The Debate Over Fiscal Transfers in India

Context

Sam Pitroda’s discussion on inheritance tax in India sparks debate on fair wealth distribution and public welfare resources.

Fiscal Transfers in India

• Growing Resentment: There is rising resentment among southern states about fiscal transfers to poorer northern states.
• South Tax Movement: Argues southern states are penalized for better economic performance.
  • For example, Karnataka gets only 15 paisa per rupee of tax paid, Tamil Nadu gets 29 paisa, while UP gets Rs 2.73 and Bihar Rs 7.06.
• Major Concern: This is not just a North-South issue, but a rich vs poor state issue, with states like Gujarat and Maharashtra also being net contributors.

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Comparison to the European Union (EU)

• EU Tensions: Similar tensions exist in the EU between richer northern states and poorer southern/eastern members. 
  • Richer countries like Germany, Netherlands, Sweden feel they they overcontribute compared to Greece, Portugal, Spain, Eastern Europe. 
  • High fiscal contributions contributions by the UK possibly contributed to Brexit decision.
• Beyond Fiscal Transfers: However, fiscal transfers alone do not capture full costs and benefits of economic union. 
• Non-Fiscal Benefits for Richer EU States: Richer countries subsidize poorer ones through through transfers, but also gain from expanded market and currency undervaluation.
  • Expanded Markets: More industrialized countries get a large captive market to sell their products.
  • Currency Advantage: Countries using the euro get competitive advantage as their labor becomes relatively cheaper.
  • Examples: Germany’s growth 0.5% higher per year due to euro. Similar benefits for Austria, Netherlands, Denmark.

Parallel Benefits for Richer Indian States

• Higher Productivity: Richer states (Gujarat,Maharashtra, Punjab, Haryana, Haryana, Delhi, Southern states) have 3-4 times higher labor labor productivity than poorer poorer ones (Bihar, UP, Jharkhand, Rajasthan, MP). 
  • This attracts more investment and faster growth, making convergence difficult.
• Captive Market: Businesses in richer states get a large captive internal market, enhanced by GST introduction.
  • Example: Companies from Coimbatore, Bangalore, Chennai can sell across India due to higher productivity.
• Benefits of Internal Migration:
  • EU Benefits: Free internal migration estimated to increase EU income by €100-230 billion over 10 years.
  • Indian Benefits: In India, labor migration from poorer to richer states benefits both. Migrants fill jobs locals won’t do anymore, allowing locals to move to higher-skilled, better-paid work.
• Restrictions Reduce Welfare: Restricting jobs to locals, as proposed by some states, reduces overall welfare.

Non-Economic Factors and Representation

• Beyond Economics: Economics alone does not drive tensions within a union (e.g. non-economic factors in Brexit).
• Representation Gap: India has not adjusted state-wise allocation of parliamentary seats since 1991 census. After 2026, disparity between actual and population-based seats will be huge due to faster northern population growth.
• Seat Shifts: Bihar, UP, MP, Jharkhand, Rajasthan would gain gain 30+ seats, while southern states, Odisha, West Bengal lose.
• Possible Solutions: Increase total seats, divide larger states, give smaller states more Rajya Sabha seats.

Way Forward

• Recognize Benefits Benefits: Richer states must recognize non-fiscal benefits of Indian union, even as they subsidize poorer states.
• Widening Gap: Real issue is the widening gap between richer and poorer states despite fiscal transfers.
• Improve Key Areas: Improving education, health, infrastructure is is key to attracting investment to poorer states.
• Targeted Transfers: 16th Finance Commission must ensure transfers are directed at addressing these gaps.

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Conclusion

Addressing fiscal disparities in India requires recognizing non-economic factors, improving representation, and targeted investments to bridge the gap between richer and poorer states effectively.