A compromise in equity bias

By R Gopalan & MC Singhi

The authors are former civil servants

The Constitution mandates setting up a Finance Commission (FC) at five-year intervals to recommend the allocation of tax resources between the Union and the states, and between the states. The FC submits its recommendation to the Union government, and these allocations determine the states’ fiscal health and expenditure commitments.

Each Commission sets out its own methodology for allocation vertically and horizontally to provide adequate resources to the states in terms of their constitutional obligations of functions and availability of resources. Three principals have usually governed the Commissions—equity, efficiency, and adequacy. Prior to the 16th FC, there have been different sets of opinions on the primacy that should be accorded to these parameters while allocating weights to the identified criteria. It was generally argued that the earlier commissions have accorded higher weights to equity considerations. The 12th FC, for the first time, considered some kind of equalisation of per capita revenue expenditure of the states on two key social services—education and health. Later FCs avoided that route of equalisation of expenditure on a sector or all across, but were usually biased in favour of equity consideration. None of the earlier FCs, therefore, considered contribution to GDP of a state, which could be considered a surrogate measure of the efficient use of resources.

The 16th FC suggests an alternative classification of horizontal devolution criteria. This divides them into need-based, cost disability-based with population under need-based criteria; area and infrastructure distance under cost disability criteria; and tax effort and fiscal stability under efficiency-based criteria. This classification could have been subsumed under the one based on equity and efficiency, since need-based and cost disability-based criteria can be included under equity. However, the 16th FC has, for the first time, tried to balance the equity and efficiency criteria by allocating specific weights to the contribution of the state to national GDP and growth.

We have used two parameters to look at that perception of balancing equity and efficiency. The first is the change in a state’s share in allocation based on the ratio of the share to population according to the 16th FC (2021-22) over the ratio of the share as per the 15th FC (2016-17). The second is the change in the state’s share in allocation based on the ratio of share in GSDP for the 16th FC (average of 2021-2024) over the share for the 15th FC (average of 2016-2019). An increase in the ratio for the more populous states would indicate continuing with the equity bias and an increase in the ratio of more prosperous states indicates a shift towards efficiency. The results are displayed in the accompanying graphic.

Three things become clear. First, out of 28 states, 14 have witnessed a decline in their share of interstate shares. The decline varies from 22.9% for Arunachal Pradesh to a moderate decline of 1.1% for Bihar. An equal number of states have witnessed an increase in their allocated share, with a high of 24.5% for Haryana and a moderate 0.4% for Tamil Nadu. Second, when changes to shares relative to the share of population are considered, 15 states have witnessed a decline and 13 states an increase. Kerala is the biggest gainer with an increase of 27.2%. Equity consideration has seen a compromise. States with relatively lower population growth have also witnessed an increase in the ratio of transfers. Third, the efficiency criteria has played a major role in shifting of relative shares in favour of better-off states. Kerala, Haryana, Punjab, Himachal Pradesh, and Uttarakhand emerge as major gainers, with moderate gains accruing to Tamil Nadu and Maharashtra. The four smallest states in area have been losers. More populous states with lower per capita incomes such as Uttar Pradesh, Bihar, Rajasthan, Chhattisgarh, Madhya Pradesh, and smaller Northeastern states have been affected adversely.

Another important recommendation from the 16th FC is doing away with state-specific revenue deficit grants, affecting them in multiple ways. Some view this as redefining fiscal federalism; others view it as ignoring the mandate of the Constitution to provide adequate resources to states so that they meet their revenue expenditure commitments. Since FCs usually review the revenue and expenditure of the states normatively, there is neither profligacy nor inefficiency and moral hazard. The 16th FC has also not assessed the impact of their recommendations on state finances, as projections of revenue and expenditure after award is not indicated. Of the nine states which depend on central transfers (these being more than two-thirds of their total revenue), seven would face moderation in tax transfers. Of the nine states who have a dependency ratio of less than one-third, eight of them (except Goa) have witnessed an increase in share of central tax transfers. The 16th FC has mentioned that these states will improve efficiency in revenue collection and expenditure management, but it cannot be achieved immediately. Currently, nearly two-thirds of tax revenues accrue to the Union and another 20% is allocated through the inter-state Goods and Services Tax Council. The remaining 15-20% taxes are the states’ domain. There are no significant leakages or untapped potential which could lead to a quick turnaround. A one-size-fits-all approach may put some states—the smaller ones, ethnically different, and border states—in stress, which needs to be addressed separately.