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Vertical Sharing and Horizontal Distribution of Resources: The Equity and Efficiency Trade-off

Examining the key recommendations of the Thirteenth Finance Commission that have a bearing on vertical and horizontal transfers aimed at correcting imbalances in the system, this paper takes a critical look at these two aspects as well as the grants given to states. It also reviews the overall design of transfers by decomposing these to identify their vertical and equalising content, pointing to problems that could arise in the long run. Yet it concedes that despite several drawbacks, the commission has arrived at a mechanism for transfers that includes some desirable features.


Vertical Sharing and Horizontal Distribution of Resources: The Equity and Efficiency Trade-off

D K Srivastava

Examining the key recommendations of the Thirteenth Finance Commission that have a bearing on vertical and horizontal transfers aimed at correcting imbalances in the system, this paper takes a critical look at these two aspects as well as the grants given to states. It also reviews the overall design of transfers by decomposing these to identify their vertical and equalising content, pointing to problems that could arise in the long run. Yet it concedes that despite several drawbacks, the commission has arrived at a mechanism for transfers that includes some desirable features.

D K Srivastava ( is at the Madras School of Economics, Chennai.

he Thirteenth Finance Commission (THFC) deliberated on its terms of reference against the background of the recent global recession, which had adversely affected the base year figures of central and state finances for 2008-09 and 2009-10 that were to be used for assessments during the recommendation period running from 2010-11 to 2014-15. This made the task of the THFC doubly difficult, particularly because union finance commissions (UFCs) in any case face considerable time constraints as their tenure is fixed in their terms of reference. Being a body without a permanent secretariat and not much of an institutional memory, considerable time is taken up for its initial establishment before core tasks are taken up. That the THFC was able to complete its work in time even while the terms of reference called for extended tasks, including a revised fiscal road map in the context of macroeconomic stability and equitable growth, is well worth appreciating.

The core tasks of UFCs relate to their recommendations on vertical and horizontal transfers aimed at correcting the vertical and horizontal imbalances in the system. This paper examines the key recommendations of the THFC having a bearing on these two aspects of transfers, placing them in a long-term perspective. The study falls into five sections. Section 1 looks at the recommendations of the THFC on the vertical sharing of resources, and Section 2 examines the recommendations having an impact on the horizontal distribution of resources. Section 3 looks at grants, while Section 4 reviews the overall design of transfers by decomposing these to identify their vertical and equalising content. Section 5 comprises concluding observations, including suggestions for the improvement of the transfer mechanism in the longer term.

1 Vertical Sharing of Central Taxes

With regard to vertical sharing of resources, there are two reference points from which the scheme can be examined. The first is with reference to the constitutional assignment of responsibilities. The second is with reference to the historical long-term trend of stability in the shares of the centre and the states in combined revenue receipts. As for the first point of reference, it is clear that the central government not only dominates some of the heads on the concurrent list but also spends excessively on heads that are on the state list under Schedule 7 of the Constitution. The UFCs do not want to substantially change this pattern as it has emerged over a long period of dispensation of responsibilities. Any change that they recommend is at best incremental. I nstead they try to maintain the observed stability in the shares

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of the centre and the states in combined revenue receipts. The THFC has also explicitly done this.

The literature on vertical sharing of resources has taken note of the long-term stability observed in the relative shares of the centre and the states in combined revenue receipts and in combined revenue expenditure (see, for instance, Rangarajan and Srivastava 2008). The THFC took note of this, considering it to be a desirable feature of transfer arrangements. It observed, “We are of the view that such fiscal stability be maintained during our award period”. As shown in Rangarajan and Srivastava (2008), an increase in the states’ share in shareable central taxes is needed in periods when the centre’s tax buoyancy is expected to be higher that that of the states. In particular, the three determinants for maintaining the observed fiscal stability are the buoyancies of central and state taxes and the initial share of states’ own revenues in total revenues.

The THFC observes that the buoyancy of central taxes has been higher than that of state taxes, thereby highlighting the need for increasing, albeit by a small margin, the share of states in central tax revenues. It accordingly recommends that the share of states in the net proceeds of shareable central taxes be raised from 30.5% to 32%. One important change since the Twelfth Finance Commission (TWFC) is that the goods under the Additional Duties of Excise (Goods of Special Importance) Act, 1957 have been exempted from the payment of duty under the Act from 1 March 2006. The three goods covered under the tax rental agreement – textiles, tobacco and sugar – continue to remain in the list of declared goods under the Central Sales Tax Act, 1956 and will remain subject to prescribed ceiling rates in case states decide to levy value added tax (VAT) on these commodities. Accordingly, the applicable share of states under the TWFC recommendations had been 30.5% of the sharable pool of central taxes. The THFC has increased this to 32%. No portion of this need be earmarked as attributable to additional duties of excise in lieu of sales tax.

As Table 1 shows, the product of the growth rate and central tax buoyancy over combined tax buoyancy, taking the average for 2004-05 to 2008-09, is 1.8 percentage points. As such the THFC was amply justified in raising the share of states by 1.5 percentage points. Since the observed stability refers to total revenue receipts, raising the benchmark share of the states in the

Table 1: Tax Buoyancies and GDP Growth Rate – Recent Years

Year Buoyancies of Growth Rate b(cgtr) [b(cgtr)-
Combined Centre’s Gross States’ Own of GDPmp b(comb) b(comb)]
Tax Revenue Tax Revenue Tax Revenue *g(GDPmp)
b(comb) b(cgtr) b(sotr)
2000-01 1.454 1.274 1.754 0.077 0.077 -0.014
2001-02 0.359 -0.097 1.097 0.084 0.084 -0.038
2002-03 1.722 2.001 1.313 0.077 0.077 0.021
2003-04 1.327 1.457 1.128 0.122 0.122 0.016
2004-05 1.353 1.388 1.296 0.143 0.143 0.005
2005-06 1.359 1.445 1.221 0.139 0.139 0.012
2006-07 1.677 1.939 1.243 0.151 0.151 0.040
2007-08 1.458 1.642 1.127 0.144 0.144 0.026
2008-09 1.308 1.380 1.172 0.127 0.127 0.009
(2004-05 to
2008-09) 1.431 1.559 1.212 0.141 0.141 0.018

Source (basic data): Indian Public Finance Statistics and National Income Accounts.

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c entre’s gross revenue receipts also seems justified. The only point to remember is that these historical benchmark figures are supposed to serve as a guide to the award period of the THFC, 2010-11 to 2014-15.

Although the states have been requesting that central cesses and surcharges be included in the divisible pool, the THFC does not recommend this. However, it does recommend that the centre review the current surcharges and cesses with a view to reducing their share in gross tax revenues. The share of states in combined revenue receipts does not depend only on UFC transfers but also on other channels of transfer. The Eleventh Finance Commission (EFC) for the first time recommended an indicative benchmark for all revenue account transfers, at 37.5% of the centre’s gross revenue receipts. This was progressively raised by the TWFC to 38% and to 39.5% by the THFC. Thus the THFC has increased both the states’ share of the shareable pool of central taxes and the i ndicative benchmark for all central transfers from the centre’s gross revenue receipts by 1.5 percentage points.

The vertical share also has a bearing on the horizontal distribution of resources. The higher the vertical share of the states, the lower the weight to the equalising component of tax revenue sharing, as with the distance formula for horizontal distribution.

2 Horizontal Distribution of Resources

The twin objectives that need to be served in the horizontal distribution of resources are equity and efficiency. There is a tradeoff between the two, but if the distribution of resources is “equalising”, it is supposed to serve both objectives. Equalisation transfers serve equity since they make up for the deficiency in fiscal capacity but not in tax effort. They also serve efficiency as people do not cause congestion in a limited number of locations in search for better public and merit services such as health and e ducation since service standards are equalised across states subject to the condition that citizens are entitled to similar levels of services if they are willing to pay the same level of taxes per unit of their respective tax bases or fiscal capacities. Migration is then driven by the search for better income-earning opportunities, which also promotes efficiency.

Criteria for Sharing Central Taxes

Table 2 summarises the criteria for determining the inter se shares of states in tax devolution, along with the weights assigned to them. As shown in Rangarajan and Srivastava (2008) and earlier in Srivastava and Aggarwal (1994), these criteria serve different objectives and there is an implicit axiomatic basis for the use and weighted combinations

Table 2: Criteria and Weights for Tax

of these criteria. A good de-

Devolution (percentages)

sign for transfers adminis-Criteria EFC TWFC THFC tered through tax revenue Population 10.0 25.0 25.0

sharing can be consistent Area 7.5 10.0 10.0

with the “equalisation” prin-Distance/capacity distance 62.5 50.0 47.5

ciple, which has guided

Fiscal discipline 7.5 7.5 17.5

transfers in some well-estab-

Tax effort 5.0 7.5

lished fiscal transfer systems

Index of infrastructure 7.5

such as those in Canada and

100.0 100.0 100.0 Australia (see Garnaut and Source: Reports of UFCs, various years.



FitzGerald 2002; Rangarajan and Srivastava 2004a, 2004b). Among others, Barro (2001), Boadway and Flatters (1982), and Courchene (1984) examine different aspects of the equalisation approach and the possibility of using a macro indicator of fiscal capacity.

In criteria-based sharing, the population criterion serves as an instrument of vertical transfers and the distance criterion as a tool of equalising transfers. The criteria of area and index of i nfrastructure have been used to partially cover cost disabilities, and those of fiscal discipline and tax effort as incentives. Table 2 shows that in the approach of recent UFCs the number of criteria has come down and the weight attached to the distance criterion has declined. Compared to the TWFC scheme of criteria and weights, the THFC has dropped the tax effort criterion and increased the weight of the fiscal discipline criterion while marginally reducing the weight of the distance criterion. Table 3 gives the share of each state in the shareable pool of all central taxes proposed by the THFC (except the service tax for which a separate set of shares apply).1 A comparison is made with the corresponding shares recommended by the TWFC.

Table 3: Inter se Shares of States: Shareable Central Taxes (Other than Service Tax)

Share Share Difference Share Share Difference
(%) (%) (% Points) (%) (%) (% Points)
Andhra Pradesh 6.937 7.356 -0.419
Arunachal Pradesh 0.328 0.288 0.040 Manipur 0.451 0.362 0.089
Assam 3.628 3.235 0.393 Meghalaya 0.408 0.371 0.037
Bihar 10.917 11.028 -0.111 Mizoram 0.269 0.239 0.030
Chhattisgarh 2.470 2.654 -0.184 Nagaland 0.314 0.263 0.051
Goa 0.266 0.259 0.007 Orissa 4.779 5.161 -0.382
Gujarat 3.041 3.569 -0.528 Punjab 1.389 1.299 0.090
Haryana 1.048 1.075 -0.027 Rajasthan 5.853 5.609 0.244
Himachal Pradesh 0.781 0.522 0.259 Sikkim 0.239 0.227 0.012
Jammu and Kashmir 1.551 1.297 0.254 Tamil Nadu 4.969 5.305 -0.336
Jharkhand 2.802 3.361 -0.559 Tripura 0.511 0.428 0.083
Karnataka 4.328 4.459 -0.131 Uttar Pradesh 19.677 19.264 0.413
Kerala 2.341 2.665 -0.324 Uttarakhand 1.120 0.939 0.181
Madhya Pradesh 7.120 6.711 0.409 West Bengal 7.264 7.057 0.207
Maharashtra 5.199 4.997 0.202 All States 100.000 100.00 0.000

It can be noted that the main gainers as a group are the special category states since all of them show a rise in share. In contrast, Andhra Pradesh, Kerala, West Bengal, Goa, Punjab, Madhya Pradesh and Uttar Pradesh are losers.

The two main changes brought about by the THFC relative to the TWFC pertain to modification of the distance formula, the new formula being referred to as the “capacity distance” formula, and the elimination of tax effort as a criterion with its weight added to the criterion of fiscal discipline. Since this is supposed to be a modification of the distance criterion used by the earlier UFCs, it is useful to explore its implication further. For this purpose, we use the following notations.

Let subscript i denote a state. The total number of states be n divided into two groups: general category states (i = 1 to m) and special category states (i = m + 1 to n);

= per capita gross state domestic product (GSDP) of state yi;


y* = per capita benchmark income (the per capita GSDP of H aryana); and

= population of the ith state (¦Ni is the total population of

Ni all states). Let the total population of the general category states be denoted by Ng and that of the special category states be denoted as

N. Then N+ N= ¦Ni.

sg s Let a = average tax-GSDP ratio of all states; ag= average tax GSDP ratio of the general category states; and a= average tax


GSDP ratio of the special category states.

Let μ be the mean per capita income of all states (μ = ¦Niyi)/ ¦Ni), μg be the mean per capita income of general category states (μ= ¦Niyi/¦Ni where (i = 1 to m), μs be the mean per capita

g i ncome of the special category states (μ= ¦Niyi/¦Ni where


i = (m + 1 to n). The average tax effort of all states is related to the average tax efforts of the two groups by the following relation (see endnote 2) a.μ (N+ N) = a. μ. N + a. μ. N …(1)

g sgggsss

We now consider the difference between the “capacity distance” formula, subsequently referred to as the THFC distance formula, and the earlier distance formula. The share of the ith state in the shareable pool of central taxes under the capacity distance formula is given by

= Ni.[ay* - a]/A (i = 1 to m)

sigyiand si = Ni.[ay* - ayi ]/A (i = m + 1 to n) for special


category states where A = ¦Ni.[ay* - ayi] (i = 1 to m) + ¦Ni.[ay* - ayi]


(i = m+1 to n) …(2) For any given distribution of per capita GSDP and population, A is fixed. The share of the general category states can also be written as = Ni [ay*- ay i + ayi - ayi]/A or

s ig si = [Ni.a(y*- yi) - (a- a)Niyi]/A


The share of the special category states can be written as = Ni.[ay* - ayi + ayi - ayi]/A or

si s = [Ni.a(y*- yi) + (a - a)Niyi]/A

si sIn the earlier distance formula, the share of both sets would have been equal to Ai = [Ni.a(y* - y i)]/A’, where A’ = ¦ [Ni.a(y* - yi)] It can be shown that the denominators of the THFC distance formula (A) and the earlier distance formula (A’) are equal. For this to be true, we need the following condition to be satisfied. ¦Ni.[ay*- ayi] (i:1 to n) = ¦N i.[ay* - ayi] (i: 1 to m) + ¦Ni .


[ay*-a] (i: m + 1 to n)

sy ior ¦Ni.[ay*- ayi] = ¦Ni.[ay*- ayi + (a - a)yi] (i = 1 to m) + ¦Ni.


[ay*-ayi + (a - a)yi] (i = m + 1 to n)


or ay*¦Ni - a¦Niyi] (i:1 to n) = ay*¦Ni (i = 1 to n) -a


(i: 1 to m) -a¦yiNi (i: m + 1 to n)


Since the first terms on the two sides are equal, A = A’ if a¦Ni.yi] (i: 1 to n) = a¦ yi(i: 1 to m) - a(i: m + 1 to n)

gNi s¦y iNi or a.μ (Ng + N) = a. μ. N + a. μ. N


Which is true from (1). Hence A = A’.

We can then write that compared to the earlier income d istance formula. In the THFC distance formula the loss to each general category state is

Li = [(a- a)Niyi]/A (i =1 to m)


Correspondingly, the gain to each member of the special category group is

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Gi = [(a - a)Niyi]/A (i = m + 1 to n)


The loss to the general category states as a group is

Lg = ¦[(a- a)Niyi]/A = (a- a) μ. N /A

g g gg

The gain to special category states as a group is

G= ¦[(a - a)Niyi]/A = (a-a)μ. N/A

s ssss

It can also be shown that the loss and gain amounts to the two groups of states are equal (see endnote 3).

The THFC distance formula, therefore, amounts to a redistribution from the general category states, who are penalised for their higher than average tax effort, to the special category states, who get a premium for their lower than average tax effort. If the THFC had continued with the earlier distance formula, the special c ategory states would have had a larger revenue gap, and would have got an equivalent amount from the central government as a revenue gap grant. The general category states lose and the gain is for the central government as the special category states would have got almost an equivalent amount through grants. In other words, the loss to the general category states is genuine but the gain to the special category states is not genuine because had their share in central tax revenue not been higher, they would have got an equal or near equal amount in revenue gap grants as it is only residually determined. Nine of the 11 special category states get revenue gap grants, but no general category state gets a revenue gap grant.

The general category states are penalised for showing higher tax effort relative to the special category states at a time when the THFC has dropped the tax effort criterion in the overall f ormula even though one of the terms of reference says that in making its recommendations it shall take into account “the taxation efforts of the central government and each state government and the potential for additional resource mobilisation to improve the tax-Gross Domestic Product ratio in the case of the Union and tax-Gross State Domestic Product ratio in the case of the States”. It is also clear that there is nothing to justify the name “capacity distance”. The difference in the THFC distance formula and the earlier formula is caused by the difference in the “tax e ffort” of the two groups of states and not by the way fiscal capacity is measured, which continues to be proxied for both sets of governments by the per capita GSDP. Measurement of fiscal capacity continues to suffer from the problems earlier enunciated in Rangarajan and Srivastava (2008). Aubut and Vaillancourt (2001) discuss various shortcomings of using GDP as an indicator of fiscal capacity and suggest a list of relevant corrections.

The proposed change in the distance formula causes a deviation from the equalisation principle, which holds that all states that show an average tax effort are entitled to the same levels of services. But here the special category states are being rewarded for lower than average tax effort at the cost of general category states. The modification that is needed in the distance formula is a better measure of fiscal capacity instead of the per capita GSDP and adjustment in tax effort.

3 Design of Grants

In this section, we look at the scheme of grants proposed by the THFC. Although the Constitution envisages that the amounts of grants be specified in absolute amounts, year-wise and state-wise,

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this could not be done for two forward-looking incentive grants – one related to the goods and services tax (GST) and the other for measures aimed at improving outcomes. The total amount involved in these two grants is Rs 60,000 crore. This may be justified in a dynamic context like India’s. Apart from revenue gap grants, the THFC has recommended several new grants such as those related to performance, improvement of outcomes, and promotion of environment-friendly measures. Some of the earlier grants have been continued, notably those for health. For some, such as education grants, the formulation has been changed. T able 4 shows the grants-in-aid to the revenues of states recommended by the THFC for the period 2011-15.

Table 4: Grants-in-Aid to States (Rs crore)

I Local bodies 87,519
II Disaster relief (including capacity building) 26,373
III Post-devolution non-plan revenue deficit 51,800
IV Performance incentive 1,500
V Elementary education 24,068
VI Environment 15,000
(a) Protection of forests 5,000
(b) Renewable energy 5,000
(c) Water sector management 5,000
VII Improving outcomes 14,446
(a) Reduction in infant mortality rates 5,000
(b) Improvement in supply of justice 5,000
(c) Incentive for issuing Unique Identity numbers (UIDs) 2,989
(d) District innovation fund 616
(e) Improvement of statistical systems at the state and district levels 616
(f) Employee and pension data base 225
VIII Maintenance of roads and bridges 19,930
IX State-specific 27,945
X Implementation of model GST 50,000
Total 318,581

Source: Finance Commission (2009), Report of the THFC (2010-2015), Vol 1, December.

Deficit Grant

It is the determination of revenue deficit grants that has been subjected to criticism in the literature, mainly for following a “gap-filling” approach that leads to adverse incentives. The THFC has followed an assessment procedure with normative elements that has resulted in only eight of the special category states meriting nonplan revenue gap grants (Table 5). The general category states and the other special category states – Assam, Sikkim and Uttarakhand – are a ssessed out of revenue gap grants. This is a result both of the higher tax devolution amount and the assessment norms on own tax and non-tax sources as well as permitted e xpenditures. The adverse

Table 5: Non-Plan Revenue Deficit Grant (Rs crore)

State 2010-11 2011-12 2012-13 2013-14 2014-15 Total
Arunachal Pradesh 534 478 623 517 364 2,516
Himachal Pradesh 2,232 2,055 1,883 1,313 406 7,889
Jammu and Kashmir 3,940 3,665 3,355 2,881 2,096 15,936
Manipur 1,186 1,105 1,379 1,272 1,114 6,057
Meghalaya 393 319 819 709 571 2,811
Mizoram 715 684 908 882 804 3,991
Nagaland 1,599 1,568 1,719 1,666 1,595 8,146
Tripura 1,054 934 1,030 835 600 4,453
Total 11,653 10,808 11,716 10,074 7,550 51,800
Total may not tally due to rounding off.
Source: Finance Commission (2009), THFC Report (2010-2015), Vol 1, December.


i ncentives of gap filling are therefore limited only to a few special category states and the effective d eterminant of transfer to the general category states is the scheme of sharing central tax revenues.

Education Grants

Education grants were introduced by the TWFC. The THFC has continued these but adopted the Sarva Shiksha Abhiyan (SSA) norms for determining the amounts for individual states. The SSA began in 2001-02 with a matching fund requirement of 15% from the states. Until 2006-07, the matching fund requirement was 25%. It increased progressively to 35% in 2007-08 and 2008-09 and to 40% in 2009-10. It is expected to go up to 45% in 2010-11 and 50% in 2011-12, the terminal year of the Eleventh Five-Year Plan. The THFC argues that this will provide some fiscal space for the states to meet a part of the additional resources required to implement the Right to Education Act, 2009. It has recommended a grant of 15% of the estimated SSA expenditure of each state for the award period. The north- eastern states are required to provide only 10% from their r esources as their share for the SSA. Their education grants have been accordingly determined. The health grants have, however, been discontinued.

Environment-Related Grants

The THFC has suggested a bouquet of environmental grants in view of the terms of reference asking it to take into account “the need to manage ecology, environment and climate change consistent with sustainable development”. It has recommended three areas for support – forests, renewable energy, and water sector management.

The forests of India constitute the first line of defence against pollution resulting from economic activity, whether of agricultural or industrial origin, and the TWFC had introduced a forest-related grant of Rs 1,000 crore to be distributed among the states in accordance with their share of the total forested acreage in the country. The THFC forest grant formula takes into consideration three factors – one, the share of the total forest area in the country in a particular state; two, states where the share of forested area in their total area is greater than the national average; and three, the quality of forests in each state, as measured by density. The forest grants are subject to a release and monitoring mechanism after the first two years. The grants are linked to progress on approval of working plans, and the entire amount will be r eleased only after approval of more than 80% of the working plans of a state. Until this is achieved, releases shall be in the r atio of the number of working plans approved to 80% of the number of working plans for a state.

The second of the environmental grants is for encouraging the production of renewable energy. It has an incentive component comprising two sub-components – one, an incentive for achievement in installed capacity addition (over a four-year period) r elative to unachieved potential (weight of 25%); and two, an incentive for achievement in installed capacity addition (over a four-year period) relative to the aggregate of installed capacity addition across all states (weight of 75%).

The third component of environmental grants is for water s ector management. The THFC has recommended setting up a Water Regulatory Authority in each state and specifying a minimum level of recovery of water charges. The environment- promoting grants are welcome, even though there may be complications in implementing all the conditionalities. If anything, these initiatives need to be strengthened by larger amounts and less conditionalities.

Grants for Improving Outcomes

Another set of new grants introduced by the THFC is grants for improving outcomes. There are six outcomes to which these r elate – one, reduction in infant mortality rates; two, improvement in the supply of justice; three, an incentive for issuing UIDs; four, a district innovation fund; five, improvement of statistical systems at the state and district levels; and six, compiling an e mployee and pension database. It is worth remembering that outcomes do not exclusively depend on state government efforts. They also depend on the role of two other major players, the c entral government and the private sector, at least for some of the outcomes in the above list.

Grants for State-Specific Needs

Like previous UFCs, the THFC has also recommended grants for state-specific needs covering a wide range of activities. Table 6 gives details of these grants.

4 Determining the Vertical and Equalising Content of Transfers

In the end what matters is the overall impact of the design of fi scal transfers. For this purpose, in this section we decompose the recommended transfers into three components – vertical transfers; equalising transfers; and transfers for special needs and incentives. Using the notations used in Section 3, let the per capita income

Table 6: Grants-in-Aid for State-Specific Needs (Rs crore)

State 2010-11 2011-12 2012-13 2013-14 2014-15 2010-15
Andhra Pradesh 20.00 312.50 312.50 312.50 312.50 1,270.00
Arunachal Pradesh 0.00 75.00 75.00 75.00 75.00 300.00
Assam 0.00 150.00 150.00 150.00 150.00 600.00
Bihar 0.00 461.25 461.25 461.25 461.25 1,845.00
Chhattisgarh 0.00 320.25 320.25 320.25 320.25 1,281.00
Goa 0.00 50.00 50.00 50.00 50.00 200.00
Gujarat 0.00 325.00 325.00 325.00 325.00 1,300.00
Haryana 0.00 250.00 250.00 250.00 250.00 1,000.00
Himachal Pradesh 0.00 87.50 87.50 87.50 87.50 350.00
Jammu and Kashmir 1,000.00 87.50 87.50 87.50 87.50 1,350.00
Jharkhand 0.00 356.25 356.25 356.25 356.25 1,425.00
Karnataka 0.00 325.00 325.00 325.00 325.00 1,300.00
Kerala 0.00 375.00 375.00 375.00 375.00 1,500.00
Madhya Pradesh 0.00 307.75 307.75 307.75 307.75 1,231.00
Maharashtra 0.00 308.75 308.75 308.75 308.75 1,235.00
Manipur 0.00 75.25 75.25 75.25 75.25 301.00
Meghalaya 0.00 62.50 62.50 62.50 62.50 250.00
Mizoram 0.00 62.50 62.50 62.50 62.50 250.00
Nagaland 0.00 62.50 62.50 62.50 62.50 250.00
Orissa 0.00 436.25 436.25 436.25 436.25 1,745.00
Punjab 30.00 362.50 362.50 362.50 362.50 1,480.00
Rajasthan 0.00 300.00 300.00 300.00 300.00 1,200.00
Sikkim 0.00 100.00 100.00 100.00 100.00 400.00
Tamil Nadu 0.00 325.00 325.00 325.00 325.00 1,300.00
Tripura 0.00 125.00 125.00 125.00 125.00 500.00
Uttar Pradesh 0.00 419.75 419.75 419.75 419.75 1,679.00
Uttarakhand 0.00 175.00 175.00 175.00 175.00 700.00
West Bengal 0.00 425.75 425.75 425.75 425.75 1,703.00
Total States 1,050.00 6,723.75 6,723.75 6,723.75 6,723.75 27,945.00

Source: Finance commission (2009), THFC Report (2010-2015), Vol 1, December.

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(GSDP) of the states arranged in ascending order be denoted by y1, y2 … y and the corresponding population be d enoted by N1, N2 ...


N. If the vertical fiscal is measured with reference to the richest


state, in per capita terms, it may be defined as [e - a.y] (assuming


that e > a.y), where e is the per capita expenditure norm, a is the


average tax-effort, and y* is the per capita fiscal capacity of the benchmark state (Haryana). If e is exogenously or normatively determined, the per capita transfer to the benchmark state is given by

[e - ay*].

Since every state gets at least the amount [e - a.y] in terms of


per capita transfers, we may write the total vertical transfer as [e - a. y*] = [e - a. y*] ¦Ni …(3)

¦Ni All other states have a lower fiscal capacity and would get an amount, in per capita terms, higher than that obtained by the highest income state in a progressive scheme of transfers under the axiom of horizontal equity. The transfers to these states can be seen as consisting of a vertical component equal to the per capita transfer to the highest income state, an “equalising” component due to deficiency in fiscal capacity, and a residual that r eflects cost disabilities and other special need considerations. Thus, for any state i, the per capita transfer can be decomposed into three components reflecting transfers made on account of vertical imbalance; transfers on account of equalisation; and the residual component. So per capita transfers to a state can be w ritten as = (e - a y*) + (ay* - ayi) + resi for a state where resi t 0. ...(4)

t i

Here, e is the permitted per capita expenditure norm, a is average tax effort, and “res” is the residual reflecting other cost disabilities and special need considerations, as also incentive components. The term (ay* - ayi) represents equalisation transfers. The states may be divided into two groups. One would be where the per capita recommended transfer consists of three components – vertical, equalising, and special needs and incentives – as pointed out above. But there could be other states, where after vertical transfers are taken out, the balance falls short of their equalisation entitlement and nothing is left for special needs and incentives. Let the shortfall in such cases be defi. In their case, we may write per capita transfers as

t i = (e - a y*) + (a y* - ayi) - defi ...(5)

In both cases, we can multiply the per capita transfers by r espective populations to get total transfers. By adding up the two sets, we get the total transfers (TT) as

TT = ¦Niti = ¦Ni (e-a y*) + [¦Ni (ay*-ayi) -¦Ni defi ] + ¦Ni resi

Here, defi > 0 for states that get less than their equalisation entitlement and resi > 0 for states that get more than their equalisation entitlement.

The total transfers can be divided into three components, and the respective shares of each in total transfers may be written as

  • (a) Share of vertical transfers in total transfers: A1 = ¦Ni (e - a y*)/TT
  • (b) Share of equalising transfer in total transfers: A2 = [¦Ni (ay* - ayi) -¦Ni defi]/TT
  • (c) Share of transfers for special needs: A3 = ¦Ni resi/TT We now calculate these shares for the THFC recommended t ransfers. In making these calculations, the following qualifications apply.
  • (1) Average per capita comparable GSDP at current prices for 2004-05 to 2006-07, centred in 2005-06 as used by the THFC, is
  • Economic & Political Weekly

    november 27, 2010 vol xlv no 48

    taken as a macro proxy of the state base for own tax revenues.

  • (2) The population for mid 2005-06 is used for calculating the amounts of equalisation transfers. It may be noted that even then the income and population data are dated by seven years compared to the mid-year (2012-13) for the award period running from 2010-11 to 2014-15.
  • (3) The estimated per capita transfer to Haryana is used to determine vertical transfers. Haryana has the minimum per capita transfer among all states.
  • (4) The all-state average tax-GSDP ratio is taken as 7.476%, which is the average for the period 2004-05 to 2006-07, centred in 2005-06, as given in the THFC Report.
  • (5) Comparisons are made for transfers centred in 2012-13, which is the mid-year of the THFC award period. Tax devolution amounts as projected by the THFC are taken. The grant amounts are in absolute figures as estimated by the THFC.
  • It is seen that the per capita transfer for the highest benchmark state, Haryana, is Rs 1,686. The total vertical transfer is estimated to be Rs 1,82,923 crore, which is nearly 54% of total transfers. Rs 1,25,440 crore is devoted to equalising transfers, which will be able to achieve 90.5% of the needed equalisation. This is commendable. But we need to remember that equalisation r equirements will be substantially higher if they are worked out in absolute amounts for 2012-13, which is the middle year of the THFC award period. The share of transfers devoted to incentives and special needs is less than 10% of the total transfers. The equalisation transfer is calculated and added for each state as d etermined by [Ni.(a).(y* - yi)], where the symbols have the same meaning as earlier. In particular, “a” is the average tax price, which is equal to the average own tax revenue to GSDP ratio of the states, or 7.476% (as given in Annexure 7.9 of the THFC R eport). The details of the calculations and the related decomposition are given in Appendix Tables 1 and 2 (p 70). Table 7 summarises the relative shares of the three components – vertical, equalising, and special needs – in total transfers.

    Several qualifications apply to these estimates. First, the equalisation benchmark is calculated with a revenue side a pproach and expenditure side considerations do not figure in it. Second, a macro base reflecting fiscal capacity like the per capita GSDP is used. Third, the highest per capita GSDP among states, excluding Goa, is used as the benchmark. Fourth, shortfalls from the equalisation benchmarks are equally weighted.

    5 Concluding Observations

    The THFC has designed a scheme of transfers for both its vertical and horizontal dimensions that has some of the desirable features of a suitable arrangement. For vertical transfers, the THFC

    Table 7: THFC Recommended Transfers – Vertical and Horizontal Components (Rs crore)

    Total transfers (average per year centred in 2012-13) 3,41,335.4
    Amount used for vertical transfers 1,82,923
    Share of vertical transfer 53.59%
    Amount for equalisation transfers 1,25,440
    Share of equalising transfers in total transfers 36.75%
    Amount needed for full equalisation 1,38,555.26
    Extent of equalisation achieved 90.53%
    Amount used for cost differentials and special needs 32,971.96
    Share of transfers for cost differentials and special needs 9.66%
    Source: Estimates based on Appendix Tables 1 and 2.


    has emphasised the objective of stability in the relative shares of the time lag in information – the use of 1971 population data and the centre and the states after transfers. For horizontal transfers, dated per capita GSDP data are two basic constraints. Second, no the THFC has successfully achieved 90% of the equalisation effort is being made to develop a better indicator of fiscal capa

    o bjective. The design could have been even better if it had not city at the macro level than the per capita GSDP of states. As state introduced an unnecessary modification in the application of the tax systems move closer to destination-based taxation such as a distance formula, which will result in discouraging tax effort, an comprehensive GST, these constraints will become even more effect further compounded by dropping the tax effort criterion s erious. It seems pointless to insist on continuing to use 1971 from the tax devolution scheme. p opulation data as the UFCs are able to achieve a significant

    There are some unnecessary constraints in designing a suita-amount of equalisation measured with reference to more up to ble fiscal transfer methodology in the Indian context. The first is date information.

    Notes Or a (μ. N+μ. N) = a. μ. N + a. μ. NE conomic Review, 35(3), pp 290-300.


    which is true from (1) and (6). Finance Commission (2009): Report of the Thirteenth Kashmir, a separate set of shares for the sharing 1 Since service tax is not levied in Jammu and

    Finance Commission, New Delhi. of service tax is also prepared putting Jammu and References – (2004): Report of the Twelfth Finance Commis-Kashmir share to be zero and adjusting the share sion, New Delhi.

    Aubut, Julie and F Vaillancourt (2001): “Using GDP in

    of other states pro-rata. Rangarajan, C and D K Srivastava (2004a): “Fiscal

    Equalisation Calculations: Are There Meaningful Mea-

    Federalism in Canada: Drawing Comparisons and 2 Let the own tax revenue raised by all states, and

    surement Issues”, Institute of Intergovernmental Re-

    Lessons”, Economic & Political Weekly, Vol 39,

    the groups of the general and special category

    lations, Working Paper, Queens University, Ontario.

    No 19, and Working Paper No 18, National Instistates be R, R, and R, where R = R+ R.

    gsg s

    Barro, Stephen (2001): “Macroeconomic versus RTS Meas-tute of Public Finance and Policy, New Delhi.

    The average tax effort is

    ures of Fiscal Capacity: Theoretical Foundations and Im

    – (2004b): “Fiscal Transfers in Australia: Review

    A = R/¦Niyi/ = (Rg + Rs)/ μ (Ng + Ns) plications for Canada”, Institute of Intergovernmental and Relevance to India”, Economic & Political or a = (Rg/μ (Ng + Ns) + Rs/μ (Ng + Ns) Relations, Working Paper, Queens University, Ontario. Weekly, Vol 40, No 27, pp 3709-722.

    Since, a = R/μ. Nand a = μ. NBoadway, R and F Flatters (1982): “Efficiency and – (2008): “Reforming India’s Fiscal Transfer System: A = (Rg /μg. N).(μg. N)/(μ (Ng+N) + (Rss/μ. Equalisation Payments in a Federal System of Gov-Resolving Vertical and Horizontal Imbalances”, Eco

    gggg sss


    N).(μ. N)/(μ (N+ N) ernment: A Synthesis and Extension of Recent nomic & Political Weekly, 7 June, and Working Paper

    sssg s

    R esults”, Journal of Economics, 15(4), pp 613-33. No 31, Madras School of Econo mics, Chennai.

    or a = a.(μ. N)/(μ (N+ N) + a.(μ. N)/(μ (N

    gggg ssssg

    Courchene, T J (1984): “Equalisation Payments: Past, Pre -Srivastava, D K and Pawan K Aggrawal (1994): “Reve+ N)

    ssent, and Future”, Ontario Economic Council, Toronto. nue Sharing Criteria in Federal Fiscal Systems: or aμ (N+ N) = a. μ. N + a. μ. N … (6)

    g sgggsssGarnaut, R and V FitzGerald (2002): “Issues in Some Similarities and Differences”, Public 3 Ls and Gs are equal if (ag - a) μg. Ng = (a - as) μs. Ns C ommonwealth-State Funding”, Australian F inance/Finances Publiques, Vol 49, No 3.

    Appendix Table 1: Transfers Recommended by the Thirteenth Finance Commission Appendix Table 2: Decomposition of Per Capita Transfer

    States Share in Grants Total Transfer Total Transfer Population Per Capita Per Capita Vertical Equalising Deficiency in Residual Total forCentral Taxes (Rs crore) (5 Years) Average (2005-06) Transfer Per Year Component Component Equalisation Equalisation and Duties (Rs crore) Per Year in crore Per Year (Rs) Transfers (Rs crore) (Rs crore) (Rs crore)

    Andhra Pradesh 2,844 1,686 990 0 168 7,944 Andhra Pradesh 1,00,616 13,532 1,14,148 22,830 8.028 2,844

    Arunachal Pradesh 15,669 1,686 1,292 0 12,691 150 Arunachal Pradesh 4,756 4,348 9,104 1,821 0.116 15,669

    Assam 4,063 1,686 1,729 0 648 4,922 Assam 52,621 5,212 57,833 11,567 2.847 4,063

    Bihar 3,843 1,686 2,157 456 0 19,415 Bihar 1,58,341 14,603 1,72,944 34,589 9.001 3,843

    Chhattisgarh 3,746 1,686 1,498 0 562 3,359 Chhattisgarh 35,825 6,176 42,001 8,400 2.242 3,746

    Goa 5,947 1,686 0 0 4,261 0 Goa 3,858 516 4,374 875 0.147 5,947

    Gujarat 1,972 1,686 277 0 9 1,510 Gujarat 44,107 9,683 53,790 10,758 5.456 1,972 Haryana 1,686 1,686 0 0 0 0 Haryana 15,200 4,271 19,470 3,894 2.310 1,686 Himachal Pradesh 6,759 1,686 118 0 4,955 76 Himachal Pradesh 11,327 10,364 21,692 4,338 0.642 6,759 Jammu and Kashmir 7,446 1,686 1,389 0 4,372 1,508

    Jammu and Kashmir 20,183 20,256 40,439 8,088 1.086 7,446 Jharkhand 3,294 1,686 1,608 23 0 4,675

    Jharkhand 40,640 7,238 47,879 9,576 2.907 3,294 Karnataka 2,660 1,686 775 0 199 4,333

    Karnataka 62,775 11,602 74,376 14,875 5.593 2,660 Kerala 2,435 1,686 413 0 336 1,367

    Kerala 33,954 6,372 40,326 8,065 3.313 2,435 Madhya Pradesh 3,544 1,686 1,858 56 0 12,226

    Madhya Pradesh 1,03,269 13,325 1,16,594 23,319 6.580 3,544 Maharashtra 1,764 1,686 54 0 24 562

    Maharashtra 75,407 16,303 91,710 18,342 10.401 1,764 Manipur 11,829 1,686 1,586 0 8,557 364

    Manipur 6,541 7,026 13,568 2,714 0.229 11,829 Meghalaya 8,018 1,686 1,236 0 5,096 304

    Meghalaya 5,919 3,924 9,843 1,969 0.246 8,018 Mizoram 18,725 1,686 997 0 16,042 94

    Mizoram 3,901 4,904 8,805 1,761 0.094 18,725 Nagaland 13,049 1,686 1,397 0 9,966 294 Nagaland 4,553 9,191 13,744 2,749 0.211 13,049 Orissa 4,083 1,686 1,683 0 713 6,513 Orissa 69,316 9,659 78,975 15,795 3.869 4,083 Punjab 1,984 1,686 196 0 103 507 Punjab 20,146 5,540 25,687 5,137 2.589 1,984

    Rajasthan 84,892 12,950 97,842 19,568 6.171 3,171 Rajasthan 3,171 1,686 1,485 161 0 9,166

    Sikkim 3,467 1,059 4,526 905 0.057 15,810 Sikkim 15,810 1,686 876 0 13,248 50

    Tamil Nadu 72,070 11,367 83,437 16,687 6.488 2,572 Tamil Nadu 2,572 1,686 541 0 345 3,509

    Tripura 7,412 5,716 13,128 2,626 0.339 7,753 Tripura 7,753 1,686 1,160 0 4,907 393

    Uttar Pradesh 2,85,397 26,743 3,12,140 62,428 18.155 3,439 Uttar Pradesh 3,439 1,686 1,753 359 0 31,821

    Uttarakhand 16,245 4,063 20,308 4,062 0.915 4,441 Uttarakhand 4,441 1,686 1,166 0 1,589 1,066

    West Bengal 1,05,359 12,639 1,17,997 23,599 8.475 2,785 West Bengal 2,785 1,686 1,099 126 0 9,312

    Total 14,48,096 2,58,581 17,06,677 341,335 108.505 3,146 Total 1,25,440 Source (basic data): Table 12.7 of the THFC Report and Annexure data. Source (basic data): Table 12.7 of the THFC Report and Annexure data.

    70 november 27, 2010 vol xlv no 48

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