Arvind Subramanian: If this were the First Finance Commission!

India is changing: From many fragmented economic Indias to one integrated India; from a more centralised political India to many quasi-sovereign Indias. As a result, its fiscal arrangements, especially on tax sharing, need to evolve. But in what direction? That is the unenviably difficult question facing the Fifteenth Finance Commission (FFC) under the chairmanship of N K Singh.
 
Already, a controversy has arisen. Initial salvos were fired by a number of Southern states. Their concerns were expressed in technicalities, namely the particular criteria the FFC should use, and their precise definitions. But the underlying issue is a serious one: How much tax revenues should prosperous states be expected to transfer to the less well-off?
 
The answer to this question is inevitably political. But economics can, indeed must, help channel the debate by providing facts and a framework in which to think about them. Otherwise, the political debate may just generate heat and discord, rather than light and comity.
 
Framework
 
So, what then is the framework that economics can provide?

Tax sharing in all federal systems needs to address three different objectives:

• Redistribution (equalising transfers),
• Risk-sharing in response to shocks, especially within the framework of a political union with a single currency; and
• Incentives for better performance — service delivery and revenue mobilisation — at the lower tiers of government.

 
In the Indian context, these objectives are influenced by some hardy perennials. There is still a lack of ‘convergence’ in per-capita incomes amongst Indian states, making fiscal redistribution politically necessary for some states and burdensome for others. Then there is the excessive dependence of the lower tiers of government on transfers from higher tiers, potentially creating a bad dynamic of poor public service delivery and weak accountability, which leads poor tax effort, which feeds back into poor delivery
 
This long-standing context has in recent years been impacted by three developments. The abolition of the Planning Commission, which implies that Centre-state transfers will now happen largely through the budgetary process and Finance Commissions. The verdict of the 14th Finance Commission,which restored more autonomy to the states,both on the tax and expenditure side. And the introduction of the GST, which has furthered economic integration, diluted fiscal autonomy and redistributed the tax base in favour of the relatively poorer and smaller states.The first two developments are well-known. Less appreciated is the impact of the GST.
 
Redistribution
 
The major task of FCs has been to come with a formula for sharing taxes between the Centre and the states as a whole (“vertical devolution”), creating a pool of resources which is then divided amongst the states themselves (“horizontal devolution”).
 
Successive FCs have deployed very different criteria for horizontal devolution. It is hard to discern any underlying method or pattern. We need to go back to first principles, and restore the primacy of the idea, implied in the Constitution, that the divisible pool comprises taxes that the Centre is collecting on behalf of the states. Accordingly, the default should be to give back to the states the taxes they have generated. Redistribution should then be understood as departures from this benchmark.
 
Based on this simple idea, we can calculate how much redistribution has been effected by successive FCs. When we do so, we find that the amount of redistribution has been rising steadily. After the 10th FC, the share of the divisible pool used for redistribution was 22 per cent. After the 14th FC, the share increased to 32 per cent. This translates as an increase from about 0.5 to 1.3 per cent of GDP, or a five-fold increase in real per-capita terms.
 

Arvind Subramanian

Second, as a result, some states have become large net contributors and others large beneficiaries. We measure contributions or benefits as a share of the notional amounts that states should have received had tax revenues simply been given back. On this basis, the fiscal impact of redistribution  amounts to as much as 70-100 per cent, both for contributors and beneficiaries.
 
The pattern of these transfers is interesting. As expected, the largest receiving states are in the North-east and the interior. But contrary to popular impression, the large contributors are not all in the South. Rather, they are in the West, South and in the North (Figure 2). The Vindhyas are not the axis (metaphorical or geographic), distinguishing beneficiaries and recipients.
 
Third, there have been important changes in the pattern of redistribution over time. The contribution of the Southern states has been rising and the benefits to the Northeast have been declining while those to some of the interior states — UP, MP, and Bihar — have been rising.
 
Fourth, some of these trends may reverse going forward, because of the introduction of the GST. Under the previous system, taxes accrued disproportionately to states that were major producers. But the GST is consumption-based. Preliminary research based on examining the first nine months of data suggests that this has indeed made a major difference, as the poorer and smaller states (that are broadly consumers) have seen a significant expansion in their tax base. Many of the net consuming states such as almost all the North Eastern states as well as UP, Rajasthan, MP, Delhi, Kerala, and West Bengal have witnessed increased post-GST shares. As a result, their need for transfers may have correspondingly diminished.
 
Risk-sharing
 
We must all learn the lessons from Europe. Integration brings prosperity but it also allows shocks to be transmitted from one state to others. And if these states lack the monetary means to deal with the shocks and have limited fiscal manoeuvrability, then serious economic and political tensions can arise.
 
The GST is transforming India into a common market. At the same time, the pooling of tax sovereignty that it has entailed has its counterpart in some loss of sovereignty for the centre and the states. For example, the GST has subsumed around 31 per cent of the gross tax revenue of the Centre. It has subsumed an even larger proportion of the states’ own tax revenue, 47 per cent. This suggests that states, in particular, have lost some fiscal flexibility, and will need some help in dealing with major shocks, such as crop failures.
 
Rewards
 
Service delivery and own tax raising at by the states and third tier institutions (urban and rural local bodies) remains a work-in-progress. Indian states collect much less own revenue (as a share of total revenue) than their corresponding tiers in countries such as Germany and Brazil. Also, both urban and local bodies in India are almost solely dependent on devolution from above. A common assertion is that not enough taxation powers have been devolved to the lower tiers. But this cannot be the explanation, for revenue collection falls far short of the potential already conferred.
 
For example, land revenue collection (for 2015-16 in three states; Karnataka, Tamil Nadu and Kerala) averages only around 7 per cent of potential, based on the market value of land. Even in states such as Kerala and Karnataka — ahead of others in devolution of powers to RLBs — collection vis-à-vis potential is only around one-third.
 
This hints at the existence of a “low-equilibrium trap.” Poor service delivery has led to weak own tax revenue generation, weak accountability and resource-dependence, which has led back to poor delivery. This is a serious problem, for if urban governments are unable to meet the growing demand for services as population shifts to the cities, there will be a risk of social disruption. 
 
Consequently, the issue facing the FFC is: Can it provide credible incentives for second and third tier fiscal to improve their own revenue performance, especially direct taxes in order to facilitate better service delivery.
 
The way forward
 
What all of the above suggests is that tax sharing should have four “pots”.
 
First, a default pot in which states get back their due based on their tax base (what might be called true “devolution”).
 
Second, a redistribution pot that balances the short run need to equalise without denting the long run incentive for revenue generation. Critically, the aggregate amount of redistribution and the contributions from the states need to be politically acceptable. Redistribution cannot permanently get ahead of the willingness of the underlying body politic to sustain it. Once the redistribution pot is decided,the allocation among states can be based on simple and parsimonious criteria, avoiding the complexity and arbitrariness that underlies current recommendations.
 

Third, there should be risk-sharing pot to deal with both all-India (financial and currency crises) and state-specific shocks (monsoon, droughts). This could be done, for example, by setting aside a small share of the divisible pool (say 1 per cent) to be deployed in the event of shocks. The Centre and the states have, of course, other fiscal instruments to deal with shocks but a common response could become more effective and a desirable feature of fiscal arrangements going forward.
 
The fourth (rewards) pot could be to break the ‘low equilibrium’ trap at the lower tiers of government. For many reasons this is not an easy task. One possibility might be to use matching grants so that a portion of the divisible pool is set aside and given to third tier institutions conditional on their raising their own resources.
 
Finally, in the absence of the Planning Commission a new institution may be needed to implement this “vision”. The GST Council could be such an institution. Thus far, it has worked very effectively and demonstrated that cooperative federalism can work. It can now build on that experience to take on issues related to resource transfers and any other follow-up/implementation work that future fiscal federalism will necessitate.
 
India's future lies in cooperative federalism. Increasingly, the Centre and the states must come together to solve problems across the economic landscape. Therefore, its fiscal arrangements must be commensurate with the challenges ahead, and based on a framework/vision that are economically coherent and politically acceptable. The Fifteenth FC has an opportunity to design them as if it were the First.

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The author is the Chief Economic Adviser. (Edited excerpts from the Business Standard Lecture delivered in Mumbai on Friday)