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As the 16th Finance Commission approaches, the need for a review of the central-state transfer mechanisms has never been more urgent. A significant part of the discussion revolves around the income distance criterion, which remains a cornerstone of the horizontal devolution formula, influencing how taxes are shared among states.
Currently, this measure holds a substantial 45 per cent weightage in the allocation formula, although it has been gradually reduced from 62.5 per cent in the Eleventh Finance Commission. The weightage over successive commissions – 62.5 per cent, 50 per cent, 47.5 per cent, 50 per cent, and 45 per cent in the Fifteenth Finance Commission – reflects a consistent effort to maintain it as the highest among all devolution criteria.
The Finance Commission aims to balance expenditure needs, equity, and efficiency to ensure a fair distribution of resources among states. In doing so, it must consider the unique strengths and challenges of each state.
To achieve this, the income distance criterion was developed to equalise tax capacities, calculated by averaging a state’s per capita income over three years and adjusting it according to the 2011 census (previously, the 1971 census was used).
Per capita Gross State Domestic Product (GSDP) is used as a proxy for income and tax capacity, recognising that poorer states have higher expenditure needs and a lower capacity to mobilise resources to provide comparable services.
However, relying on per capita income in the income distance formula may not fully capture the complex economic realities across Indian states.
Although the goal of this approach is to be progressive, providing greater funds to lower-income states oversimplifies the reality of fiscal capacities across states.
States with similar per capita incomes can exhibit varying levels of tax effort; while some may be proactive in generating revenue, others may lag despite having comparable economic practicalities.
Relying solely on per capita income also neglects the impact of income inequality within states. A state with high inequality may have a large portion of its population earning low incomes, which limits its tax base, despite a seemingly high per capita income.
Furthermore, structural factors like urbanisation, industrialisation, monetisation, and efficiency significantly influence a state’s tax capacity. States with higher levels of industrialisation and urbanisation may have more taxable economic activities.
Conversely, states with predominantly service sectors or large informal economies, even with similar per capita incomes, may struggle to generate comparable tax revenues.
More significantly, it fails to account for differences in the cost of living. For instance, states with higher living costs must generate significantly more revenue to provide the same level of public services as lower-cost states. One critical flaw is the “denominator effect”.
Dividing by population and scaling by population size, this approach can obscure the actual economic needs of some states, particularly those facing second-generation challenges, despite having slower population growth. While it aims to redistribute funds to larger states, it can disproportionately impact states with smaller populations or unique developmental challenges.
While GSDP per capita is often used as a measure of tax capacity, this approach assumes that high-income states can generate more revenue. Yet, structural differences such as the nature of economic activities, industrial development, sectoral composition, demographic factors, and other contextual variables can significantly affect a state’s ability to raise resources.
This criterion fails to consider these critical differences, presenting an incomplete picture of fiscal capacity. Consequently, the well-intentioned aim of fair distribution is undermined by an overly simplistic measure.
Towards equitability
Given these limitations, it is essential to reassess the use of per capita GSDP as the sole measure of income distance. While the objective is to support lower-income states, this method can inadvertently disadvantage states with unique developmental challenges.
A more equitable formula for fund allocation should incorporate a complementary measure that mitigates the relative losses caused by the per capita income distance approach.
A composite measure that factors in real fiscal capacity, population size, and per capita metrics would offer a more precise and balanced reflection of each state’s fiscal needs and capacities. Such a reform would ensure that states with distinct challenges, whether due to economic structure, cost of living, or demographic shifts, are not unfairly affected in the allocation process.
Moving beyond the per capita income distance criteria based on per capita income and introducing an additional compensatory metric will help promote a more just and inclusive framework for resource distribution.
As the Finance Commission undertakes this critical task, it must move towards a formula that truly reflects the diverse realities of Indian states, fostering sustainable and balanced development across the country.
(The writer is an Assistant Professor at the Gulati Institute of Finance and Taxation)