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Horizontal fiscal imbalances — Equity and efficacy options for transfers

N. Sreedevi

THE Twelfth Finance Commission (TFC) must be toiling on different criteria for the horizontal distribution of shareable tax revenue — the most crucial and critical part of the recommendations. The Centre-State financial relations, particularly horizontal distribution of resources, is a perennial source of interest in the backdrop of the long existing fiscal imbalances and income disparities across States and their further widening in the reform period and the objective of Finance Commission (FC) recommendations to minimise both vertical and horizontal fiscal imbalances. However, the arguments such as "when certain States are not doing well... " and "why should better-off States part with their resources at the cost of their own interest... " require a probe into the reasons for the widening fiscal/income disparities across the States and also suggestions of an alternative criterion for the horizontal distribution of the shared taxes.

Horizontal fiscal imbalances

The Twelfth Finance Commission should keep in mind not only the general reasons for horizontal fiscal imbalances (inter-State variations in revenue capacity and effort, variations in the unit cost of services, and the volume of requirements of a State, expenditure management and income variation) but also the specific factors that widened the income disparities and fiscal imbalances such as:

  • Historical factors which contributed to the socio-economic development process in and around the major centres of activity under the British rule;

  • Extent of inter-State tax exportation;

  • Higher ability of the high-income States to raise the funds required for obtaining matching transfers;

  • Some Central policies (low payment of royalty to mineral rich low-income States and freight equalisation policy against the interest of these States) that neutralise the natural advantages of the rich States to attract industries.

    Besides these factors, the sharp deceleration of State economies in the reforms period widened the inter-State inequality and poverty, with social and political implications. This demands the distribution of unconditional transfers across the States to offset the fiscal disadvantages. The re-distributive role of the Centre assumes greater urgency in federations where, as in India, the regional disparities tend to be accentuated as the economy gets market-oriented.

    Devolution of Central tax revenue

    The Finance Commissions so far reassessed the receipts and the non-Plan revenue expenditure only to estimate the "non-Plan revenue gap", which the Commissions defined as `need' of a State. They recommended grants-in-aid only to those States where the gap persisted even after the recommendations of shared taxes and duties. But these calculations had some relevance only till the Sixth Finance Commission and after that its proportion in the total FC transfers decreased substantially. Moreover, on the receipts side, the norms set by the FCs were seldom reached, while on the expenditure side they were exceeded even after adjusting for inflation and other factors.

    While recommending horizontal distribution of shared taxes, the Finance Commissions relied neither on a theoretical base nor on economic rationale, though they have aimed at `progressivity' in their transfers. Their objective of minimising horizontal fiscal imbalances remained implicit and piecemeal. But the arbitrary selection of both the criteria and their weights is independent of the estimated `need' of the States. The objections of a few States to the EFC criteria raises the need to look for an alternative criterion for distribution of shared taxes based on economic rationale.

    Horizontal distribution of Central shared taxes

    The supporters of the equity approach justified such a distribution on efficiency ground because that would prevent resource migration induced by lower public spending in the poorer regions. It is also agreed that equitable transfers could lead to higher growth where income differences of the States for some reason do not reflect the resource endowments. This applies to the Indian context on two grounds:

  • Income differences are not reflected in resource endowments. For example, Bihar and Orissa are resource-rich low-income States; and

  • The Central policy of ``freight pooling'' transferred the resources from mineral-rich low-income States to the rest of the country.

    Equity theory in the Indian context

    The Twelfth Finance Commission can attempt to apply the equity principle to unconditional transfers, particularly the shared taxes. Then, the question arises whether two sources of inequity (deficiency in revenue capacity and variations in unit costs, as in Australia) are to be tackled or just one opted for. Which is to be opted with immediate effect and which in the long run?

    As the low-income group States see themselves as the victims of Central policies/reforms, revenue and cost disadvantages, the equity-based transfers should also be progressive in their favour. Minimising the revenue gaps of the States either by restraining expenditure or augmenting revenue is in the hands of the State government. In any long-term effort to minimise revenue gaps, the Finance Commission procedures will have to focus on improving tax revenue that constitutes three-fourths of the total revenue and is the main component of the ability side of the equation. Here comes the taxable capacity equalisation concept.

    Equalisation of taxable capacity

    An attempt may be made to estimate the "relative taxable capacity" of State governments and equalise their taxable capacity by distributing the shareable Central taxes. For this purpose, the cross-section time-series regression method may be used taking the Per Capita State's Own Tax Revenue (PCSOTR) and the Per Capita Net State Domestic Product (PCNSDP), which is derived by taking the actuals of SOTR and NSDP and the population figures estimated by the Census.

    As the estimation of relative taxable capacity is for the future period for which the recommendations of the FC apply, the PCNSDP is projected for that period considering the projected population of each State and the projected NSDP (taking respective trend growth rates of the States using log-linear method). (The differences in the structure of SDP could influence the taxable capacity of the State in several ways. This limitation is inherent.) As the fluctuation in the inflation rate would get averaged in the time trend method it is less hazardous than the application of presumed rate of inflation.

    It is to be remembered that all States which levy union taxes and duties are entitled to a share in the Central pool. Therefore, there can be two phases of transfers. In the first, the distribution of resources should be made on the basis of average capacity — fulfilling the entitlement of the States' share in the Central shareable pool. "All-States Average Capacity" multiplied by the respective State's average population would get the share of each State. Here, the population acts as a weight to determine the share of a State (though the Finance Commissions assign arbitrary weights for the `population' criterion). The sum of this amount is kept aside from the divisible pool. However, the necessary condition here is that the amount kept aside under the "All States Average Capacity"-based distribution should be lower than that of the total shareable amount.

    For the distribution of the remaining amount, the "highest taxable capacity" State should be chosen as the "standard taxable capacity" and the distance of each State's relative taxable capacity is measured from there. Then, each State's distance is multiplied by its population and then the relative share derived. The shareable pool of Central resources is distributed as per their relative share. Finally, adding the two gives the `total shareable amount' and then the relative share of each State is calculated.

    In the second phase of the transfer, States with higher tax base and growth rate will get a lower share and vice-versa. The other two categories (States with lower tax base and higher growth rate and those with lower tax base and lower growth rate) lie in between these two.

    If the normative rate/buoyancy is applied uniformly (instead of the prevalent tax rates in those States) to the tax base of the States, the `relative taxable capacity' of each State is derived.

    The perceptions of various Finance Commissions on the tax effort and the taxable capacity show that it is relevant to apply `capacity' as the basis.

    The EFC has also considered aggregate SOTR (State's Own Tax Revenue) while reassessing the State's resources. (The efficacy of methodology could be questioned on the ground that the non-tax and the tax revenue taken together would be a better indicator of the taxable capacity of a State. The Commission may include the non-tax revenue component.)

    The measure of taxable capacity plays a dual role, as a measure of `need' and as a criterion for the distribution of shareable pool among the States without any arbitrary weights. The other merits of this measure are:

  • The taxable capacity equalisation as a criterion is free from `grantsmanship';

  • It is explicit and objective;

  • It neither penalises the States with a better record of tax effort, nor encourages inefficiency of States in raising their resources;

  • Achieves revenue equalisation from the side of Finance Commission;

  • Makes data availabile on the tax base such as PCNSDP; and

  • Has a theoretical and economic basis for the horizontal distribution.

    Since Central policies govern the regulation of all economic activities in the broad national interest, there is every reason to adopt the equity-based approach to minimise the horizontal fiscal imbalances.

    (The author is Associate Fellow, Centre for Economic and Social Studies, Nizamiah Observatory Campus, Hyderabad. The views are personal. The author can be reached at

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