Tax contribution by States needs to be revisited 

1. Tax Contribution and State Revenue Sharing

• The Finance Commission plays a crucial role in recommending a distribution formula for determining each State's share in the Union tax revenue allocated to States.
• Since the 1st Finance Commission, there has been an ongoing debate regarding the distribution formula's determinants, with some States contending that their higher contributions to the Union tax revenue should result in proportionally higher shares.
• In the initial eight Finance Commissions, tax contribution held minimal weight in the distribution formula. However, since the 10th Finance Commission, tax contributions have been excluded from the formula.

The Efficiency Argument

• The tax contribution by each State serves as an effective measure of efficiency. States with higher tax contributions showcase a more robust and efficient economic performance.
• The Goods and Services Tax (GST) regime is presented as an opportune moment to reintroduce tax contribution as a determinant in the distribution formula. The argument emphasizes the relevance of tax contribution in reflecting a State's economic efficiency.
• The potential advantages, of this section highlight how incorporating tax contribution in the distribution formula can incentivize States to enhance their economic efficiency, leading to a fairer distribution of Union tax revenue.

• The Finance Commissions are entrusted with two significant tasks: recommending the proportion of Union tax revenues allocated to States and determining the share of each State in the assigned tax revenue. The principles guiding these recommendations are equity and efficiency.
• Till the 10th Finance Commission (till 2000), States' share was limited to personal income tax and Union excise duties. Post-2000, Central tax revenues were pooled, and a new allocation mechanism was instituted.
• The Finance Commission formulates a distribution formula based on equity and efficiency. Equity ensures revenue-scarce and high-expenditure States receive larger shares, while efficiency rewards States proficient in revenue collection and spending rationalization.
• The delicate balance between equity and efficiency remains normative and dynamic in successive Finance Commission recommendations.
• States emphasizing their significant contributions to income tax revenue argued for higher weightage to 'tax collection' as an indicator. However, the complexity of identifying the origin of income led to assigning only 10% to 20% weight to income tax revenue collection/assessment in the distribution formula.
• Identifying the origin of income for tax contribution poses challenges, and successive Finance Commissions assigned a limited weight (10% to 20%) to this efficiency indicator.
• In earlier Finance Commissions, population, a key indicator of a State's expenditure needs, was given substantial weight (80% to 90%) in income tax distribution. For Union excise duties, various indicators such as area, per capita income, and social and physical infrastructure needs were considered.
• Post the 10th Finance Commission, a unified distribution formula for both income tax and Union excise duties was adopted, emphasizing more than 75% weight on equity indicators.
• Since 2000, the distribution formula incorporated efficiency indicators, including tax effort and fiscal discipline, with a weight of approximately 15%. Tax effort is defined as the ratio of a State's own revenue to its Gross Domestic Product, while fiscal discipline considers the proportion of its own revenue to the State's revenue expenditure.
• In the 15th Finance Commission, tax effort and demographic performance (an efficiency indicator for population control) were part of the formula, with the majority (85%) weight distributed among equity indicators such as per capita income, population (2011 Census), area, and forest cover.

The Goods and Services Tax (GST), implemented in India in 2017, marked a significant transformation in the country's tax system. Replacing a complex web of cascading indirect taxes, GST unified various levies under a single, comprehensive framework. 

Key Features of GST

• Tax is levied on the consumption point, eliminating cascading effects and incentivizing inter-state trade.
• Consists of Central GST (CGST), State GST (SGST), and Integrated GST (IGST) for interstate transactions.
• 0%, 5%, 12%, and 18%, with certain goods and services attracting additional cess.
• Businesses can claim credit on taxes paid on inputs used to produce goods and services, reducing the final tax burden.
• GST registration, filing returns, and claiming refunds are facilitated through a single online platform, improving transparency and efficiency.

Benefits of GST

• GST has streamlined the tax system, reducing compliance costs for businesses and improving ease of doing business.
• Input tax credit mechanism lowers the final tax burden for manufacturers and traders, potentially leading to lower consumer prices.
• The online platform and stricter regulations encourage better tax compliance, boosting government revenue.
• GST promotes inter-state trade and reduces tax-induced distortions in the economy, potentially leading to higher growth.
• The online platform and standardized procedures bring greater transparency and accountability to tax administration.

Challenges and Concerns

• The transition to GST was not without hiccups, with businesses facing initial adjustment difficulties and technical glitches.
• Complying with GST requirements can be challenging for small businesses due to limited resources and digital literacy.
• Some essential items attract high tax rates, raising concerns about affordability and the potential impact on inflation.
• The multiple tax rates and exemptions can create complexities for businesses and may require regular updates and clarifications.
• Integrating the informal sector into the GST system remains a challenge, potentially impacting tax collection and economic inclusivity.

5. Incorporating Tax Contribution in the Distribution Formula

• The ongoing debate over the weightage of efficiency indicators in the Finance Commission's distribution formula, particularly tax effort and fiscal discipline, has raised concerns about their stability. This article argues for the inclusion of tax contribution, particularly under the Goods and Services Tax (GST), as a more stable and objective measure of efficiency.
• Tax effort and fiscal discipline face challenges due to discretionary tax policies and unexpected changes in tax bases, affecting their stability. The article suggests that a more stable indicator is needed to accurately measure a State's efficiency.
• GST, being a consumption-based destination tax equally divided between the State and Central governments, provides a stable measure of a State's tax contribution. The article emphasizes that estimating a State's GST contribution to the Union exchequer is feasible under GST, as the State GST accrual should match the Central GST accrual from that State.
• Petroleum consumption, outside the GST framework, is proposed as another indicator of tax contribution. The cascading tax burden on petroleum products, including Union excise duty and sales tax, falls on the consumers in a State. The article argues that relative shares of petroleum consumption are stable over time, making it a valuable efficiency indicator.
• Including both relative GST contribution and petroleum consumption in the distribution formula is compelling. These indicators not only reflect a State's contribution to the national exchequer but also indicate relative differences in incomes (personal and corporate) accrued to the residents of a State.
• The proposed efficiency indicators, GST revenue ratio (relative contribution to GST revenue) and petroleum consumption ratio (relative contribution to Union excise duties and customs duties on petroleum products) could be included in the distribution formula. The article suggests assigning a weightage of at least 33% to these ratios in the formula.
• The relative contribution of a State to GST revenue and petroleum consumption serves as a fair and accurate measure of a State's efficiency. The ratios also align with the share of CGST and Union excise duty in Central tax revenue, reinforcing their relevance.

6. Conclusion

The inclusion of tax contribution as a measure of efficiency in the Finance Commission's formula is a complex and nuanced issue with potential benefits and challenges. Carefully considering the proposed indicators, their impact on equity, and the overall effectiveness of the distribution system is crucial for ensuring fair and sustainable resource allocation across Indian states.