Debate over Revenue Sharing Formula 

Syllabus: GS 2/Polity and Governance 

In Context

• Recommendations of the Finance Commissions have  created friction between States and the Centre.

About Finance Commission 

• It is a constitutional body formed by the President of India to give suggestions on centre-state financial relations.
• Article 280(1) of the Constitutions lays down that the modalities for setting up of a Finance Commission
  • Currently, 41 percent of taxes collected by the Centre is devolved in 14 instalments among states during a fiscal year.
• The Fifteenth Finance Commission was constituted in 2017.
  • The recommendations of the Fifteenth Finance Commission are valid upto the financial year 2025-26.

Roles and responsibilities

• The important tasks of the Finance Commissions are (i)
  • To recommend the proportion of the Union tax revenues to be assigned to States and
  • To recommend the share of each State in the assigned tax revenue. 

Distribution formula 

• It devises a distribution formula to arrive at a share for each State, and it is based on the principles of equity and efficiency. 
  • Equity stipulates that the revenue-scarce States and States with higher expenditures get larger shares of Union tax revenue than others. 
  • Efficiency is to reward the States that are efficient in collecting revenue and rationalising spending. 
  • The trade-off between equity and efficiency is normative and remains dynamic in successive Finance Commission recommendations.

Methodology of 15th finance Commission

• Successive Finance Commissions have assigned 10% to 20% weight to income tax revenue collection/assessment in the distribution formula for income tax revenue because collection is not a good indicator of contribution.
• In the 15th Finance Commission, the distribution formula had a tax effort with a weight of 2.5%, and demographic performance, an indicator of efficiency in population control, was given a weight of 12.5%.
  •  The remaining 85% weight was distributed among equity indicators of per capita income, population as per the 2011 Census instead of the conventional 1971 Census, area, forest cover, etc.
• It  introduced the fertility rate in the formula to reward States which had reduced the fertility levels.

Concerns of various states 

• Revenue sharing among states is a controversial subject given that there is always a fund crunch and the welfare needs vary. 
• This leads to complaints from some states, especially those in southern India, that they get a smaller share, especially considering their contribution to taxes.
  • Some States have been arguing that their contributions to the Union tax revenue have been higher than others and, therefore, they rightfully have higher shares in the Union tax revenue. 
• Tax contribution is an efficiency indicator because a State’s level of development and economic structure decides its tax contribution.
  • However, Finance Commissions had assigned only 10% to 20% weight to this efficiency indicator. 
  • The Finance Commissions have always favoured assigning more than 75% weight to equity indicators.

Suggestions 

• Some states feel  ‘cheated’ because of the overuse of the equity criterion. 
• Therefore an appropriate balancing of criteria is needed particularly in the context of the rise in unconditional transfers.
• Tax contribution by each State is a good measure of efficiency, and the Goods and Services Tax (GST) regime creates an opportunity for its inclusion in the distribution formula.
  • In addition to GST, petroleum consumption is also an indicator of tax contribution to the national exchequer. 
• But Due attention needs to be paid to the needs of the lower income States.
  • These States are expected to provide a relatively larger share of ‘demographic dividend’ to India in future provided attention is paid to the educational and health needs of their populations
• Instead of using a large number of tax devolution criteria, the transfer of resources to individual States may be guided by the equalisation principle using a limited number of criteria such as population, area and distance, supplemented by a suitable scheme of grants.
  • The equalisation principle is consistent with both equity and efficiency. 
• The dynamics of the emerging fiscal federalism of India entails significant rethinking especially in the context of the 16th Finance Commission.