How to Get States to Get Their Act Together

We should change the way taxes are distributed to our states. We need to fix the incentives, and align performance with revenues. Here’s how it can work.

As I write this, the 15th Finance Commission is at work trying to decide the manner in which the taxes levied and collected by the central government–corporate tax, income tax, customs and the central goods & services tax–will be distributed among the states of India. There are two steps in this: the first is determining the share of all states in the central taxes, and the second is the ratio in which the taxes will be distributed among the various states. The previous finance commissions have generally increased the share of central taxes that are distributed among states. (The 14th finance commission increased the share of states in the central taxes from 32% to 42%.) It is quite possible that the current finance commission will do the same, and an even higher share of central taxes will now ‘devolve’ to the states.

The second step in tax devolution is determining the manner of distributing these ‘devolved’ taxes among the states. Historically, the finance commissions have built a complex formula involving several variables such as population, land mass, economic backwardness, fiscal capacity etc. The underlying philosophy is one of redistribution, whereby the more developed states should have a lower share in tax devolution than their share in actual  tax collections, while the relatively backward states would have a correspondingly higher share. One can question this philosophy of redistribution. If 70 years of redistribution does not make the backward states start to catch up with the developed states, then perhaps there is something else that needs to be done. But this article is not about questioning redistribution. It is about questioning the basis of treating the central taxes as a homogenous pool. Simply put, this piece is about aligning incentives.

The implicit objective behind devolving a higher share of taxes to states is decentralisation.  Developmental needs vary across regions, and thus it is efficient for local governments to allocate resources rather than bureaucrats sitting in Delhi deciding for the entire country. This being the case, it is only fair that the quantum of tax devolved discriminate between states based on their performance. It is also the case that most governments want to spend money, and the primary constraining factor in their ability to spend is the available pool of tax revenues. Tax collections are broadly linked to economic activity. Thus, linking quantum of tax revenues to economic activity aligns the interests of citizens who want more growth and the government which wants more tax revenues so that it can spend. While our current system of levying and distributing taxes does this to an extent, we can and should do better!

The way taxes are distributed in the country today, around 36% of the tax revenue of states come via devolution from the formula that the finance commission determines. This is lower than the 42% that the 14th finance commission determined, since the central government levies ‘cesses’ which are not shared with states. The remaining 64% come from taxes that the state governments themselves levy – principally the State Goods and Services Tax (now). Since tax collections are linked to economic activity (at a very broad level), what follows is that only around 64% of taxes that states have access to are linked to economic activity in their state, while the remaining third of the tax collections reflect the average economic activity in the country. Further, this 36% is average across all states, and there is considerable divergence across states. For the more developed states like say Gujarat or Maharashtra, around 20% of their taxes are ‘devolved’, while for the relatively backward states like Bihar or UP, 50% of their taxes come from the central pool. The aligning of interests of state governments’ and economic performance of the state is thus relatively weak for the very states which must grow faster and catch up with the relatively developed states.

A better system of distributing taxes would be one in which even the centrally levied and collected taxes are attributed to the state where they are generated and then devolved to that state. This better aligns the incentives for state government and its citizens. If the state performs poorly, it will see slower tax revenue growth, which means less money for the bureaucracy to spend. Equally, a state government which drives strong economic performance in a state gets a bigger pool of tax resources to spend. So, the ideal scenario is that the state government gets to keep the entire tax generated within that state rather than it first going to the central government and then coming back to the state through a complicated formula. That complicated formula can be reserved for the shortfall if any that a state government may face after implementing this framework.

The way this will happen in practise is as follows: In the first stage, taxes that the central government levies are attributed to the state where they are generated. This is very straightforward in the case of central goods and services tax (given that it is a consumption-based levy) and income tax (which is based on residence). In the case of corporate tax this is difficult since a company would have business activity throughout the country, but taxes would be paid only in the state where it has its registered office. And in the case of customs duties also, it is difficult to attribute the taxes collected to states given that it is difficult to attribute imports to a state. So, for the time being, we can keep corporate tax and customs duties outside this new framework. The states would thus keep 100% of collections of Central GST and personal income tax collected in their state, while the central government would keep the entire collection of corporate tax and customs duties. The outcome of the reassignment of taxes as per above would result in the central government having far less revenue than it has currently. Also, some states would have excess tax revenue while some states would have less tax revenue, relative to what they have currently.

Stage 2 would be to calculate the shortfall relative to the current tax base (for states and the central government). A part of tax collections of states with surplus revenues will be redistributed to states with the deficit and the central government. This redistribution can continue as per current complex formula. The net result would be that states would have the same tax revenues as they had before, but the drivers would be different. The more developed states would have 100% of their revenue base linked to economic activity within their state (as against around 80% currently) while the poorer states would have far more than the ~50% of their revenues linked to economic activity within their state. There would thus be better alignment of incentives for bureaucrats who want to spend and citizens who want growth. Also, at this stage, we are excluding corporate and customs taxes from this new framework of distributing taxes. But later even these taxes should be included, with an appropriate base. This is especially important in the case of corporate taxes where the regional skew will be the highest, and if growth is rebalanced, this skew will reduce.

There is bound to be an apprehension that this system will favour the richer states at the expense of the poorer states. But it is the opposite that is true. The inter-state inequality in India has actually increased since the relatively poorer states are growing slower than or at best at same rate as the richer states. What needs to happen is for the poorer states, some of which have per-capita GDP equal to some sub-Saharan African countries, to start growing faster than the richer states. If a state government delivers on this, it will start to see faster growth in tax revenues, which it will not have to share with other slower growing states. The new system thus encourages Government in the relatively backward states to adopt policies that promote economic activity and reap its benefits in the form of higher tax revenues.

Bihar is a good case in point. In the last 10 years (FY07-17), the tax revenues of Bihar have grown 500bps faster per annum than that of UP. 500bps annualised higher growth over a 10-year period is a lot! However, given the fact that devolved taxes are a large share of the total tax revenues of both Bihar and UP, the overall tax revenue growth for Bihar was just 150bps faster. If the faster growth in tax revenues of Bihar reflects better economic performance (and GDP data suggests that), the state has not shared in the upside in terms of tax revenues. The current tax system thus penalised Bihar relative to UP.

Taking this idea one step ahead, this idea of linking revenues to tax collections in a region should be extended to local bodies also. In the case of Maharashtra for example, the power of local bodies to collect their own tax (Octroi/Local Body Tax, which to an extent were linked to economic activity), has been eliminated post the transition to GST. The local bodies now get a fixed growth in the tax revenues as compensation. It would be much better if a part of GST revenue collected in that local body is directly assigned to them. If economic activity in Pune grows faster than in Mumbai, there is no reason why both should receive the same growth in tax.

The bottom line is that if spending needs to be decentralised so that they better match the needs of a locality, revenues should do. If a local government is entrusted with spending responsibility, it should take the revenue responsibility too, as that ensures that they responsibly use their expenditure responsibility. And if governments use their expenditure responsibility to boost economic activity, it is a win-win for both bureaucrats and citizens.

About the author

Ashutosh Datar

Ashutosh Datar was the Economist at Institutional Equities research team of IIFL from 2007 till a few months ago. He is now an independent blogger.