Published Sep 26, 2024 | 12:00 PM ⚊ Updated Sep 26, 2024 | 6:06 PM
Data from the 11th to 15th finance commissions show that states with lower per capita incomes, such as Bihar and Uttar Pradesh, received a larger share of central taxes due to the income distance criterion. (Creative Commons)
The 16th Finance Commission has arrived at a crucial juncture in India’s fiscal landscape. Historically, Finance Commissions have emphasised equitable resource distribution, ensuring that less-developed states received larger shares of central taxes.
However, as India’s economy matures, there is a growing debate about whether this equity-first approach has led to inefficiencies. States that have demonstrated fiscal prudence and economic growth, like Karnataka and Tamil Nadu, argue for a shift in focus — rewarding efficiency and performance.
As the Commission begins its work, it faces a fundamental question: Is it time to prioritise efficiency over equity?
A primary dilemma for the 16th Finance Commission is to balance equitable resource distribution with fiscal discipline. The increasing competition for limited resources and growing concerns about equity and efficiency create a complex environment for policymaking. The discussion surrounding efficiency versus equity in fiscal policy has been a crucial focus of India’s Finance Commissions.
Throughout history, the balance between these two goals has profoundly influenced fiscal allocations and regional development. This ongoing debate continues to shape the discourse on policy priorities.
Earlier, Finance Commissions, especially till the 10th Finance Commission, strongly emphasised equity, reflecting a commitment to reducing income disparities and supporting underdeveloped states.
For instance, the weight assigned to equity criteria, such as income distance, has consistently remained high in subsequent Commissions, peaking at 70% in the 11th Finance Commission. This approach aimed to bridge the development gap between wealthier and less developed states, promoting national cohesion and addressing historical inequities.
In contrast, efficiency-oriented recommendations focus on performance-based incentives and fiscal discipline, aiming to create a dynamic and self-sustaining federal structure.
The introduction of efficiency criteria, such as tax effort and fiscal discipline, became more pronounced in the 13th Finance Commission, which allocated 17.5% weight to these indicators. However, efficiency has generally received less emphasis compared to equity. This historical evolution indicates a clear prioritisation of
equity over efficiency, although the exact balance has shifted over time based on economic conditions and political priorities.
For instance, the 15th Finance Commission had to address the immediate fiscal stress caused by the Covid-19 pandemic. The Commission focused on need-based allocations to provide immediate relief, rather than rewarding states for their efficiency. This shift led to a perceived imbalance, as historically high-performing states did not receive adequate recognition for their fiscal prudence and economic success.
Another challenge confronting the 16th Finance Commission is the methodology used to calculate income distance. This calculation involves a degree of arbitrariness that disproportionately impacts well-performing states such as Karnataka, Kerala, Andhra Pradesh, and Tamil Nadu. This inconsistency raises concerns about the fairness of resource allocation based on income distance.
The 12th Finance Commission used the average per capita income of the top three states to calculate income distance. The 12th Finance Commission assessed the average per capita comparable Gross State Domestic Product (GSDP) of each of the 28 states over the past three years.
It calculated the income distance for each state by taking the average of the top three states with the highest per capita income—Goa, Punjab, and Maharashtra—and assigning a notional distance based on their per capita income compared to the fourth-highest ranked state, Haryana.
While this approach aimed to promote equity by providing more central tax revenue to less-developed states, it inadvertently disadvantaged wealthier states with higher per capita incomes.
The 13th Finance Commission introduced the concept of Fiscal Capacity Distance, which further complicated the situation. This criterion assessed states’ fiscal capacity, comparing their ability to generate revenue against their expenditure needs.
As a result, states with lower fiscal capacity received increased funding, while those with higher capacity received less. This system favored economically weaker states and penalised more prosperous ones for effectively managing their finances.
The methodologies used by the 14th and 15th finance commissions for calculating income distance have sparked significant debate, particularly concerning their effects on high-performing states in terms of per capita GSDP. The arbitrary elements in these methodologies have led to inequitable resource distribution, adversely impacting states that excel economically.
Data from the 11th to 15th finance commissions show that states with lower per capita incomes, such as Bihar and Uttar Pradesh, received a larger share of central taxes due to the income distance criterion.
Conversely, economically successful states like Karnataka and Kerala saw their share of tax devolution decrease over time. For instance, Karnataka’s share of devolution dropped from 4.97% in the 11th Finance Commission to 1.09% in the 15th Finance Commission, despite its significant contributions to the central tax pool.
This trend highlights a perceived disincentive for states that have effectively managed their resources and achieved substantial economic growth.
As the 16th Finance Commission embarks on its mandate, the need to integrate efficiency indicators into its framework becomes increasingly evident. By placing a greater weight on efficiency, the Commission can promote a culture of accountability and fiscal responsibility among states.
States that demonstrate a commitment to enhancing their revenue base, improving tax administration, and adhering to fiscal discipline should be recognised and rewarded. This recalibrated focus not only aligns fiscal policy with economic realities but also cultivates a competitive environment where states are incentivised to innovate and improve their fiscal management.
Additionally, incorporating the Human Development Index (HDI), considering environmental sustainability or the contribution of the states to GDP could provide a more holistic approach to resource allocation. By balancing efficiency and equity, the 16th Finance Commission can create a more nuanced framework that promotes sustainable development while addressing regional disparities.
This approach would not only reward good governance but also support balanced regional development and economic growth.
(Dr Rajeshwari UR is an Associate Professor in the Department of Economics at Christ University in Bengaluru. Views are personal. Edited by Majnu Babu).
