Population, GST lie in the heart of India’s North, South money wars over central funds

Not just Karnataka, Kerala and Tamil Nadu have also raised concerns over the shrinking share in devolution from central taxes.

With a few months left for general elections, the narrative of a North, South divide has picked up steam and this time it is primarily over the allocation of central funds among states.

Southern states like Karnataka are claiming that they are being deprived of their legitimate share from central taxes, while the Centre has cited the Finance Commission norms to defend the current levels of devolution.

The dispute is threatening to escalate into a slugfest, with the Karnataka Congress government, steered by Chief Minister Siddaramaiah, all set to protest in the heart of Delhi on February 7 against what it terms as “unfair treatment in tax devolution” by Prime Minister Narendra Modi-led government at the Centre.

Labelled as the “South Tax Movement,” Siddaramaiah’s rally against the Centre follows claims that the state has lost an estimated Rs 62,098 crore over five years in tax share from the divisible pool on account of the sharing pattern laid out by the 15th Finance Commission.

“Under the 14th Finance Commission (2015-2020), Karnataka received 4.71 percent of the tax share, which was reduced to 3.64 percent by the 15th Finance Commission (2020-2025), which is a decrease of 1.07 percent," Siddaramaiah wrote on social media platform X.com on February 5.

At the Centre, Finance Minister Nirmala Sitharaman on February 5 rubbished similar claims made by Congress parliamentarian Adhir Ranjan Chowdhury in the parliament. Sitharaman said that "devolution to states happens as per the Finance Commission recommendation" and that the Union government has no "discretion" in the allocation of tax revenues.

The discussion over lower devolutions to states, especially due to the Centre’s higher reliance on cesses is not new. But with general elections slated in April, May 2024, the renewed intensity of this debate is significant.

At the heart of the devolution dispute seemingly lie two major issues. First, the devolution given to states has been significantly lower in the last few years compared to the recommended levels of the 15th Finance Commission.

Second, the share of devolution for the less populous and fiscally stronger southern states tends to be lower, while few northern states, which are weaker on these metrics, get a larger share of central taxes.

Tax devolution refers to the distribution of net proceeds of Union taxes and duties by the Centre to the states, which help them to carry out spending on development, welfare and priority-sector projects and schemes. At present, as per the recommendation of the 15th Finance Commission, 41 percent of the divisible tax pool of the Centre is transferred to states in 14 instalments annually covering the five-year period of 2021-22 to 2025-26.

India Ratings and Research on February 6 in a note said that tax devolution given to states has been significantly lagging compared to the recommended levels of the 15th Finance Commission.

In FY25, the Union government has budgeted to share 35.5 percent of the divisible tax pool (gross tax revenues net of cess and surcharges (excluding GST compensation cess) and taxes of Union territories) with states, lower than the suggested 41 percent. Furthermore, the states’ share in central taxes has been trending downwards, averaging 35.4 percent of the divisible pool during FY21-FY25BE, down from 39.8 percent during FY16-FY20, the note added.

The Reserve Bank of India in its latest edition of State Finances: A Study of Budgets of 2023-24 released on December 11, 2023, highlighted the same. “Due to increase in cesses and surcharges, the divisible pool has shrunk from 88.6 percent of gross tax revenue in 2011-12 to 78.9 percent in 2021-22 despite the 10-percentage point increase in tax devolution recommended by the 15th finance panel.”

The central bank suggested that since the actual tax devolution hinges critically on the cesses and surcharges levied by the Centre, the states need to augment their own fiscal capacity and reduce dependence on transfers.

“Over the years, the share of central taxes shared with states as a percentage of the divisible pool has been hovering around 35-36 percent in the last four years. One of the reasons for that is cess and surcharges are more than 10 percent of the gross tax revenue. So, it is reducing the overall pie. And, out of that overall pie a lower share is going to the states, which is why some states are asking the Centre to share more revenues,” India Ratings’ chief economist Devendra Pant told Moneycontrol.

Concerns were raised by southern states even before 2020, when the 15th Finance Commission submitted its report using the 2011 population census to decide the devolution of taxes from the central government to the states, with a separate factor to reward some for controlling their population.

This was a shift from the previous commission, which used a combination of the 1971 and 2011 censuses as macro-indicators in the equalisation formula, with a much higher weight being given to the former. This was done to reward states that have effectively controlled population growth.

The NK Singh-led Commission's pivot to the 2011 census entirely, as one of the criteria for deciding the pattern of devolution, was done to be more responsive to existing population levels.

This means that higher the population of a state as per the latest census, the higher the amount of funds it will get from the central government for its spending needs. Therefore, the less populous states in India stand to lose from the divisible pool of revenues.

This is where the North, South divide debate makes an entry. North Indian states like Uttar Pradesh and Bihar whose populations have expanded rapidly since 1971 naturally get a relatively larger share of funds thanks to the shift by the erstwhile 15th finance panel.

Take for example, the population of the northern state of Uttar Pradesh, which grew at the rate of over 20 percent in the period between 2001 and 2011, while the southern state of Karnataka saw an increase of 15.60 percent during the same period.

The situation would be different if the Finance Commissions still used part of the 1971 census as a criterion since both these states had a lower gap in the rate of increase in population with Uttar Pradesh seeing a rise of over 25 percent between 1971-1981 while Karnataka witnessing an increase of over 26 percent.

The story runs the same if you compare another southern state with a counterpart in the North. Tamil Nadu’s population grew by over 15 percent between 2001 and 2011, whereas Bihar saw a much larger increase of over 25 percent.

The statement showing the state-wise distribution of net proceeds of Union taxes and duties as per the Budget estimates for 2024-25 seemingly makes the impact of this divergence in population apparent. All five Southern states – Andhra Pradesh, Karnataka, Tamil Nadu, Telangana, and Kerala will be getting 15.8 percent as a share of the total allocated amount for devolution for the next fiscal, while the northern states of Bihar and Uttar Pradesh alone account for nearly 28 percent.

Though the specific details of this proposal are not available yet, one must separately note that in the Budget for 2024-25, the Centre announced the move to form a high-powered committee for "an extensive consideration of the challenges arising from fast population growth and demographic changes". It is not known if this would have an impact on the metrics used by finance commissions.

What makes matters even more complicated is that as admitted by the 15th Finance Commission in its report, most of the lower per capita income states are also more populous.

Therefore, many of the southern states that perform better on this metric would get a lower share compared to states with lower per capita income. This is a result of the income distance criteria, another metric used by the Finance Commission to decide on the pattern of devolution among states.

Weighing in on the debate, Congress leader Praveen Chakravarty raised the issue of double counting. “The farther the state is from the prosperity of the national average, the greater they get in devolutions. So, Bihar, which is the farthest from the national average, will get a lot more than, say, Kerala. But there is an issue of double counting here since if a state is distant from the national average in prosperity then it usually has a higher population as well as a lower human development index,” he said.

According to India Ratings’ Pant, since two of the indicators deciding the sharing pattern are population and the development parameter of a state compared to the national average, the states that rank higher on population and lower on development would predominantly get a larger share in devolutions.

This has led to allegations by some southern states over the past few years that by getting a smaller share of tax revenues, they are getting penalised rather than being rewarded for effectively controlling population.

In the current financial year, the central government has released Rs 8.20 lakh crore of shareable proceeds in 12 instalments (including two advance instalments) to the states till January 2024 against the Budget target of Rs 10.21 lakh crore, which has now been increased to Rs 11.04 lakh crore as per revised projections for FY24. For the next fiscal, the devolution of states’ share has been enhanced to Rs 12.20 lakh crore, which is 3.7 percent of the GDP.

Not just Karnataka, Kerala and Tamil Nadu have also raised concerns over the shrinking share in devolution from central taxes.

In his speech for Budget 2024-25, Kerala Finance Minister KN Balagopal pointed out that despite the likelihood that their own tax revenues will almost double the figures of 2020-21 by the end of the next fiscal, the state is facing a financial crisis given the dip in the share from central revenues.

“Our total tax revenue includes Kerala’s eligible tax share from the tax collected by the Centre. As per (RBI) statistics of 2021-23…the Centre will provide Rs 35 for every Rs 65 collected by the respective states. But the Centre provides only Rs 21 against Kerala’s own tax collection of every Rs 79. That is, only Rs 21 out of Rs 100, which is the Centre’s contribution. Uttar Pradesh gets Rs 46 out of Rs 100 from the Centre. Bihar gets Rs 70 out of Rs 100. Do we need any other better proof than the statistics of RBI?” Balagopal said.

Tamil Nadu’s Dravida Munnetra Kazhagam (DMK) government has also claimed that the state has been receiving a lower share from central levies. Finance minister Thangam Thennarasu last month reportedly explained that the state received only 29 paise for every rupee it gave to the Centre, adding that while Tamil Nadu accounted for 6.1 percent of the country’s population, its share in the pool of taxes had reduced from 5.30 percent under 12th Finance Commission to 4.07 percent in the 15th Finance Commission.

Chakravarty says that the argument of the Southern states is that “their share of giving keeps growing but they have not seen good use of those funds in the northern states. So, at what point will it end, because the whole point is to bridge the gap".

What adds to the misery of states is the nature of the goods and services tax (GST). Some states have alleged that the control they have over their own revenues has been reducing, with the rollout of the GST in July 2017 further lowering their ability to tinker with tax rates and increase revenues.

“Absolutely, GST exacerbates the problems. GST has certainly made the southern states that much more unwanted in the fiscal plan of India,” Chakravarty adds.

Another school of thought, however, says that the Centre has little role to play in this, given that the Finance Commission is an independent entity.

“This demand has been coming for a while, so the 16th Finance Commission may look into it, but the outcome is difficult to gauge. Whatever the Finance Commission has recommended in the past, the Union government has accepted, including the increase in the percentage of devolution,” Pant said.

The ball therefore clearly lies in the court of the newly constituted 16th Finance Commission.

“Since states are responsible for over 60 percent of general government expenditure, lower than the recommended share of states in central taxes coupled with cess and surcharges will remain an important issue before the 16th Finance Commission,” according to Paras Jasrai, Senior Analyst, India Ratings.

Arvind Panagariya, the former vice-chairman of NITI Aayog and now the chairman of the 16th Finance Commission, has a tough task ahead as he steers the panel that will decide the new formula for sharing of tax revenues between the Centre and states for a period of five years starting April 1, 2026.