The time has come for a states income tax

India’s public finances have always been in very dire straits. Basically, neither the central government nor the states ever have enough money to do what they need to do.

The pandemic has made the situation very much worse. Incomes of both labour and companies have plummeted and, a few months down the line, so will tax revenues. 

Overall, the aggregate demand curve has shifted downwards for the rest of this decade. 

Fiscally, therefore, we are back to where we were at the beginning of the 1970s because after two and half wars in 1962 and 1965, and two back-to-back droughts in 1965 and 1966, the economy had been completely devastated. So now, as then, borrowings will have to increase. And they will continue to increase throughout his decade.

The question therefore arises: how will the debt be repaid?

Debt repayment is easy for the Centre. As a final recourse it can always borrow more to pay its own debt after all other avenues of raising revenue like higher taxation--a favourite method in the 1970s--have been exhausted.

Sinking funds

It is in this context of debt repayment that the latest RBI Bulletin has suggested some important modifications to the states’ sinking funds. These were created by NDA 1 in 1991 to help states pay their debts.

The idea was the same as a piggy bank: put little coins in it at regular intervals. Painless and useful.

Well, now a huge fiscal problem is here. But, as the RBI has pointed out, there is a problem.

Given how poor the states’ revenue are, no state contributes the minimum needed and many don’t contribute at all. The RBI thinks the fund should have 5 percent of outstanding liabilities. The funds are nowhere near that level.

The RBI has also suggested a fund for redeeming guarantees and suggested some tweaks to the sinking funds which ought to help the states do better in this regard as well.

But the main problem remains: they simply don’t have any money to spare to put into a piggy bank. It’s exactly why the poor don't save: they can’t save. Hence, my suggestion below is to augment states’ revenue, not deplete them which is what a sinking fund does.

It sounds impossible to implement. But we can at least discuss it.

A states’ income tax

Here’s a question I have been asking for 25 years. Why is income tax not in the concurrent list of the Constitution when so many other lesser things are in it? 

After all, what better way is there to empower states than for them to have their own income tax and have a greater degree of financial independence?

I would suggest that the states income tax should not exceed 10 percent and the central income tax should not exceed 30 percent. All told, no more than 40 per cent of a citizen’s income should be taxed away directly.

To start with, the state income tax could be optional. All would continue to get all other money from the Centre.Thus, after the states decide how much they need and how much they can raise via the current system, they can impose an income tax, say, along the lines of the professional tax that some states collect. 

The lowest hanging fruit is a tax on agricultural incomes of persons who are not farmers.

It is inevitable that a states income tax will come eventually. The only is how soon. That’s why a debate is needed now so that it can become a reality soon after the 2024 general election.

Objections

There are, however, two major objections to a states’ income tax. One relates to the income-wise weaker states and the other to administrative capacity. 

The answer to the weaker states issue is that central responsibility towards them will continue. Some criteria can be worked out to define ‘weak’. Is Kerala weak?

The administrative capacity argument is about the ability of states—weak and strong—to collect tax. But this is a non-starter. The capacity exists. They used to collect sales and excise taxes.