Here is why the Centre should hand over a lower share of taxes to states

The Centre should share only 25 per cent of tax revenues with states, and the states should be allowed to impose their own income tax

A few days ago, the think tank PRS Legislative Research published detailed statistics about state finances. It’s not a comforting picture. The states have huge deficits in all the usual measures because they are spending far in excess of their incomes.

This is not a new development. Since independence, they have always been in a fiscal hole. This suggests that there is something structurally wrong with our financial arrangements. Otherwise, no problem can last this long.

The received wisdom is that the Centre is to blame for the poor condition of states’ finances. But that argument doesn’t wash because it hands over around 35 per cent of the tax revenues it collects. The states are supposed to collect the rest, but they don’t. They fall short by as much as 20 per cent.

It is true that according to the 14th Finance Commission, the Centre should hand over 42 per cent. It is also true that since the introduction of GST, the states have lost a lot of revenue. But the real problem isn’t with the Centre because even if it hands over 50 per cent, the states will still be short of funds.

And there are three reasons for this. First, all states now have more people who don’t pay any tax than those who do. So not only are there more people because of population growth, but also more poor people in absolute terms. All have the same needs for health, education, justice, policing etc., that only governments can provide at an affordable price or cost.

The second reason is electoral politics: around 70 per cent of the people in each state have the vote. And they all have their political preferences. These preferences can be over three or more parties. That makes political competition intense, which leads us to the third reason, political pusillanimity.

No political party dares to do anything to raise revenue beyond current levels. Indeed, as the movement towards the old pension scheme shows, many parties would like to spend more rather than tax more.

Even when the same party is in power at the Centre and a state, the state spends far more than it receives through taxes. Himachal Pradesh and Madhya Pradesh are excellent examples of this. The BJP ruled both till recently (Congress returned to power last week), and both are desperately broke.

That’s why I say that the fault lies in our overall structure of economic and political governance. Both need to be reformed, but the economic aspects need greater reforms at the state level because every political party has come to believe, against the evidence, that it can win an election via an excessive and exclusive focus on distribution instead of growth.

So what should be done? The answer is not rocket science. The states must be forced by an amendment to the Constitution that disciplines regional politicians by saying the states will receive only 25 per cent of all tax revenues from the Centre. Indeed, in real terms, that’s all they are getting anyway. They must raise the remaining 75 per cent themselves. This provision will be for ten years, after which it will be renewed if half the states haven’t made the cut.

In return, the Centre should give up its monopoly on income tax and let the states impose their income tax. The maximum rate for the Centre should be 25 per cent — the traditional Chauth — and for the states, 10 per cent. This will force them to tax agriculture, which is on the state list.

A reduction in devolution will also force them to collect other taxes like municipal taxes and reduce subsidies to power and water. These should not be eliminated, but they must not be open-ended either. It will also force the states to sell land, which traditionally is a huge source of revenue.