Revisiting India’s resource allocation model

Horizontal imbalances in resource distribution among Indian states, deeply embedded in the devolution formula, significantly impact the share of each state in the central tax pool.

The 16th Finance Commission faces the critical task of addressing the persistent issue of horizontal imbalances in resource distribution among Indian states. These imbalances, deeply embedded in the devolution formula, significantly impact the share of each state in the central tax pool. It is important to study the two fundamental criteria employed by the Finance Commission – population and income distance – and their consequential effects on states’ shares.

Population is a foundational factor in the Finance Commission’s resource allocation framework. It ensures that states receive resources proportional to their population size and needs, but it also serves as a major determinant of each state’s share of the divisible pool of central taxes. The effect of population on resource distribution is twofold. On one hand, states with slower-growing populations see a reduction in their percentage share. As India’s population has shifted over the decades, particularly in the southern states, those with better-controlled population growth are now receiving a smaller share relative to others. On the other hand, population acts as a scaling factor for most other criteria used by the Finance Commission. In fact, about 75% of the transfers either directly or indirectly are influenced by population size. This makes the criterion a key player in shaping resource distribution.

The 15th Finance Commission introduced a notable shift by transitioning from the 1971 census to the 2011 census for determining states’ fiscal allocations. This was aimed at better reflecting current demographic realities. However, this change has been met with criticism, particularly from states that have successfully managed population growth. To mitigate the backlash, the Finance Commission introduced a new criterion called “demographic performance,” with a weight of 12.5%. This criterion seeks to reward states for their efforts in controlling population growth by measuring their Total Fertility Rate (TFR). States with lower TFRs, indicating better population control, receive a higher score. However, the formula, paradoxically, continues to favour more populous states, raising questions about its effectiveness in truly reflecting states’ long-term demographic achievements.

A major concern is that states that controlled their population earlier – some as far back as the 1970s – might not receive the same level of recognition under this criterion, as the formula relies heavily on contemporary metrics. States that have successfully controlled population growth through significant investments in human development may feel disadvantaged despite their early achievements.

While the introduction of the demographic performance criterion is a step in the right direction, its weightage is insufficient to offset the overwhelming influence of population in determining states’ shares. Given that 75% of transfers are determined by population, performance-based incentives must be expanded to ensure that states with slower population growth and better human capital development are not unfairly disadvantaged.

One potential improvement could involve incorporating other criteria that reflect states’ fiscal needs beyond population size. For instance, factoring in the share of elderly populations could better capture the reduction in fertility and higher life expectancy. Or using the Human Development Index (HDI) could reflect the unique challenges faced by states with ageing populations and higher demands for education or healthcare. These measures would address second-generation problems emerging from demographic shifts, such as the need for increased social spending in states with older populations.

If the Finance Commission’s formula is to continue rewarding population control, it must evolve to encompass broader human capital outcomes. By balancing historical achievements in population control with contemporary needs, the formula would align more closely with the principles of fiscal federalism, ensuring a fairer distribution of resources.

Income distance: A contested criterion

Income distance currently holds a 45% weight in the horizontal devolution formula. This criterion measures the gap between a state’s per capita income and the state with the highest per capita income. While it is intended to promote equity by allocating more resources to lower-income states, its reliance on per capita measures often fails to capture the diverse fiscal realities across Indian states.

Higher-income states have consistently advocated for reducing the weight of the income distance criterion, while lower-income states argue for its increase. The issue lies in the formula’s narrow focus on per capita income which does not account for income inequality within states. For instance, a state with significant income inequality may have a large portion of its population earning low incomes, which limits its tax base even though its overall per capita income appears high. Consequently, this state’s ability to generate revenue is overstated, leading to an inadequate share of tax transfers.

Furthermore, structural factors such as urbanisation and industrialisation heavily influence a state’s tax capacity. More industrialised and urbanised states typically have higher taxable economic activities, while states with larger informal sectors may struggle to generate tax revenue despite similar per capita income levels.

To address these shortcomings, a more refined approach to income distance is required. Incorporating additional factors such as cost-of-living adjustments and structural economic conditions could lead to a more accurate assessment of states’ fiscal capacities. By acknowledging the varied challenges faced by states in generating revenue, the Finance Commission can foster a more balanced and equitable distribution of resources. Moreover, adjustments should be made to prevent states with slower population growth or higher human capital investments from experiencing share shocks.

The 16th Finance Commission has the opportunity to address the complex interplay of demographic changes and fiscal capacity in determining states’ shares. By revisiting the population and income distance criteria, and incorporating performance-based incentives alongside structural adjustments, the Commission can pave the way for a more equitable and sustainable model of fiscal federalism.

This evolution in the devolution formula would ensure that states are not unfairly penalised for their demographic success while fostering a more accurate reflection of fiscal realities. Aligning the formula with the diverse needs of Indian states will promote balanced development, allowing for a fairer allocation of resources that serves both historical and contemporary demands.

(The writer is an assistant professor at Gulati Institute of Finance and Taxation)

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.