In today’s Finshots, we tell you how the central government shares taxes with the states.

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The Story

Karnataka believes it is being short-changed by the central government — for a whopping ₹62,100 crores!!!

It says that it’s not getting its fair share of taxes. Heck, the state’s government even launched a protest in Delhi to right this wrong.

What on earth is going on, you ask?

Okay, let’s take it from the top.

Now here’s what you should know — India has a 3-tiered tax system.

  1. You have the central government at the top. They tax our income — so it doesn’t matter whether you live in Karnataka or Uttar Pradesh, the central government still gets your tax. Then they levy a tax on profits from companies all over the country. And they also earn from GST.
  2. Then you have the state government in the middle. They also earn a share of the GST. And they’ve managed to keep alcohol and fuel out of the GST net so that’s a big source of revenue. And then they charge things like road tax and stamp duty which is paid whenever there’s a legal document involved — such as during the sale of property.
  3. Finally, you have the local municipal bodies. They don’t have many lucrative tax sources. They earn from property tax or taxes on utilities like electricity.

Do you see the potential problem that emerges here?

Income and corporate tax forms the lion’s share of tax revenue for the country. And all that goes to the central government. Meanwhile, it’s the states’ responsibility to build and develop stuff like education and healthcare. And since they don’t collect too much tax, they have to wait for money to be transferred to them. Then they have to transfer some money to their Municipal bodies to handle local roads, water supply, street lights, sewage etc.

As you can see, the Central government wields the power.

For instance, Karnataka says that out of every ₹100 that gets collected from the state and goes to the Centre, it gets a measly ₹12–13 back for its development.

So this begs the question — how does the government calculate what states deserve?

Well, we have a special body called the Finance Commission (FC) that advises the government on such matters. In theory, it’s an impartial body. We say “in theory” because the head of the previous Finance Commission was a member of the ruling party.

But anyway, there are two parts to the FC’s decision-making.

There’s vertical devolution or the macro level decision which calculates how much revenue the Centre has to share with the States.

And by now, you know that States have larger spending responsibilities than the Centre. By that, we mean they spend on stuff like healthcare and roads. They need a lot of money for this. So you’d assume it’s a 50:50 split. Or maybe even think that States get a big chunk of the overall tax revenue.

But that’s not what happens. It’s actually more of a 60:40 split in favour of the Centre these days.

And there isn’t a quantitative method to determine this. It’s completely up to the folks at the FC to decide how to go about this.

But that’s not the only problem here. It looks like the central government has actually been keeping a larger share to itself!

See, the rules state that the Centre has to share a part of the income tax and corporate tax with the states. But it is mum on what to do about any cess or surcharge. You know, the ‘tax on tax’ type like a Swachh Bharat (clean India) cess or a Krishi Kalyan (farmers welfare) cess.

So if the Centre isn’t in a mood to share taxes, it can simply slap on a new cess and keep more money to itself.

And that’s what seems to be happening. The share of cess-related tax has gone up in the overall scheme of things.

So states aren’t happy and are clamouring for a more equal distribution of taxes.

But hold on, that’s not Karnataka’s primary worry today. It has an issue with the horizontal devolution aspect. Or how much of the tax pie each state should receive.

See, after independence, the first few Finance Commissions simply looked at the population distribution. The states with more people got a bigger share. But that wasn't fair — states that didn’t care about family planning would keep getting a larger and larger chunk of money.

So over time, the calculations were tweaked. The FC included a bunch of new factors —  such as the area of the state, forest cover, and even fertility rates. It became quite holistic. And each factor was assigned a weight too. For instance, population only has a 15% weight in the calculation these days.

Source: EY

But the bone of contention here is a metric which has a 45% weight in the calculations — something called ‘Income Distance’.

Now don’t worry. This isn’t some complicated finance jargon. All you have to do is take a state’s per capita income. Then determine the per capita income of the richest state. And finally, calculate the difference between the two. That will give you the income distance.

And if you think about it, it’s quite an important metric, no?

Because it allows a state with a lower per capita income to get a higher share in the horizontal devolution. It will give them the much-needed monies to develop their public services and match the richer states. It’s all about equity!

But that’s also where Karnataka’s problem begins.

You see, the state has a lot of IT firms headquartered in Bengaluru. When these IT companies do well, they contribute to the GDP of the state. And naturally, a higher GDP figure increases the per capita income of the state.

This also means that the state eventually ends up with a smaller share of taxes. In fact, while Karnataka used to get 4.71% of the pie before, it has now fallen to just 3.64%.

But the thing is, Karnataka can’t tax these IT companies and make money for itself. Nor does it get income taxes from the rich techies in the state. So the state ends up making a big contribution to the Centre’s coffers but gets a tiny share in return.

And Karnataka is pointing out that it actually leads to inequity within the state itself. All the growth is concentrated in Bengaluru and it gets less money to develop the hinterland of Chamarajnagar, Kalaburgi, and Yadgir.

So it wants regional inequity to be taken into account too and not just state-level per capita income. That’s the crux of the debate here.

The only question that remains is — Will things change?

We don’t know about that. All we can tell you is that this isn’t the first time there’s been a tussle between States and the Centre over sharing taxes.

I mean, in 2008, when Narendra Modi was the Chief Minister of Gujarat he lamented the state only got 2.5% of the Centre’s tax revenue. And he said,

“If the Centre so wishes, it need not pay anything to Gujarat for a year but then the Union government should also not collect any taxes from the state.”

It’s kind of the same argument that Karnataka is making today. So you can see that nothing has changed.

But who knows, maybe one day, the Finance Commission will come up with an idea that will revolutionize the tax devolution process. And every state will be at peace. Maybe one day!

Until then…

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