GSDP Share As A Criterion for Central–State Transfers

Rising disputes over the fairness of Centre–State transfers after GST and increased use of cesses and Centrally Sponsored Schemes have revived demands to give greater weight to GSDP in the Finance Commission’s devolution formula.

Mechanism of Fiscal Transfers in India

• Constitutional Basis: Article 280 mandates the President to constitute a Finance Commission every five years to recommend the distribution of financial resources between the Centre and the States.
• Tax Devolution Mechanism: The Centre shares a fixed percentage of its gross tax revenues with States, as recommended by the Finance Commission, through the divisible pool of taxes.
• Devolution Types: Vertical devolution is the split between the Centre and States (currently 41% to States), while horizontal devolution is the split among the various States.
• Status of Finance Commission Recommendations: The 15th Finance Commission’s recommendations are currently in force, under which States receive 41% of the divisible pool of taxes. 
  • The report of the 16th Finance Commission is yet to be tabled and implemented.
• Other Channels of Transfers: In addition to tax devolution, States receive funds through grants-in-aid and Centrally Sponsored Schemes, which are designed to support specific sectors and national priorities.

Key Concerns in Federal Transfers in India

• Erosion of Fiscal Autonomy after GST: Post-GST, States lost the power to levy several independent taxes, increasing their financial dependence on the Centre.
• Rising Use of Cesses and Surcharges: The Centre has increased reliance on cesses and surcharges, which are not shared with States, reducing effective tax devolution.
• Dominance of Centrally Sponsored Schemes (CSS): A large share of transfers is routed through conditional CSS, restricting States’ flexibility to spend according to local priorities.
  • Centrally Sponsored Schemes (CSS) are jointly funded programmes of the Union and State governments, targeting national priorities, with Union funding and guidance and State-level implementation flexibility.
• Equity Prioritised over Efficiency: Finance Commissions have given greater weight to population and equity, while performance and efficiency receive lower weight, which is seen as disadvantageous to better-performing States.

The Conflict- Collection vs Contribution

• Grievance of High-Revenue States: States such as Karnataka, Maharashtra, and Tamil Nadu argue that they contribute large amounts to central taxes but receive a disproportionately small share in transfers.
• Counter-Argument by the Centre and Poorer States: They argue that tax figures reflect the place of collection and not necessarily the place where income is actually generated.
• Ground Reality of Tax Payment: Individuals and companies often pay taxes in places other than where economic activity actually occurs, making it difficult to accurately measure each State’s true contribution.

The “Headquarters Effect” in Tax Collection

• PAN-Based Jurisdiction Is Misleading: Tax is often attributed to the location of a company’s registered or head office, not to the place where economic activity actually occurs.
  • Scenario 1- Automobile Industry:  Manufacturing takes place in Tamil Nadu using local land, labour, and environmental resources, but the company’s registered office is in Mumbai or Gurugram.
    • As a result, tax is recorded in Maharashtra or Haryana, not in Tamil Nadu.
  • Scenario 2 – Plantation Sector: Plantation companies earn profits from estates located in Kerala, but taxes may be paid at head offices in other metropolitan cities.
    • This shifts tax attribution away from the actual production location.
• Inference:  Direct tax data fails to accurately capture multi-State operations and inter-State economic activity, making State-wise “contribution” estimates unreliable.

Solution Ahead

• Meaning of GSDP: Gross State Domestic Product represents the size of economic activity and the underlying tax base within a State.
• Logic Behind Using GSDP: If tax administration efficiency is broadly similar across States, a State’s share in national GSDP is the best approximation of its actual contribution to central taxes.
• Reasons for GSDP Being a Better Indicator: It reflects where production and value creation actually occur.
  • It correlates strongly with GST collections, which are destination-based and relatively reliable.

Empirical Evidence Supporting GSDP as a Proxy (2023–24)

• Correlation with Direct Taxes: There is a strong positive correlation of 0.75 between a State’s GSDP and its direct tax collections.
• Correlation with GST Collections: There is a very strong correlation of 0.91 between a State’s GSDP and its GST collections.
• Implication for Federal Transfers: This strong relationship suggests that using GSDP shares corrects distortions caused by the “Headquarters Effect” and provides a fairer measure of where tax actually accrues.

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Disparity Between Tax Collection and Transfers (2020–21 to 2024–25)

• Mismatch: According to the Ministry of Finance’s data, there is a significant mismatch between States’ tax contribution shares and the transfers they receive, reflecting a strong redistributive bias in India’s federal fiscal system.

Correlation Analysis

• 15th Finance Commission Shares vs Actual Transfers: The correlation is 0.99, showing a perfect match and indicating that policy is being followed.
• 15th Finance Commission Shares vs Tax Collection: The correlation is 0.24, which is very weak and suggests that the current formula ignores contributions.
• GSDP Shares vs Tax Collection: The correlation is 0.81, which is high.
• GSDP Shares vs Devolution Shares: The correlation is 0.58, which is moderate.
  • GSDP strikes a balance, as it reflects efficiency (tax contribution) better than the current formula, while still allowing for some equity through redistribution.

Way Forward

• Assign Higher Weight to GSDP: The Finance Commission should assign a higher weight to GSDP share in the devolution formula so that transfers better reflect actual economic contribution while maintaining redistribution.
• Increase GSDP Weight: Assign higher importance to Gross State Domestic Product (GSDP) in the devolution formula to better reflect actual economic contribution of States.
• Balance Equity and Efficiency: Combine redistributive transfers with GSDP-based allocation to reward high-performing States while supporting weaker ones.
• Mitigate “Headquarters Effect”: Use GSDP to correct distortions caused by tax attribution to corporate headquarters instead of the location of production and value creation.
• Rationalise Transfers and Schemes: Reduce reliance on conditional Centrally Sponsored Schemes (CSS) and unshared cesses, giving States more spending flexibility aligned with local priorities.
• Data-Driven and Cooperative Approach: Base devolution on empirical correlations (GSDP, GST, direct taxes) and promote Centre–State consultation for transparent, credible, and adaptable fiscal transfers.

Conclusion

Using GSDP improves fairness and credibility in Centre–State fiscal relations by better capturing States’ real economic contribution.

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