Tax divide: Why are southern states upset?

The problem? Fiscal devolution. That’s a process by which taxes raised by the central government are shared with the states.

For every rupee it contributes towards central taxes, states like Karnataka, Tamil Nadu and Kerala get far less compared to what Bihar and Uttar Pradesh corners. That’s because re-distribution of resources helps the less developed states, so that they can bridge the inequality gap. But, over the years, the better developed states have seen significant reduction in transfer of devolution funds. And it is now beginning to hurt them.

“While redistribution is an important element of equity, it should remain within limits. Today, Kerala is in a financial crisis on account of it,” said Thomas Isaac, Kerala’s former finance minister.

Last year, the Centre reduced Kerala’s borrowing limit and it faced a severe cash flow problem, to the extent of ₹15,000 crore. The state was unable to pay salary and arrears among other payments. Subsequently, Kerala dragged the union government to the Supreme Court for limiting its borrowing powers. Earlier this week, the Supreme Court refused to grant any interim relief to the state and referred the matter to a larger constitutional bench.

Politicians from southern states said that even with significant redistribution for many decades in their favour, states like Uttar Pradesh and Bihar continue to have poor records when it comes to social and economic development. “As it stands today, the devolution process rewards bad outcomes and penalizes good governance,” said Palanivel Thiaga Rajan (popularly called PTR), Tamil Nadu’s IT minister who till recently held the finance portfolio.

With elections knocking on the door, regional parties in south India have made fiscal devolution into an electoral issue—in nearly every speech, politicians in Tamil Nadu, Karnataka and Kerala take potshots at the Bharatiya Janata Party (BJP), India’s ruling party, accusing it of depriving funds to opposition-ruled states.

Politics aside, India’s devolution process does need an urgent revamp, experts said. The 16th Finance Commission, which will arrive at the devolution formula for the 2026-31 period, has its task cut out.

The structure

In India’s fiscal structure, the central government raises much of the tax revenue and states, by virtue of delivering last-mile governance, bear much of the expenses. To tackle this imbalance, a process of transferring resources is in place.

The Finance Commission is the constitutional body that oversees this transfer, which happens in two stages. ‘Vertical devolution’ determines how the revenue raised by the central government is shared between the Centre and the states. The 15th Finance Commission had recommended that 41% of the divisible pool (arrived at after deducting cess, surcharges and the cost of collecting taxes from gross tax revenue) be shared with the states.

The Finance Commission then determines the ‘horizontal devolution’—in other words, what each state receives. It does so using a formula that looks at many parameters such as population, land area and so on. As mentioned earlier, to bring about more equitable development, the redistribution of resources is also based on the per capita income of each state. Apart from devolution funds as per Finance Commission recommendations, states also get funds from the central government through grants and centrally sponsored schemes.

This process worked well initially but recent protests underline significant heartburn.

The claw back

Till 2014-15, the central government got 68% of the gross tax revenue while states received the balance. The 14th Finance Commission, under former Reserve Bank of India (RBI) governor Y. V. Reddy, increased the states’ share from 32% to 42% (February 2015). After Jammu & Kashmir and Ladakh were categorized as union territories, the share fell to 41%.

The problem intensified since then.

“The 14th Finance Commission gave a substantial increase. It left the central government with less money,” said C. Rangarajan, former RBI governor who had led the 12th Finance Commission.

This is when the Centre started to claw back resources by accelerating the levying of cess and surcharge, revenue that are not shareable with states.

In 2014-15, the share of cess and surcharge in gross tax revenue was just 9%. It increased to 12% in 2015-16, the year the 14th Finance Commission recommendation took effect and rose sharply to touch 20% in 2020-21 before declining to 15% in 2023-24.

“While the Centre has every right constitutionally to levy cess and surcharges, it is ethically wrong and against the spirit of federalism,” said R. Ramakumar, professor, Tata Institute of Social Science. If the quantum of cess and surcharges that were raised by the Centre is added to the divisible pool, then the share of devolution that states received would be 32%, he added.

 

The 14th Finance Commission gave a substantial increase. It left the central government with less money
—C. Rangarajan

 

“The increase that the 14th Finance Commission gave was effectively neutralized,” said Nilakantan R.S., a data scientist and author of the book South Vs North—India’s great divide.

In 2011-12, the size of the divisible pool—the total fund that is shared by Centre and states—was 90% of the gross tax revenue. By 2019-20, it had fallen to 70%, as the quantum of cess and surcharges in the gross tax revenue increased sharply. So, the divisible pool itself had shrunk.

Government officials clarified that states have not seen any fall in the quantum of transfers in absolute terms. In almost all cases they have only increased. Also, the revenue raised through cess and surcharges have not been retained entirely by the central government but has been spent on highways, railways and plethora of centrally-sponsored schemes which benefit the states.

Total transfers from New Delhi to states (excluding GST compensation) as a portion of the Centre’s gross tax revenues rose from 32.4% during the third finance commission to 58.7% in the 14th and 15th finance commissions (2015-20 and 2020-25).

“The central government has always argued before the Finance Commissions that it needs more resources to meet expenses on defence, internal security, foreign affairs and interest obligations but it actually spends a lot on areas such as education, agriculture, health and social welfare that fall under the state subject through centrally sponsored schemes,” said Neelakantan.

Opposition ruled states resent them as it infringes on their rights.

Centrally sponsored schemes have other shortcomings too. “They are tied funds and states do not have the freedom to spend as they want. Most of the time, they are poorly designed and one-size-fit-all schemes that are ineffective,” said PTR.

Isaac agreed. “Kerala has built very strong social infrastructure, especially schools and higher education institutions. What is the point in centrally sponsored schemes like Sarva Siksha Abhiyan for us? We want to build roads and other hard infrastructure,” he said, stressing that Kerala needs untied funds. “The Centre-state fiscal relationship has indeed sunk to an all-time low,” Isaac added.

Sarva Siksha Abhiyan is the Indian government’s programme aimed at elementary education.

Ramakumar studied different Finance Commission recommendations and concluded that successive governments have fallen short in implementation.

“During the 13th Finance Commission period, the total funds transferred was only 31% of the divisible pool as against 32% recommended. For 14th and 15th Finance Commission period, it was 40.3% and 38.1% respectively, as against 41%,” he said.

Finance Secretary T.V. Somanathan dismissed this claim. “Devolution to the states is done every month exactly as per the norms. There is no deviation at all. Initial devolution is based on budget estimates, and it is modified after revised estimates are available. Final adjustments are made after CAG (Comptroller And Auditor General Of India) audit becomes available. Every rupee is completely accounted for,” he said.

Horizontal Devolution

The biggest responsibility of the Finance Commission, when it comes to horizontal devolution, is equity. An important criteria is ‘income distance’ or how far is a state, in terms of per capita income, from the richest state. The further the state (which means less developed), the higher the devolution. This explains why Bihar receives a lot more than Kerala and Tamil Nadu.

Over the years, this approach has reduced what better developed states get from devolution (see chart).

However, the union finance minister, Nirmala Sitharaman, has denied that better developed states are receiving less. Speaking in the Parliament, she said that tax devolution for Kerala increased 224% between 2004-14 (period when the United Progressive Alliance was in power) and 2014-24 (period of the National Democratic Alliance government, led by the BJP). Grants, she said, increased by 458%.

These absolute numbers are misleading and belie the fact that gross tax revenue grew at a much higher rate, countered PTR. In the last five years alone, the Government of India’s tax revenue jumped from ₹11.55 trillion to ₹32.62 trillion, he pointed out.

Meanwhile, Sushil Kumar Modi, former deputy chief minister of Bihar, believes that the contention of the southern states is untenable. “If Finance Commissions were to distribute the divisible pool of taxes among states matching their contributions to it, ignoring the needs of different states, it would not be necessary to have a Finance Commission at all,” he wrote in an article in the Times of India, on 3 May 2018.

“As long as disparities remain, the devolution pattern should favour the poorer states. Just as it is desirable for the state governments to reduce inter-district disparity, it is equally desirable for the Centre to reduce inter-state disparity,” he further wrote.

“We are not against redistribution. All we are asking is what is the outcome of decades of redistribution? Hindi-heartland states continue to remain underdeveloped, both socially and economically,” said Isaac.

“Why have their (states getting more funds) debt levels risen so sharply despite such high transfers from the central government? It is because they are inefficient,” said R. Srinivasan, member, Tamil Nadu Planning Commission. “Tamil Nadu’s total expenses to GSDP (gross state domestic product) ratio is around 11% while that of Bihar and Uttar Pradesh are about 17%. Spendthrift states are given more resources,” he added.

Short of funds, developed states are borrowing more. In the long run, this could hurt their growth.

The Way Forward

The 16th Finance Commission, therefore, has a difficult task.

It has to come up with innovative parameters to ensure that better developed states get enough funds without depriving the less developed ones of their needs. It should also recommend ways that can push the less developed states to grow faster.

PTR suggested that there be no fixed ratio for five years. “Instead, change it every year based on performance on various social parameters. This will ensure that there is a good feedback loop,” he said.

Rangarajan suggested that a sunset clause on the ‘income distance’ parameter could motivate the less developed states to reform faster. But will such a clause work? The mandate for a Finance Commission is only for five years.

 

The 16th Finance Commission will take into cognizance the states’ concerns.
—Gopal Krishna Agarwal

 

An ideal mathematical devolution formula would be impossible to arrive at, Neelakantan said. If the Centre stays away from spending on state subjects—such as education, healthcare, agriculture and social welfare—the money it gets from the current devolution ratio is sufficient to meet its needs. There will be no need for cess and surcharges at all. However, the reality is that no central government wants to give up spending on social needs. It is a political necessity, other experts Mint spoke to said.

Gopal Krishna Agarwal, an economist and a national spokesperson of the BJP, sounded hopeful things could be sorted out soon. “The 16th Finance Commission will take into cognizance the states’ concerns,” he said.

Jayaprakash Narayan, general secretary of Hyderabad-based Foundation for Democratic Reforms views the problem differently. The political parties in the south are setting the stage for hard negotiation on fiscal and other issues, going forward. “Like always, a reasonable compromise will be found,” he said. But, he added: “Our bark is always worse than our bite.”