Tax devolution causing North South divide in India

India has a 3-tiered tax system.

1. Central government at the top. They tax our income?—?so it doesn’t matter whether you live in Karnataka or Uttar Pradesh, the central government still gets your tax. Then they levy a tax on profits from companies all over the country. And they also earn from GST.
2. State government in the middle. They also earn a share of the GST. And they’ve managed to keep alcohol and fuel out of the GST net so that’s a big source of revenue. And then they charge things like road tax and stamp duty which is paid whenever there’s a legal document involved?—?such as during the sale of property.
3. Local municipal bodies. They don’t have many lucrative tax sources. They earn from property tax or taxes on utilities like electricity.

Income and corporate tax forms the lion’s share of tax revenue for the country. And all that goes to the central government. Meanwhile, its the state's responsibility to build and develop stuff like education and healthcare. And since they don’t collect too much tax, they have to wait for money to be transferred to them. Then they have to transfer some money to their Municipal bodies to handle local roads, water supply, street lights, sewage etc.

Central government wields the power. For instance, Karnataka says that out of every ?100 that gets collected from the state and goes to the Centre, it gets a measly ?12–13 back for its development.

How does the government calculate what states deserve?

The Finance Commission (FC) advises the government on such matters. In theory, it’s an impartial body. The head of the previous Finance Commission was a member of the ruling party.

There are two parts to the FC’s decision-making.

There’s vertical devolution or the macro level decision which calculates how much revenue the Centre has to share with the States. And by now, you know that States have larger expenditure responsibilities than the Centre. They spend on stuff like healthcare and roads. They need a lot of money for this. So you’d assume it’s a 50:50 split. Or maybe even think that States get a big chunk of the overall tax revenue.

But that’s not what happens. It’s actually more of a 60:40 split in favour of the Centre these days.

The tax devolution rules state that the Centre has to share a part of the income tax and corporate tax with the states. But it is mum on what to do about any cess or surcharge like a Swachh Bharat (clean India) cess or a Krishi Kalyan (farmers welfare) cess etc. If the Centre isn’t in a mood to share taxes, it can simply slap on a new cess and keep more money to itself. And that’s what seems to be happening. The share of cess-related tax has gone up in the overall scheme of things.

So states aren’t happy and are clamouring for a more equal distribution of taxes.

After independence, the first few Finance Commissions simply looked at the population distribution. The states with more people got a bigger share. But that wasn't fair?—?states that didn’t care about family planning would keep getting a larger and larger chunk of money. So over time, the calculations were tweaked. The FC included a bunch of new factors?—? such as the area of the state, forest cover, and even fertility rates. It became quite holistic. And each factor was assigned a weight too. For instance, population only has a 15% weight in the calculation these days.

But the bone of contention here is a metric which has a 45% weight in the calculations?—?something called ‘Income Distance’. Take a state’s per capita income. Then determine the per capita income of the richest state. And finally, calculate the difference between the two. That will give you the income distance. It allows a state with a lower per capita income to get a higher share in the horizontal devolution. It will give them much-needed funds to develop their public services and match the richer states. It’s all about equity!

But that’s also where Karnataka's problem begins.

The state has a lot of IT firms headquartered in Bengaluru. When these IT companies do well, they contribute to the GDP of the state. And naturally, a higher GDP figure increases the per capita income of the state. This means that the state eventually ends up with a smaller share of taxes. In fact, while Karnataka used to get 4.71% of the pie before, it has now fallen to just 3.64%.

But the thing is, Karnataka can’t tax these IT companies and make money for itself. Nor does it get income taxes from the rich techies in the state. So the state ends up making a big contribution to the Centre’s coffers but gets a tiny share in return. And Karnataka is pointing out that it actually leads to inequity within the state itself. All the growth is concentrated in Bengaluru and it gets less money to develop the hinterlands. Technically saying we have poor districts like poor states, and to develop those districts we need the funds that we generated for the central coffers.

So it wants regional inequity to be taken into account too and not just state-level per capita income. That’s the crux of the debate that most well to do states are raising, it just happens most of them are southern states and are governed by opposition parties.