GSDP-for central-State transfers

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The question of whether Gross State Domestic Product (GSDP) should be incorporated as a criterion for central transfers to States has gained prominence amid growing strains in Centre–State fiscal relations.

The Framework of Fiscal Devolution in India

IC establishes a federal structure with a “unitary bias,” creating a Vertical Fiscal Imbalance – the Centre holds major taxation powers, while States bear the primary burden of social expenditure.
Articles 268 to 293 of the IC govern the distribution of financial powers between Union and state governments.
Seventh Schedule of the Constitution (Article 246) delineates the tax base between the centre and states.
Finance Commission, under Article 280 has exclusive authority to recommend the distribution of intergovernmental finance, including tax devolution and grants-in-aid.
Additionally, Constitution provides for grants-in-aid to states from the Consolidated Fund (Article 275) and regulates state borrowings (Article 293).
Earlier, the Planning Commission exercised parallel influence through plan grants, creating overlap and central dominance. The dismantling of this arrangement marked a turning point in fiscal federalism.

Abolition of Planning Commission & Rise of NITI Aayog: This signalled a shift from centralised planning to competitive federalism. While NITI Aayog lacks financial powers, its Governing Council provides a platform for political coordination rather than fiscal redistribution.
Introduction of GST in 2017: GST created a unified indirect tax regime, theoretically giving states a stake in decision-making through the GST Council. But it also curtailed states’ own taxation powers since many local taxes were subsumed.
GST Council’s Voting Structure: Central government holds one-third votes; states share two-thirds. Critics argue that the weighted voting system still favours the Centre, undermining pure federal equality.

Docile Federalism (1947–early 1970s): Strong central control, facilitated by one-party dominance, with States heavily dependent on central transfers.
Cooperative Federalism (1970s–mid-1990s): Greater State participation in development planning and fiscal decision-making.
Combative Federalism (mid-1990s–present): Frequent Centre–State disputes over resources, taxation powers, and fiscal autonomy, especially in the post-GST era.

The “Shrinking Pie”: Cess and Surcharges account for nearly 22–25% of the Centre’s gross tax revenue, these levies are excluded from the divisible pool, reducing the share available for States.
Centrally Sponsored Schemes (CSS): CSS account for about 40% of central transfers, often with rigid conditions and high State co-financing requirements, constraining fiscal autonomy.
The “Prosperity Paradox”: Under the 15^th FC, weight for income distance (45%) and population (15%) reduced the relative shares of fiscally high-performing States.
GST Centralisation: After GST, States surrendered key taxation powers; GST compensation ended in June 2022, while many States still report revenue shortfalls relative to pre-GST growth trends.
Declining Autonomy: States’ own tax revenue averages ~7% of GSDP, while expenditure responsibilities continue to rise, widening vertical fiscal imbalance.

PAN Bias: Direct taxes data reflects the place of collection, not where production occurs; E.g., factories in Tamil Nadu generate output, but taxes are booked in headquarters States.
Multi-State Firms: Large firms operate across States, but tax is booked centrally, distorting estimates.
Labour Mobility: Migrant labour generates income in host States, but tax attribution remains unclear.

GSDP measures the aggregate value of goods and services produced within the geographical boundaries of a State. It serves as a proxy for the size and structure of the State’s economy.
GSDP reflects consumption, income, and production – the bases for GST, Income Tax, and Corporation Tax. Since tax effort does not vary widely across States, GSDP reasonably approximates tax-accrual capacity at the State level.

Arguments For

Arguments Against

Correcting the “Headquarters Bias“: Corporate taxes are collected where a company is headquartered (often Mumbai or Delhi), not where the factory is located, distorting data. GSDP captures economic value at the point of production, offering a fairer metric of a state’s contribution.
Incentivizing Growth: By linking devolution to GSDP, the FC would reward states that expand the national economic pie, aligning state incentives with the goal of a $5 Trillion economy.
High Correlation: The correlation between GSDP and direct tax collections is 0.75 (2023–24), showing that States with larger economies contribute more to direct taxes.

Exacerbate Regional Inequality: Using GSDP as a positive criterion would channel more funds to already rich states, widening the gap.
Undermining “Equalization“: The primary mandate of the FC is to ensure that a citizen in Bihar has access to the same standard of public services as a citizen in Kerala. This requires transferring resources from surplus to deficit areas. GSDP-based devolution opposes this “Income Distance” principle.
Ignoring Structural Constraints: Poorer states face historical disadvantages and geographical constraints. Penalizing them for lower GSDP ignores the fact that they often provide labor and raw materials that fuel the growth of industrialized states.

Addressing the Divisible Pool: A constitutional amendment or a binding commitment to cap cesses at 10% of GTR would ensure states get their fair share of the vertical pie.
Specific Purpose Grants: Rather than altering the devolution formula, Centre can use Article 275 grants to support urban infrastructure in major industrial hubs. This supports the “engines of growth” without distorting the equity-based devolution formula.
SDG-Linked Devolution: Link incentives to outcomes in Health, Education, and Climate Action, ensuring that funds result in tangible development in lagging states.