Rich states don't mean rich districts: Is it time to reimagine tax distribution?

In the mosaic of India's economy, where the gleam of metropolitan prosperity often overshadows the struggles in its hinterlands, a critical question emerges: Is our approach to sharing tax with states fair? Beneath the surface of aggregated state wealth figures lie stark disparities that paint a different picture — one of the affluent cities standing in stark contrast to their struggling neighbours.

WHY IT MATTERS

The current method of allocating tax revenue in India, based on state-level income, overlooks significant disparities within states. Right now, tax devolution is decided based on population, area, forest and ecology, tax and fiscal efforts, demographic performance, and income distance. The last one is the most significant since it carries a 45 per cent weightage in the decision.

Income distance refers to the difference in per capita income between a state and the state with the highest per capita income. The larger this gap, the more financial support a state is allocated.

The contrasts between districts lay bare the flaws in a one-size-fits-all policy and make a compelling case for a shift towards district-level analysis in tax devolution: A single affluent region can significantly impact a state's average income, hiding the economic struggles of other areas. This isn’t just a matter of bureaucratic adjustment; it’s about redefining fairness and equity in a nation marked by vast disparities.

IN NUMBERS

Karnataka, often hailed as a beacon of economic and technological progress in India, presents a paradox that mirrors a national challenge. While Bangalore Urban dazzles with its skyscrapers and booming IT sector, a short drive out reveals a starkly different reality. Neighbouring districts like Chikkaballapur and Kolar, despite their proximity to the state's economic powerhouse, lag far behind in per capita income.

With a per capita income of Rs 6.21 lakh, Bengaluru Urban is significantly wealthier than the rest of Karnataka — Rs 3.56 lakh above the state average of Rs 2.65 lakh. Districts like Bidar, Kalaburagi, and Yadagiri are at the lower end of the spectrum (Rs 1.32 lakh, Rs 1.41 lakh, and Rs 1.26 lakh below the average respectively).

Similarly, cities like Hyderabad, and Gurugram skew state income averages, masking internal inequalities. The disparity within Karnataka serves as a microcosm of the broader inequities that plague India, underscoring the urgent need to revisit our approach to tax distribution.

BIG PICTURE

These numbers are part of the long-standing argument that the southern states generally perform better than other states, especially those in the north. While the argument holds merit, an analysis of district-level data shows that development is restricted to certain pockets of Karnataka.

Experts, however, don’t agree with this argument for changing tax devolution rules. According to Manish Gupta, an associate professor at the National Institute of Public Finance and Policy, "Constitutionally, this shift isn't possible, and it's the states' responsibility to address imbalances within their territories. The central government can also bring schemes for addressing the needs of the backwar districts."

This suggests that while the idea could address disparities more effectively, legal and administrative frameworks currently limit such a change, placing the onus on state governments to address intra-state inequalities.

GOING DEEPER

The Third Finance Commission considered equity factors such as relative underdevelopment and the presence of Scheduled Caste/Scheduled Tribe populations. Over time, the focus has shifted from need to equity, but after the 11th Finance Commission, need-based criteria gained importance again.

Analysing data from 1995-96 to 2019-20, covering the 10th and 14th Finance Commissions, experts found states with lower incomes get more tax money. “The opposite is true for relatively wealthier states. This pattern is statistically significant," Gupta told India Today. Devolution is also higher for states with relatively higher tax-GSDP ratios.

BOTTOMLINE

The reliance on state-level income data for tax distribution has been criticised for not capturing the nuanced economic realities of India’s diverse districts. While the idea of moving to district-level data analysis for tax distribution in India presents technical challenges, it offers a compelling path toward more equitable development.