GSDP Share as Criterion for Central–State Transfers

UPSC Syllabus Topic: GS Paper 2-Indian Polity – Issues and challenges pertaining to the federal structure.

Introduction

India’s system of sharing central tax revenues with States has come under debate due to concerns over fairness, autonomy, and efficiency. After GST, States depend more on central transfers decided by Finance Commissions. Many States argue that present criteria do not reflect real economic contribution. This has renewed focus on using Gross State Domestic Product (GSDP) as a key basis for central–State transfers. GSDP Share as Criterion for Central–State Transfers.

India’s Structure of Central Transfers

1. Role of the Finance Commission: The Finance Commission decides the share of gross tax revenue given to States and the formula for distribution. Recommendations of 15 Finance Commissions have been implemented, while the 16th Finance Commission’s report is pending.
2. Channels of Central Transfers: States receive funds through tax devolution, grants-in-aid, and centrally sponsored schemes (CSS). While tax devolution is formula-based, grants and schemes are often tied to central priorities.
3. Post-GST Fiscal Stress: GST reduced States’ taxation powers and caused revenue losses due to rate cuts. At the same time, the rise of cesses and surcharges reduced the divisible pool shared with States.
4. Equity-Focused Devolution Approach: Most Finance Commissions have prioritised equity using income distance and population criteria. Frequent changes in weights and large regional differences in fiscal capacity continue to create dissatisfaction among States.

Concerns in India’s Structure of Central Transfers

1. Shrinking Divisible Pool: Cesses and surcharges rose from 11.3% of gross tax revenue in 2009–10 to 16.3% in 2022–23. These are not shared with States, reducing their fiscal space.
2. Increase in Tied Transfers: The expansion of centrally sponsored schemes has limited States’ freedom to allocate funds based on local needs.
3. Weak Compliance with Finance Commission Norms: During the 15th Finance Commission period, only 38.1% of gross tax revenue was actually devolved, against the recommended 41%.
4. Equity Over Efficiency Bias: Most Finance Commissions relied heavily on income distance and population. These criteria prioritised redistribution but weakened the link between contribution and transfers.

Tax Collection versus Tax Contribution Problem

1. Location-Based Tax Recording: Direct tax data reflects the place of collection, not the place where income is generated, creating distortion in assessing State-wise contributions.
2. Registered Office Bias: Companies operating across India pay taxes where their registered offices are located, inflating tax contribution figures of some States.
3. Labour and Business Mobility: Labour migration and multi-location work arrangements weaken the accuracy of PAN-based tax attribution.
4. Data Gaps in Inter-State Transactions: Lack of detailed data on inter-State transactions among associated enterprises prevents accurate estimation of tax accrual.

Need for an Alternative Measure

1. Limits of Direct Tax Data: PAN-based jurisdiction fails to capture real economic contribution at the State level, weakening the credibility of tax-based devolution claims.

2. GST Attribution is Less Contested: GST is destination-based and reflects consumption across States, but it cannot fully capture income generation patterns.

3. Requirement of an Indirect Proxy: A broader economic indicator is required to estimate where central taxes actually accrue.

Gross State Domestic Product (GSDP) as an Alternative Criterion

1. Economic Base Indicator: GSDP reflects the scale of economic activity within a State and represents the underlying tax base where income is generated.
2. Limits of Direct Tax Attribution: Direct tax data records the place of collection, making it unsuitable for estimating State-wise tax contribution.
3. Assumption of Uniform Tax Efficiency: If tax administration efficiency and tax-to-GSDP ratios do not vary sharply, GSDP share can approximate contribution to central taxes.
4. Alignment with GST Structure: GST attribution across States is relatively clear. GSDP complements GST by capturing production and income generation.
5. Correlation with Direct Taxes: In 2023–24, the correlation between States’ GSDP and direct tax collections was 0.75, showing a strong relationship.
6. Correlation with GST Collections: The correlation between GSDP and GST collections was 0.91, indicating that GSDP closely tracks taxable economic activity.
7. Balance with Devolution Shares: GSDP shares showed a correlation of 0.58 with devolution shares, reflecting a balance between redistribution and contribution.

Way Forward

1. Higher Weight, Not Exclusive Use: GSDP should be given a higher weight in devolution formulas, without replacing existing redistribution criteria.
2. Balancing Equity and Efficiency: GSDP can reflect economic contribution, while other criteria can continue to support redistribution to poorer States.
3. Correcting Registered Office Bias: Adjustments are needed where tax collections exceed GSDP due to concentration of registered offices of multi-State firms.
4. Accounting for Production–Tax Location Mismatch: GSDP can address cases where production occurs in one State but tax payments are recorded in another.
5. Moderating Fiscal Impact: A calibrated use of GSDP can ensure that gains and losses across States remain moderate.
6. Strengthening Credibility of Transfers: Closer alignment between economic activity and transfers can improve trust in the fiscal transfer system.

Conclusion

Using GSDP as a stronger criterion can improve fairness in central–State transfers by linking distribution to real economic activity. It balances efficiency with equity better than existing approaches. However, it should complement, not replace, redistribution criteria to address regional disparities and maintain cooperative fiscal federalism.

For detailed information on Fiscal Federalism in India- Significance and Challenges read this article here

Question for practice:

Examine the rationale for using Gross State Domestic Product (GSDP) as a criterion for central–State transfers in India, and assess how it balances equity and efficiency in the existing fiscal federal framework.

Source: The Hindu