There are many issues that the Sixteenth Finance Commission will have to deal with. In this article, we focus on one issue which has been raised by many States, particularly those in the south of India. The issue (or the complaint) is that these States have been facing a decline in their share out of the resources transferred from the Centre to the States, from Finance Commission to Finance Commission.
In finding a solution to this issue, we need to look at: which States have been gaining and which are losing their share over time; the criteria of horizontal distribution which has led to some States steadily losing their share; and what can be done to reverse this trend.
In Table 1, the shares of groups of States and those for selected States are shown, for the Twelfth Finance Commission to the Fifteenth Finance Commission (final report). In the case of the southern States, there has been a steady fall in their share, from 19.785% to 15.800%. In a comparison of these two Commissions, the northern and eastern States have also lost. The ‘gainer States’ were the hilly, central, and western States including Maharashtra.
The distance criterion
The shares of individual States in tax devolution depend on the criteria and the weights used by different Commissions. Table 2 provides a list of the different criteria used by Finance Commissions, from the Twelfth to the Fifteenth. The distance criterion has been accorded the highest weight amongst these criteria. Its weight was reduced from 50% to 47.5% by the Thirteenth Finance Commission and further reduced to 45% by the Fifteenth Finance Commission. Earlier, the Eleventh Finance Commission had given this criterion a weight of 62.5%. The equalisation principle has always been regarded in India and elsewhere as a key principle governing distribution. Economic and social justice demand this.
The main reason for the loss of the southern States is the income distance criterion (Table 1). Distance criterion means that the farther a State is from the highest income State, the higher its share. The main reason for the gain of the hilly States is area/forest criterion, although its impact is not separately shown. Between these two Finance Commissions, the loss to the southern States due to the distance criterion amounted to 8.055% points, although the overall loss was much less at 3.985% points, implying that there was a gain under other criteria.
Although on account of the distance criterion, low-income States such as Bihar and Uttar Pradesh have gained over time, they have lost on account of other criteria. Bihar and Uttar Pradesh show, in terms of their overall share, a loss of 0.970% points and 1.325% points.
On population
One other criterion that has caused some controversy is population. Until the Fourteenth Finance Commission, the data for the population in 1971 was used. For the Fifteenth Finance Commission, data for the population in 2011 was used. However, in order not to penalise States that showed better performance in reducing fertility rates, the demographic change criterion was introduced. The joint impact of these two changes has been marginal for all groups of States. For Tamil Nadu, the joint impact was marginally positive.
Steps to take
As mentioned, we cannot give up the income distance criterion. Some raise the question whether such a criterion can continue indefinitely. This is a legitimate question. But this question can be raised in relation to many other issues. Perhaps one step that the Sixteenth Finance Commission can consider is to reduce its weight while correspondingly raising the weights attached to other criteria.
Related to the question of share is also the quantum of the divisible pool. While accepting the recommendation of the Fourteenth Finance Commission to raise the share of all States to 42% from 32%, the Centre increased the cesses and surcharges, thereby reducing the size of the divisible pool. This is not desirable. One option is to limit the share of cesses and surcharges to 10% of the Centre’s gross tax revenues. After the recommendation of the Fourteenth Finance Commission, the share of the States in the combined revenue receipts increased from 63.9% to 68.1% (Table 3). It increased further to 70.7% in 2020-21. Since then, it has fallen to 67.5% in 2022-23, although this level is still higher than 61.3% in the Twelfth Finance Commission period.
To sum up, there is a case to address the issue raised by some of the States regarding their declining shares. The major factor contributing to this situation is the adoption of income distance criterion and giving it a weight as high as 45%. But in any scheme of fair distribution, this criterion cannot be given up.
The Finance Commission can reduce the weight of this criterion by 5% to 10% points. Also, cesses and surcharges may be subjected to some upper limit by the Sixteenth Finance Commission.
C. Rangarajan is former Chairman, Prime Minister’s Economic Advisory Council and former Governor, Reserve Bank of India. D.K. Srivastava is former Director, Madras School of Economics. The views expressed are personal
