The southern alliance and the 15th Finance Commission
State shares have to be firmly founded on accurate measures of relative state taxable capacity—which is now enabled by the goods and services tax
On 10 April 2018, the finance ministers of three southern states and Puducherry (a Union territory) met at Thiruvananthapuram to protest the terms of reference (ToR) of the 15th Finance Commission (FC-15), which will prescribe state shares in statutory fiscal support from the Centre for the period 2020-25. It was not just a political meeting, because I was invited too, as, presumably, were other scholars. I could not attend unfortunately because of a competing commitment.
A follow-up meeting early this month is planned to finalize a formal protest to be lodged with the president of India, who appoints every finance commission. The principal concern centres on the direction in the ToR to use population figures from the 2011 census in place of the 1971 census in the formula for determining state shares.
To begin with, these are state shares of a divisible pool, which has risen from roughly 24% of the Centre’s tax revenue at the start of reform in 1991, to a peak of 42% prescribed by FC-14 for the period 2015-20. The elliptical suggestion in the ToR that FC-15 might consider a reduction of this divisible pool has led to widespread state disaffection, and not just in the south. But let me now confine myself to shares within the aggregate, which is what the southern protest is mostly about (I should state that I played no part whatever in drawing up the ToR of FC-15).
Population has declined in importance in terms of its direct weight over the years, although it enters indirectly into other factors going into the formula. To prevent population size from becoming a perverse incentive for states to neglect population control, seven finance commissions over a span of 35 years were explicitly directed in their ToR to freeze population shares of states at the 1971 census levels. FC-14 was the first released from that constraint, to which it responded by taking a mix of shares of the 1971 and 2011 censuses.
Today, it is time to bring on board the incremental population in states which failed (even without a perverse incentive) at population control. Those extra people, those extra children, exist. State shares cannot be viewed as an entitlement, independent of the underlying basis. If southern states get lower shares owing to a lower relative population today, that is the formula. No anti-southern bias there.
Southern states’ statutory shares fell starting in the mid-1980s from what had previously been a roughly stable one-quarter of the aggregate. The fall in shares became particularly sharp after the year 2000, to the present level of slightly under 18% prescribed by FC-14. More than 90% of the post-2000 drop happened before FC-14, while the 1971 census population freeze was on. The formula dropped weightage for contributions to revenue, introduced area (thus disadvantaging densely populated states) and gave more weightage to indicators of economic deprivation.
The statutory share from the Centre has to be viewed as a top-up to what states are able to generate from their own tax base. Finance commission flows aim to provide broadly similar access to publicly funded amenities over a landscape characterized by wide regional inequalities. A more prosperous state like Goa has higher per capita collections from its own tax base, and clearly needs less of a top-up than a state like Bihar. At the same time, finance commissions cannot go by observed tax revenue, since the tax effort of states might (and does) vary. A common tax effort percentage is, therefore, applied to variations in state domestic product per capita, which is used to proxy differences across states in the taxable base.
With the goods and services tax (GST), we now have for the first time a closer approximation to the true relative taxable base in different states. This is despite the exclusion of petroleum products, electricity and liquor from the GST. Since the coverage of the GST tax base is uniform across states, and since the GST can be presumed to have imposed a uniform tax effort across states within its coverage (although this may be contested), state-wise collections give us a better handle on the relative taxable capacity of states than the domestic product proxy that has been used hitherto.
Compensation for differential fiscal capacity is what currently dominates the formula determining state shares, with a weightage of around 50% over the last four finance commissions. Is this a perverse growth incentive? Yes, if viewed that way. But what has to be remembered is that state growth is valued for itself, and will not be held back just because a statutory share is going to fall as a consequence.
So, the decline in southern state shares over the past several commissions until FC-14 largely reflects faster economic growth. That should be cause for pride, not grievance.
A legitimate grievance of the southern states, however, is population migration to these states from the slower growing states of the north. In the Economic Survey (ES) for 2016-17, an excellent chapter estimated inter-state economic migration between the censuses of 2001 and 2011 at roughly 5.5 million per year. Of this, the annual flow to Kerala was slightly under half a million (Delhi and Maharashtra far eclipse the southern states in terms of their migratory pull). But any economic migration reflected in census figures will determine relative census population shares. No worries there.
What does not get captured in the census is migration of the temporary kind. For the post-census period after 2011, the ES innovatively used data on unreserved passenger traffic on the rail network for five years to get an estimate of nine million for annual nationwide inter-state economic migration on a net basis, which is to say it netted out return journeys between every pair of destinations. Thus, they capture what may be termed long-term accretions to the population of the destination state, and are in that sense similar to migration reflected in the census (except that they cover five years rather than 10).
Gross migration is not reported in the ES, but informal estimates suggest they could be three times the estimated net figure (which means that of every 100 migrants, two-thirds are temporary and make the return journey, and one-third stay on and get into the net figure). These population inflows do impose a strain on water, sanitation and road networks in the destination state, and do not enter into census-based calculations of fiscal entitlements.
So yes, temporary migration is something FC-15 has to worry about providing for. But don’t temporary migrants typically move towards some targeted work opportunity in a rapidly growing node? Wouldn’t they be adding to state domestic product in the host state, and thereby to the taxable capacity of the destination state? Yes, and no. The work contribution of these migrants does indeed get reflected in the income originating in the host state, but if they remit all their income home, or carry most of it back with them, the income accruing to the host state, and thereby the consumption base on which state taxes are levied, will be less than the income originating.
This is where the new GST helps in estimating the relative taxable capacities of states. When the migrant returns home to Jharkhand, say, and makes GST-bearing purchases there (a bike, or cement for house renovation), the effect will show in the GST base of Jharkhand in a way that the state domestic product of Jharkhand would not (because the way it is measured in India at the state level excludes remittance income and indirect taxes).
With GST offering a better measure of relative state taxable capacity than what we have had so far, the grievances of host states with high outward remittances, corresponding to labour in-migration, get partly taken care of.
Even if wages are remitted out entirely, some benefits of domestic migrant labour do get captured in the state where they work, in the form of higher profits for the employer (because migrants tend to hold down wages), and higher profit income will get reflected in the taxable base of the host state, in terms of higher purchases of GST-leviable goods and services, or of petrol and diesel, or of liquor, all of which are taxable by the state. To repeat, although the GST taxable base is not comprehensive, it provides a relative measure which is all that is needed to estimate the relative top-up needed.
Kerala may be a host state for domestic migration, but it has been an exporter of prized manpower to the rest of the world. As a major recipient of international remittances, the income accruing to Kerala far outpaces the income originating in the state. Since finance commissions have so far been compelled to use state domestic product as a measure of relative tax capacity, which excludes remittance income, Kerala has on that account actually been getting a top-up higher than was due.
There remains the problem of compensating for the strains imposed by temporary migrant flows on infrastructure capacity. Migrants head mainly for city nodes. Delhi is the biggest migrant magnet but, as a Union territory, gets excluded from the field of vision of finance commissions, which look only at flows from the Centre to states. Delhi’s expenditure burdens are borne directly by the Central government. There may be a strong case for bringing back an earlier finance commission practice of a carve-out for Union territories from the divisible pool, appropriately ring-fenced to secure better pollution control, water and sanitation.
Other issues raised by the southern alliance are not covered here for lack of space. I will only conclude by saying that a strong institutional tradition has been built up over the years by which finance commissions are entirely free to deal with their ToR as they choose.
Indira Rajaraman is an economist.