Going truly federal: Why states should be allowed to levy an income tax

The finance minister met state finance ministers recently for a pre-Budget meeting. As expected, they told her they wanted more money. How much more they eventually get depends on their negotiating skills and the Centre's bloody-mindedness. Time will tell.

More importantly, this tussle with the Centre for money is several decades old, underscoring a huge problem with our federal arrangements. On the one hand, is the political reluctance of the states to tax their residents more to raise revenue. On the other, the constitutional scheme of things gives the Centre overwhelming power on financial matters and limits the revenue instruments at the states' disposal.

The resulting problems have been debated for the last 50 years without any meaningful change in the status quo. India is stuck in a time warp created by what is essentially an imperial constitution and a highly contestable political structure.

This intensity of political competition affects everything. And the greater it is, the higher the incentive to the Centre to hang on to the imperial scheme of an overweening central power — and the more it does, the more contested the politics becomes. It's a vicious cycle that no one wants to break.

To add to this, there's a paradox too: while everyone wants a stable central government, which enjoys a simple majority in the Lok Sabha, even if it is just of one seat, that very majority makes the Centre more imperial. In other words, a central government with a majority in the lower house vitiates against the spirit of federalism.

This doesn't happen in any other federation. Their constitutional scheme facilitates genuine federalism. Ours, in contrast, is a pretence. Or, as the Supreme Court said back in 1962, we have a unitary constitution with federal features.

However, it's not as if the unitary aspects have not been diluted. They have, over the years. But that dilution has happened largely in the political sphere. In the economic sphere, things are mostly as they were, as the existence of the Finance Commissions shows. It decides how much money each state gets from the taxes collected by the Centre, as also grants. Examine the last four finance commissions' performance, and you will see the sheer pointlessness of it.

I think the time has come for a GST-like transformation of personal income tax. We need to ask why, in India, income tax is levied only by the Centre while in many other federations, the constituent units also levy it. Should not income tax be in the Concurrent List of the Constitution when so many other lesser things are in it?

To begin with, a state income tax could be optional. It would be interesting to see how many states opt for it. Will Tamil Nadu, which keeps whining, do it? Will West Bengal? Or anyone else?

The states can decide how much extra revenue they need and how much they can raise. Once allowed, we will quite quickly see agricultural incomes being taxed.

I see one major objection: can the economically weaker states cope? Will they be able to collect any significant amount as income tax?

There's also the matter of tax rates. A fundamental question that needs to be walked now is, if indirect tax rates can be fixed, why not direct tax rates?

My solution is as follows. The states should have an income maximum tax rate of 10 per cent and the Centre of 30 per cent maximum. No surcharges. No cesses. The Centre should ask the states if they want this. If they say no, they should be resigned to their fates.