Distribution of Net Proceeds among States

Facts:

• The Centre’s tax collections are pooled-in from States and a part of it is distributed among them, based on the Finance Commission’s (FC) formula. 
• The share of taxes that each state gets is decided by a formula. The largest weight in this formula is given to what is called the “income distance” parameter, which is essentially the inverse of the per capita income of a state. Thus, the lower the per capita income, the more the state gets.
• India’s poorest states, Bihar and Uttar Pradesh, therefore, have the highest share in tax devolution to states, much higher than they would get if population was the only parameter
• The 15th FC formula is skewed in favour of some States, resulting in wide inter-State variations. As population is given a higher weightage, it tilts the balance in favour of some northern States. 
• For every one rupee that Tamil Nadu gives the Centre, it gets back 29 paise. On the other hand, Uttar Pradesh gets ₹2.73, and Bihar gets back ₹7.06.

• The 15th FC had arrived at the States’ share in the divisible pool of taxes based on each State’s needs (population, area and forest and ecology), equity (per capita income difference) and performance (own tax revenue and lower fertility rate).
• The weight assigned to needs was 40%, equity 45%, and 15% for performance.
  • This formula meant that Uttar Pradesh and Bihar got 17.9% and 10%, respectively in the XVFC. Karnataka, Kerala and Tamil Nadu got 3.65%, 1.93% and 4.08%, respectively. 
  • Chart below shows that in successive FCs, the share of southern States has seen a consistent decline.

• Also, the 15th FC introduced the fertility rate in the formula to reward States which had reduced the fertility levels.
• While this does favour the developed States which have pushed their TFR below replacement rate as shown in the chart below, the weightage given to the component is relatively lower than equity and need

Rationale for Equitable Distribution

• Active state intervention was envisaged to reduce the developmental disparities. 
• The mechanism employed to achieve these goals was the transfer of resources from the Centre to the states.
• These transfers, which are more heavily directed to populous and poorer states, were channelled in the past through the Finance Commission and the Planning Commission.

Arguments:

• In Favour: The objective is not to return the money you get from a State. Transfers enable a State to provide comparable levels of services. The basic rationale is horizontal equity. Taxes accrued to Tamil Nadu are not necessarily from the State. Yes, per capita income levels increased substantially in Karnataka, Kerala and Tamil Nadu. Now, the increase need not necessarily have to do only with the States’ efforts.
• Against: The southern States have grown faster, and contribute larger revenue to the central kitty. The argument is that both Northern as well as Southern states should get equally higher amounts. Equity needs to be balanced so that it does not adversely impact efficiency of Southern states. The Centre needs to incentivise developing States to generate more tax revenue for an even more effective distribution.

Article 280 of the Indian Constitution:

• Clause (1): The President shall, within two years from the commencement of this Constitution and thereafter at the expiration of every fifth year or at such earlier time as the President considers necessary, constitute a Finance Commission which shall consist of a Chairman and four other members to be appointed by the President.
• Clause (2): Parliament may by law determine the qualifications which shall be requisite for appointment as members of the Commission and the manner in which they shall be selected.
• Clause (3): It shall be the duty of the Commission to make recommendations to the President as to:
  • (a) the distribution between the Union and the States of the net proceeds of taxes which are to be, or may be, divided between them under this Chapter and the allocation between the States of the respective shares of such proceeds;
  • (b) the principles which should govern the grants in-aid of the revenues of the States out of the Consolidated Fund of India;
  • (bb) the measures needed to augment the Consolidated Fund of a State to supplement the resources of the Panchayats in the State on the basis of the recommendations made by the Finance Commission of the State; 
  • (c) the measures needed to augment the Consolidated Fund of a State to supplement the resources of the Municipalities in the State on the basis of the recommendations made by the Finance Commission of the State;
  • (d) any other matter referred to the Commission by the President in the interests of sound finance.
• Clause (4): The Commission shall determine their procedure and shall have such powers in the performance of their functions as Parliament may by law confer on them.

15th Finance Commission:

Criteria for Horizontal distribution of taxes among States:

• The criteria for distribution of central taxes among states for the 2021-26 period is the same as that for 2020-21.

Way Forward:

• The inequalities between rich and poor states are manifest in almost every economic dimension. Incomes, assets and discretionary purchasing power are higher in the richer states. They are the locus of formal employment and of high value jobs, which is why the hunger for government jobs is so much more intense in the poorer regions of India. The overwhelming majority of foreign investment comes to the richer states. They have better healthcare, higher levels of literacy and better public services than the poorer states.
• Therefore, any scheme of allocation should take into account both development needs as well as past performance, with the latter serving both to incentivize better performance and to allocate resources where they can be most effectively used.
• ‘Committee for Evolving a Composite Development Index of States’ in 2013 proposed a general method for allocating funds from the Centre to the states based both on a state’s development needs as well as its development performance.

• The methodology developed by the Committee first allocates funds across states based on need. Need is based on a simple index of (under) development. The index proposed here is an average of the following ten sub-components: (i) monthly per capita consumption expenditure, (ii) education, (iii) health, (iv) household amenities, (v) poverty rate, (vi) female literacy, (vii) percent of SC-ST population, (viii) urbanisation rate, (viii) financial inclusion, and (x) connectivity.
  • The proposed allocation scheme accommodates differences in needs, even while recognizing that the truly needy should be given disproportionately more. Less developed states rank higher on the index, and would get larger allocations based on the need criteria.
• Given that poor administration or weak institutions in a recipient state can fritter away allocated resources to the detriment of the population, there should be some recognition for effective governance and the efficiency of resource use. This becomes all the more necessary since the proposal to give substantially more to underdeveloped states might create a mild disincentive to develop.
• In sum, 8.4% of funds will be allocated as a fixed basic allocation. Of the remaining 91.6%, we choose parameters such that 3/4th of it is allocated based on need and 1/4th based on performance. 
• A positive feature of this formula for allocation of funds is that the incremental reward for performance is increasing in the level of underdevelopment – this is because the reward for performance is multiplied by need.