Mentor’s Comment

Debates on fiscal federalism in India often oscillate between equity and efficiency. The article examines whether Gross State Domestic Product (GSDP) can be a fair and reliable basis for sharing Central tax revenues among States, especially in the post-GST era where tax attribution has become complex.

Why in the News

The article gains significance amid ongoing debates on Central-State fiscal relations, especially after the implementation of GST, which has weakened the direct link between tax collection and the place of economic activity. The issue is critical because ₹75.12 lakh crore was transferred to States between 2020-21 and 2024-25, and the method used to distribute this amount affects State fiscal autonomy and perceived fairness. A key finding is the very high correlation (0.99) between actual transfers and GSDP, compared to a much weaker link with Finance Commission devolution, making GSDP a stronger alternative measure.

Introduction

India’s system of fiscal transfers relies heavily on the recommendations of successive Finance Commissions, which distribute Central tax revenues through tax devolution, grants-in-aid, and Centrally Sponsored Schemes (CSS). However, the post-GST tax regime has disrupted the traditional linkage between tax collection location and economic value creation, raising questions about whether existing criteria adequately capture States’ real contribution to national revenues.

Why is tax collection an unreliable indicator of State-level contribution?

1. GST structure: Breaks the link between the location of production and the location of tax collection due to destination-based taxation.
2. Corporate taxation: Attributes tax payments to the registered office location rather than where economic activity occurs.
3. Multi-State operations: Dilutes State-wise attribution due to labour migration, inter-State supply chains, and inter-corporate transactions.
4. Example distortion: Automobile manufacturers pay taxes where offices are registered, not necessarily where factories operate; plantation companies record profits centrally despite dispersed production.
5. Outcome: Direct tax figures reflect collection points, not value creation.

Why does GSDP emerge as a credible proxy for tax accrual?

1. Economic base representation: Captures the size and intensity of economic activity within a State.
2. Uniform tax base assumption: Assumes broadly similar tax administration efficiency across States.
3. Empirical validation: Correlation between GSDP and GST collections stands at 0.75 for 2023-24.
4. High correlation with transfers: Correlation of 0.91 between GSDP and total Central tax transfers.
5. Policy neutrality: Avoids contentious attribution disputes inherent in GST accounting.

How do actual transfers align with GSDP shares?

1. Overall transfers: ₹75.12 lakh crore transferred during 2020-25, including FC devolution, grants, and CSS.
2. High-alignment States:
   1. Uttar Pradesh: 15.81% transfer share vs 16.85% population share.
   2. Maharashtra: High tax contribution (40.3%) but only 6.64% of transfers, reflecting redistribution.
3. Mismatch States:
   1. Bihar: Receives 8.65% transfers despite only 4.66% GSDP share.
   2. West Bengal: 6.96% GSDP share vs 6.69% transfers.
4. Interpretation: Transfers broadly track economic output, not tax collections.

How does the equity-efficiency trade-off emerge in fiscal transfers?

1. Redistributive bias: FC criteria prioritize equity over efficiency by favoring population and income distance.
2. Regional disparities: Persist due to differential expenditure needs and fiscal capacity.
3. Efficiency trade-off: GSDP-based transfers better reflect contribution but reduce redistributive scope.
4. Evidence: Correlation between GSDP and FC devolution shares is only 0.58, indicating weak alignment.
5. Outcome: GSDP balances fairness and efficiency more transparently than current metrics.

Which States gain or lose under a pure GSDP-based system?

1. Major gainers: Tamil Nadu and Karnataka: High production but lower tax attribution due to GST mechanics.
2. Major losers: Uttar Pradesh, Bihar, Madhya Pradesh: Benefit currently from redistributive weights.
3. Exception States: Haryana, Karnataka, Maharashtra: GSDP share lower than tax collection due to tax concentration effects.
4. Inference: GSDP corrects distortions arising from centralized tax accounting.

Conclusion

The debate on using GSDP as a basis for Central-State transfers highlights the need to realign India’s fiscal federal framework with the realities of the post-GST economy. While redistribution remains essential for equity, greater reliance on GSDP can improve transparency, efficiency, and trust by linking transfers more closely with economic activity. A calibrated approach, combining GSDP-based devolution with targeted grants, offers a balanced pathway to strengthen cooperative federalism.

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