States and tax shares: The fight for fiscal space

As southern states demand higher share in devolution of taxes, what can work in Karnataka's favour

The relationship between the Union and southern states in general, and Karnataka in particular, has come under considerable strain in recent days. At the heart of the tension is the substantial erosion in the share of the state in the devolution of Union taxes from 4.713 per cent under the 14th Finance Commission to 3.647 per cent under the 15th. Accusations have been flying thick and fast. The state government has accused the Union government of denying it the amount of money that it would have accrued, had the 14th Commission’s formula been applied.

The Union government stated that even the Raghuram Rajan Committee for evolving a composite development index of states had recommended a share of 3.713 per cent in the allocation of development assistance similar to the 15th Finance Commission. Rajan’s committee was appointed in 2013 and the 14th Finance Commission was submitted after that. Nevertheless, the charges and counter-charges have reached a feverish pitch, with a Member of Parliament going to the extent of suggesting secession. 

It is curious that while the report of the 15th Finance Commission was submitted in October 2020 for the period covering 2021-22 to 2025-26, and was implemented from 2021-22, the discussion on the reduction in the tax share has raised its head only now, after three years following the presentation of the 15th Finance Commission in the Parliament.

The reasons for this are (i)  BJP, which was ruling until the elections, did not want to raise the issue with the Union government and the Congress came to power after the elections, (ii) the implementation of five election guarantees by the ruling party creates substantial fiscal pressure on the state government as it costs almost Rs 50,000 Crore and (iii) the 16th Finance Commission has just been appointed, so the state has to gear up to highlight the “injustice” caused to it by the 15th Commission and the Union government, and argue for larger transfers in its recommendation.

The fact of the matter is that the state got a 1.066 per cent lesser share of tax devolution under the 15th Finance Commission as compared to the 14th. In fact, under the 14th Commission, the state received the highest share as compared to the 12th (4.459), 13th (4.328), and 15th (3.647). 

The major reason for the state receiving a lower share under the 15th Commission is that the distance from the highest per capita income state was much lower than that under the 14th Finance Commission.

The 14th Finance Commission took the average per capita income for three years 2010-13, but Karnataka’s per capita income was Rs 76,781, when the highest (Haryana’s) was Rs. 1,16,179. Karnataka’s rank was 13 among 28 states.  

Besides, with 7.56 per cent weightage assigned to the forest cover, the state’s share increased appreciably from the previous Commissions. In contrast, during the three years 2016-19 which the 15th Finance Commission took, Karnataka’s rank in per capita income was fifth, and if the two small states of Goa and Sikkim are excluded, the comparable per capita income in Karnataka (Rs 2,04,419) was behind only Haryana (Rs 2,25,547) and Kerala (Rs 2,05,114).

Even when the Commission gave 10 per cent weightage to the forest cover and 12.5 per cent weightage to fertility improvement, the share of the state reduced by 1.066 per cent.

There is a lot of discussion that while the residents of the state pay much more in taxes than they get in return, making a political appeal is not rooted either in federal principles nor in the intent of the Constitutional provision for appointing the Finance Commission by the president every five years (or earlier if required under Article 280).

The rationale for tax devolution, according to federal principles, is to offset the vertical fiscal imbalance between the revenue powers and expenditure responsibilities of the Union and state governments and to enable every state to provide comparable levels of public services mandated in the Seventh Schedule of the Constitution at comparable revenue effort.  

If it is merely returning the tax collections to the state based on the origin, you do not require an expert body like the Finance Commission to apply a uniform approach in its assessment and be impartial between the Union and states.

This is a classic case of ‘competitive federalism’, where both the Union and the states vertically and individual states horizontally compete with one another to claim larger fiscal space. The Finance Commission has the difficult task of facilitating the negotiation and bargaining to resolve the best possible compromise.

In this situation, every state will put forward its arguments to claim a larger share of the tax devolution in the memorandum submitted to the Finance Commission. Naturally, every state will build up a case to convince the Commission of the alleged injustices meted out to it in the past and how these should be corrected in its report for the ensuing five years. Therefore, it is not surprising that the southern states have raised a banner of complaints on the alleged unfair treatment meted out to them. Each state will attempt to convince the 16th Finance Commission in their memorandums that it should consider those factors that are favourable to it.

Karnataka’s case

As far as Karnataka is concerned, the growth of per capita income has been impressive, and that can be a cause for concern. The Finance Commission uses data on comparable per capita income especially estimated for this purpose by the National Statistical Organisation. As mentioned earlier, the per capita income of Karnataka has been rising much faster than that of the state with the highest per capita income. Karnataka’s rank has improved from 13th to fifth in six years. Out of these five, since Goa and Sikkim are not reference states, Karnataka’s position in the last Commission was evaluated as third. It will not be surprising if we find that Karnataka’s per capita income has now exceeded even that of Haryana and it has become a reference state, in which case, there will be further erosion in the shares.  

To be fair, the distance from the highest per capita income is taken in the formula to represent revenue disability. As export incomes in the Gross State Domestic Product do not yield taxes, the state should make a plea that the per capita income variable used in the formula should exclude income from exports. Karnataka has the largest export income from services and its exclusion from per capita income could work out favourably and this is conceptually a correct argument. 

Similarly, when there is so much talk about achieving sustainable development goals and countering carbon emissions, the state could ask for greater weightage to be given to the forest cover in the formula. There are three arguments for the inclusion of this factor in tax devolution.
First, areas covered by forests do not generate income or tax revenue as there is a ban on the felling of trees. Besides this revenue disability, there is a cost disability of providing public services to the sparse population residing in the fringes of forests and there are also additional costs of maintaining the forest cover. Finally, forest cover is a global public good that deserves to be rewarded. 

In addition, the state should also ask for additional grants for the provision of infrastructure and services in millennium cities like Bengaluru, which is a magnet of economic activity.

(The author is a councillor at Takshashila Institution. His past positions include Member, 14th Finance Commission and Director, National Institute of Public Finance and Policy, New Delhi.  The views are personal).