a larger weight for equity.
The assignment of the entire commodity tax to the States has several advantages. One, it helps correct the vertical fiscal imbalance, that is, the States will have adequate tax powers to mobilise enough revenues for their mandated expenditures. Two, the collection of commodity tax revenue by each State will be a function of the size and structure of its economy and its efficiency in tax administration. Therefore, efficiency need not be the guiding principle for the distribution formula of Central grants. Three, all commodities, including petroleum and excluding liquor, will be brought under value added tax.
Four, a State’s domestic consumption expenditure being the tax base of this commodity taxation, it will be as elastic as income tax, and States cannot complain about their inelastic tax sources. Five, there will be little incentive for the Union government to resort to non-divisible cess and surcharge collection as there is no compulsion for it to share tax revenues with all States.
As a case in point, Table 3 shows the increased level of non-divisible cess and surcharges in the Union government’s direct tax revenue.
Having addressed the issue of efficiency, it need not be the guiding principle of further financial transfers from the Union government to State governments. Thus, there is a need for the Union government to distribute some portion of its revenue to States so as to address the horizontal fiscal inequality. Addressing the horizontal fiscal inequality means essentially to distribute grants so as to equalise the minimum standards and quantum of basic public services across States. Prioritising public expenditure at the State level, such as providing adequate public administrative and civic services, water, sanitation, calamity relief, law and order, justice, school education, basic health care, access to food and nutrition, surface transport and a few more in the order of preference, is essential. Setting minimum standards and a normative unit cost for these services should be calculated.
After that, the adequacy of tax revenue raised by each State shall be determined by comparing its tax revenue with the normative level of public expenditure as calculated on the basis of priorities and unit costs. If a State is assessed to have a fiscal deficit in this account, then such a State gets the equalisation grant from the Union government. Obviously, this equalisation grant will differ between States, and some States may not even get it. Apart from the equalisation grants, the Union government will continue to carry out some of the key developmental expenditures, particularly in infrastructure and services (higher education for example), through its many public sector enterprises and schemes. These expenditures are geographically anchored. For instance, a port, though developed by the Union government, makes an immediate economic effect in its neighbourhood, and thus the State in which the port is located will gain.
In other words, there is no special geographical territory for the Union government, and its expenditures have to be necessarily geographically hooked to States. Developmental expenditures in a location will crowd in more such expenditures. Hence, a conscious effort to achieve geographical efficiency will have to be tempered with equity as well in regard to such expenditures. With the reassignment of taxes, expanding equalisation grants and developmental expenditures can be achieved by the Union government only through a continuous increase in its tax effort.
Conclusion
Reassigning all the commodity taxes to the States and effecting only equalisation grants by the Union government shall be the ideal fiscal federalism in a market-driven economy. The States shall provide adequate public services at a minimum standard so that every citizen gets the capability to participate in the economy profitably. It also provides freedom for the States to chart their strategy of economic development, with the Union government playing the essential roles of regulation of markets and giving guidance to provide necessary public services and protection from external threat and internal disturbance.
R. Srinivasan is Registrar, University of Madras, and S. Raja Sethu Durai is Associate Professor in economics, University of Hyderabad. The views expressed are that of the authors and not of the institutionsthey are affiliated to.
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