GSDP Share: A Better Criterion for Central-State Fiscal Transfers?
Using GSDP share for central transfers could improve fairness and acknowledge state contributions.
Photo by engin akyurt
Editorial Analysis
The authors argue that GSDP share is a more reliable indicator of a state's contribution to central taxes and should be given higher weightage in the distribution of central transfers to improve fairness and credibility of the system.
Main Arguments:
- States like Karnataka, Maharashtra, and Tamil Nadu contribute disproportionately to central tax revenues but receive relatively smaller shares through tax devolution, leading to concerns about equity.
- Direct tax figures reflect the location of collections rather than the actual place where income is generated, making it difficult to accurately capture State-wise contributions to direct taxes.
- GSDP represents the underlying tax base within each State, and empirical evidence shows a strong correlation between GSDP and tax collections, making it a meaningful indicator of the accrual of central taxes at the State level.
Counter Arguments:
- The claim that some states contribute disproportionately is often contested on the grounds that direct tax figures reflect the location of collections rather than the actual place where income is generated.
- Most Finance Commissions have prioritized equity over efficiency, relying heavily on debatable criteria such as income distance and population, and frequently altered the weights assigned to these variables.
Conclusion
Policy Implications
Key Facts
GSDP correlation with direct tax collections: 0.75
GSDP correlation with GST collections: 0.91
Centre devolved 41% of gross tax revenues to States (2020-21 to 2024-25)
UPSC Exam Angles
GS Paper II: Issues relating to devolution of powers and finances up to local levels and challenges therein.
GS Paper III: Government Budgeting, Fiscal Policy.
Potential question types: Statement-based questions on Finance Commission recommendations, analytical questions on fiscal federalism.
Visual Insights
Potential Impact of GSDP-Based Fiscal Transfers
This map illustrates how states might benefit or see a moderate reduction in their share of central transfers if GSDP share is given higher weightage, based on 2023-24 data trends extrapolated to 2026.
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More Information
Background
The debate surrounding central-state fiscal relations in India has deep historical roots, tracing back to the Government of India Act of 1935, which laid the foundation for revenue sharing between the center and provinces. Post-independence, the Finance Commission, established under Article 280 of the Constitution, became the primary mechanism for recommending principles governing the distribution of tax revenues. Early Finance Commissions heavily relied on population as a key criterion, leading to concerns about equity and incentives for fiscal prudence.
Over time, the criteria evolved to include factors like income distance, area, and fiscal discipline, reflecting a continuous effort to balance equity and efficiency. The Goods and Services Tax (GST), implemented in 2017, further altered the fiscal landscape by subsuming various state taxes, necessitating adjustments in the devolution formula to compensate states for potential revenue losses.
Latest Developments
In recent years, there has been increasing scrutiny of the Finance Commission's recommendations, particularly regarding the weight assigned to different criteria. States have voiced concerns about the impact of demographic performance and forest cover on their devolution shares. The 15th Finance Commission, for instance, introduced a criterion for demographic performance, which penalized some southern states for their success in population control.
Furthermore, the COVID-19 pandemic has exacerbated fiscal stress on states, highlighting the need for a more responsive and equitable transfer mechanism. The debate now centers on finding a balance between rewarding fiscal efficiency and addressing regional disparities, with proposals ranging from revisiting the weighting of existing criteria to exploring alternative indicators like GSDP share. The future trajectory likely involves greater emphasis on performance-based incentives and a more nuanced understanding of states' contributions to the national economy.
Practice Questions (MCQs)
1. Which of the following statements accurately describes the historical evolution of criteria used by Finance Commissions in India for central-state fiscal transfers? 1. Early Finance Commissions primarily relied on area as the dominant criterion. 2. Over time, the criteria have evolved to include factors like income distance and fiscal discipline. 3. The Goods and Services Tax (GST) implementation had no impact on the devolution formula. Which of the statements given above is/are correct?
- A.1 only
- B.2 only
- C.1 and 3 only
- D.2 and 3 only
Show Answer
Answer: B
Statement 1 is incorrect because early Finance Commissions relied heavily on population. Statement 3 is incorrect because GST implementation necessitated adjustments in the devolution formula.
2. Consider the following statements regarding the Goods and Services Tax (GST) and its impact on central-state fiscal relations in India: 1. GST has subsumed all state taxes, eliminating the need for central-state fiscal transfers. 2. GST implementation necessitated adjustments in the devolution formula to compensate states for potential revenue losses. 3. The GST Council, headed by the Union Finance Minister, plays a crucial role in decisions related to GST rates and revenue sharing. Which of the statements given above is/are correct?
- A.1 and 2 only
- B.2 and 3 only
- C.1 and 3 only
- D.1, 2 and 3
Show Answer
Answer: B
Statement 1 is incorrect because GST did not subsume all taxes and central-state transfers are still needed. Statements 2 and 3 are correct.