Tax Contribution by States Needs to Be Revisited

Why in News?

• The Finance Commission plays a pivotal role in recommending the distribution formula for States' share in the Union tax revenue.
• Over the years, the inclusion and weight of various determinants in this formula have evolved, with tax contribution being a central point of contention.
• Therefore, it is important to highlight the historical context, the principles of equity and efficiency, and the impact of inclusion of the Goods and Services Tax (GST) regime to the distribution formula.

The Historical Perspective and Evolution of Distribution Formula

• The Historical Perspective
  • The historical evolution of the Finance Commission's distribution formula has played a crucial role in shaping fiscal federalism in India.
  • Initially focused on personal income tax and Union excise duties, the formula underwent significant changes with the introduction of the 10th Finance Commission.
  • This limited scope reflected a more simplistic understanding of fiscal relations between the Union and States.
• Expansion of Revenue Streams with Introduction of 10th FC
  • With the introduction of the 10th Finance Commission, a significant transformation occurred as all Central tax revenues were pooled.
  • Also, the range of revenue streams was expanded in the distribution formula.
  • This marked a departure from the earlier approach, acknowledging the need for a more comprehensive and inclusive framework to address the complex fiscal dynamics among the States.
• Equity and Efficiency Became Guiding Principles
  • The formulation of the distribution formula began to prioritise equity and efficiency.
  • Equity considerations aimed to rectify imbalances by allocating larger shares to revenue-scarce and high-expenditure States.
  • Simultaneously, the efficiency principle sought to reward states demonstrating proficiency in revenue collection and spending practices.
  • This represented a departure from the earlier emphasis solely on needs-based criteria.
  • This new method recognised the importance of incentivising states to enhance their fiscal capacities and contribute more effectively to the overall economic well-being of the country.
• Dynamic Interplay of Equity and Efficiency
  • The dynamic interplay between equity and efficiency in successive FCs' recommendations exemplifies the ongoing normative debate within the Indian fiscal framework.
  • Striking the right balance between these principles remains a complex task, and the formula has evolved over the years to reflect the changing priorities of fiscal federalism.
• Inclusion of Various Indicators
  • The inclusion of various indicators, such as population, per capita income, and area, in the distribution formula was the norm in the early FCs.
  • However, since the 10th Finance Commission, there has been a notable shift towards a more comprehensive and consolidated formula.
  • The convergence of income tax and Union excise duties into a single distribution formula from the 10th FC onward reflected an effort to streamline the approach and ensure consistency across different revenue sources.

An Assessment of Efficiency Indicators in Distribution Formula

• Tax contribution is an efficiency indicator reflecting a state's level of development and economic structure.
• However, it has historically received modest weight (10-20%) in the distribution formula.
• Population, a chief indicator of expenditure needs, dominated the formula with weights ranging from 80% to 90% in the early commissions.
• Since 2000, the formula has incorporated tax effort and fiscal discipline as efficiency indicators with around 15% weight.
• However, these indicators faced challenges due to their instability, influenced by discretionary tax policies and unexpected changes in tax bases.

The Case for Inclusion of GST and Petroleum Consumption as Efficiency Measures in Distribution Formula

• GST Revenue Provide an Accurate Reflection of State’s Tax Base
  • The introduction of the Goods and Services Tax (GST) has revolutionised the taxation landscape in India.
  • Its consumption-based destination tax system, equally divided between the State and Central governments, provides a unique opportunity for a more accurate estimation of a state's tax contribution.
  • Under GST, the State GST accrual to a state should be equivalent to the Central GST accrual to the Union government from that state.
  • This inherent symmetry in the system makes GST a stable and reliable measure of a state's tax base.
• Stability and Uniformity in GST Contributions
  • Unlike previous indicators, GST offers a unified tax system that minimises variations in tax efforts among states.
  • While the absolute amount of GST revenue generated may differ based on the size and economic structure of each state, the relative contributions are stable over time.
  • This stability is crucial in establishing a fair and consistent measure of a state's efficiency, particularly in revenue collection.
• Exclusion of Discretionary Policies in GST
  • A significant advantage of incorporating GST into the distribution formula lies in its insulation from discretionary tax policies.
  • Unlike tax effort, which can be influenced by state-specific policy decisions, GST reflects the accurate tax base of a state, free from the impact of varying policy choices.
  • This characteristic makes GST a more objective and reliable indicator of a state's contribution to the national exchequer.
• Petroleum Consumption as a Supplementary Indicator
  • In addition to GST, considering petroleum consumption as an efficiency indicator adds depth to the formula.
  • Union excise duty and sales tax on petroleum products, excluded from GST, contribute significantly to the national exchequer.
  • The stable and consistent nature of relative shares of petroleum consumption across states makes it an attractive supplementary indicator for assessing a state's contribution to specific tax categories.
• Linkage to Income Levels
  • A compelling argument for the inclusion of both GST and petroleum consumption lies in their indirect reflection of the relative differences in the incomes accrued to the residents of a state.
  • Consumption patterns are inherently tied to income levels, making the shares of CGST and Union excise duty accurate proxies for assessing both personal and corporate income tax contributions.
• Proposal for Weightage Increase
  • Given the fair and accurate nature of GST and petroleum consumption as measures of efficiency, there is a strong proposal for the 16th FC to assign a more substantial weightage to these indicators.
  • A weightage of at least 33% has been proposed, considering the significant role these indicators play in reflecting a state's contribution to the national exchequer.

Conclusion

• The evolving nature of the Finance Commission's distribution formula has witnessed a shift in focus from population-centric indicators to efficiency measures.
• The GST regime, along with stable indicators like petroleum consumption, provides an opportunity to reevaluate the distribution formula.

As the 16th FC deliberates on the next formula, giving due weight to tax contribution as an efficiency indicator can ensure a fair and accurate representation of states' contributions to the national exchequer.

Q1) What is GST in India, and how does it differ from the previous taxation system?

GST, or Goods and Services Tax, is a comprehensive indirect tax levied on the supply of goods and services in India. It replaced the complex and fragmented tax structure that existed before. Unlike the earlier system, GST is a destination-based tax that follows a value-added tax principle, ensuring a more transparent and unified tax regime across the country.

Q2) How does the GST system benefit businesses in India?

GST streamlines the taxation system by eliminating cascading taxes and providing input tax credit. This benefits businesses by reducing tax complexities and creating a more business-friendly environment. It promotes ease of doing business, enhances compliance, and fosters a common market, facilitating the free flow of goods and services across state borders.

Source: The Hindu