Relevance for UPSC: GS II (Centre–State Relations), GS III (Fiscal Federalism)
Source: Finance Commission data; national accounts and Goods and Services Tax statistics

Context

India’s framework of Centre–State fiscal transfers, designed by successive Finance Commissions under Article 280, seeks to balance redistribution for equity with recognition of economic contribution. Recent debates have intensified as economically advanced States question whether the current formula adequately reflects their role in generating national income.

The Central Issue

States such as Maharashtra, Tamil Nadu, Karnataka and Gujarat contribute significantly to national output but receive a relatively smaller share of devolved funds. Their grievance arises largely from reliance on tax collection data, which often does not correspond to the actual location of economic activity.

Conceptual Clarity: Tax Collection vs Tax Accrual

• Direct taxes are booked where firms are registered, not where production occurs.
• Goods and Services Tax, being destination-based, weakens production-based attribution.
• Inter-State supply chains, labour migration, digital services, and remote work further distort collection figures.

Gross State Domestic Product (GSDP) therefore provides a more accurate measure of economic contribution, capturing income generated within a State’s territory.

Why GSDP Performs Better

• Reflects the real size and structure of State economies.
• Minimises distortions arising from administrative or accounting practices.
• Supported by strong empirical evidence:
  • 0.91 correlation with Goods and Services Tax collections
  • 0.75 correlation with direct tax collections
  • 0.99 correlation with actual transfers under the Fifteenth Finance Commission

This indicates that GSDP naturally aligns contribution with devolution outcomes.

Inter-State Transfer Outcomes (2020–21 to 2024–25)

• Total transfers: ₹75.12 lakh crore
• Largest recipients: Uttar Pradesh, Bihar, West Bengal
• High-output but lower-transfer States: Maharashtra, Karnataka, Tamil Nadu
• Several States exhibit GSDP shares exceeding tax collection shares, implying value creation outside tax-booking locations.

Policy Implications

• A higher weight for GSDP can:
  • Improve perceived fairness in fiscal federalism
  • Strengthen trust between Centre and States
  • Reduce political friction in revenue-sharing debates
• However, exclusive reliance on GSDP could undermine redistributive justice, making continued support for less-developed States essential.

Conclusion

Using GSDP as a stronger criterion in Centre–State transfers offers a balanced, evidence-based approach—recognising States’ economic contribution while preserving redistribution. Such calibration is crucial for sustaining equity, efficiency, and cooperative federalism in India’s fiscal architecture.

Q. Consider the following statements:

1. Gross State Domestic Product is a better proxy for economic contribution than tax collection data.
2. Increasing the weight of GSDP in devolution would eliminate the need for redistribution.

Which of the statements given above is/are correct?
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Correct Answer: (a)