There are few things more fundamental to the functioning of a state than its finances. It should therefore not come as a surprise that Indian politics is gripped by the question of taxes and the appropriate method to distribute them. On Tuesday, the finance ministers of three South Indian states met to discuss what they saw as unfair tax distribution by the Union government. They were angry with the terms of reference – a set of instructions – provided by the Modi government to the 15th Finance Commission. The South alleges that although they generate a large share of taxes, the new terms will see an unfair amount of that money distributed to the Hindi states in the North by virtue of their larger, fast-growing populations.
The finance commission decides how taxes collected by Delhi will be distributed between the states and the Union government – a task critical to the functioning of the country. Given the importance of its charge, this is not the first time a finance commission has generated controversy. In fact, the very first finance commission itself was contentious, with West Bengal – then India’s most developed state – repeating the South’s charge of unfair tax distribution.
In the Raj
The colonial Indian state under British rule was incredibly fiscally centralised for a population of its size. In 1859, Charles Trevelyan, Governor of the Madras presidency wrote of the “humiliating necessity of making a separate application to Calcutta [then capital of British India] on every occasion on which any new expenditure, however trifling, was required”. This system was amended with the introduction of the Government of India Act, 1935, a new constitution for British India that created popularly elected governments in the provinces (even as the Centre would remain in British hands). To work this new system of provincial government, the colonial government released what came to be known as the Niemeyer Award – a plan for the newly elected provincial government to get sufficient funds from the Centre. The Niemeyer Award can be seen as the predecessor of the modern Indian system of appointing technocratic financial commissions to rule of the federal distribution of tax monies.
The Niemeyer Award was a move away from the excessive centralisation of the Raj but in absolute terms, it still left a lot of power in the hands of the Centre. Income tax would be levied by the Centre and only 50% of that would be distributed to the provinces. Apart from this gap between Centre and provinces, there was friction over how much provinces got relative to each other too. The highly industrialised provinces of Bengal and Bombay each received 20% of the provincial share and felt aggrieved that tax collected from them was getting diverted to less developed provinces such as Odisha and Sindh.
Independence and taxes
Bengal would see its share slashed further still as on the stroke of the midnight hour, as India became independent, the Nehru government reduced the province’s share of income tax to 12%, driven by the fact that the province had now been partitioned. This was greatly resented in West Bengal, which argued that this cut was unfair since its ability to generate taxes had barely gone down given that almost all of Bengal’s commercial and industrial assets were in West and not East Bengal.
West Bengal’s anger pushed the Jawaharlal Nehru-led Central government to appoint a commission led by CD Deshmukh (a civil servant who had been the first Indian to be appointed the Governor of the Reserve Bank of India in 1943 by the British Raj). The Deshmukh Award came into force in 1950 and was notable for using population as a major factor in determining tax allocation. This decision was to inform all future finance commissions and is currently the main bone of contention between the southern states and the Union government. West Bengal, though, got little from the Award, seeing its share rise from 12% to only 13.5%, still far below the Niemeyer Award’s 20%.
The Indian Constituion came into force on January 26, 1950. The document did not do much to change the system the Niemeyer Award had set up: the Centre would collect the lion’s share of the taxes and then a part of that would be distributed to the states. However, the document did make one significant concession to state rights: it spoke of the appointment of a finance commission. This technocratic commission would, in theory, be less amenable to political pressures and ensure that the Centre would have to devolve a fair share of taxes to the states.
Unfortunately, even before a finance commission could be appointed, the Nehru-led Central government undermined it. In 1950, a Planning Commission was appointed which would transfer monies to the states. This body, as K Subba Rao, a Chief Justice of the Supreme Court put it, ”functioned in violation of the provisions of the Constitution.” Often called a “super cabinet”, the Planning Commission would in fact dwarf the constitutional finance commission and in the first two decades after independence, the former would allocate almost twice the amount of money as the latter.
The monies routed through the Planning Commission depended completely on the whims of the Central government which used it to impose its will on the states. Like Madras governor Charles Trevelyan, a century earlier, states would complain about having to go the Planning Commission with a “begging bowl”. Prime Minister Narendra Modi, who had himself sparred with the system during his time as Gujarat chief minister, abolished the Planning Commission in 2014.
First Finance Commission
A year later, in 1951, the Nehru government appointed the first finance commission. It was headed by KC Neogy, a Hindu Mahasabha member from Bengal who had been a part of the cabinet till 1950, when he resigned in protest over Nehru’s East Pakistan policy.
Like 2018, the question of population immediately created a divide in 1951. The two developed states of West Bengal and Bombay wanted tax distribution to be based on collections. Bombay wanted 41% of the state’s share of tax to be based on where it was collected and only 16% on “need”, which included factors such as poverty and population. West Bengal was even more strident. Using Article 270, Kolkata contended that the money raised in one state should not be shared with another state at all. Only the Centre should get its share and all the rest should come back to West Bengal. Like the South’s case today, these arguments were based on the fact that West Bengal and Bombay were far more industrialised than the rest of the Union. West Bengal and Bombay in fact contributed nearly three-fourths of all of India’s income tax.
The finance commission, however, completely dismissed the arguments of West Bengal and Bombay and stuck to the Nehruvian vision of centralised planning. It decreed that as much as 80% of a state’s share would be decided by population and only 20% on the basis of where it was collected. West Bengal lost significantly as a result of this. While its tax collections had not decreased by much, partition had meant the state had lost more than half its population – now the main criteria for distributing monies. Under the Niemeyer Award, Bengal had been awarded 20% of the state’s income tax share, which now plummeted to 11.25% under the first finance commission. Overall, the finance commission awarded 55% of income tax to the states – a small increase from the Niemeyer Award’s 50% – and kept the rest for the Centre.
Like the South today, this decree of distribution hurt West Bengal fiscally. By 1955, it was facing a revenue deficit of Rs 13 crores as the tax generated by West Bengal’s industries was distributed to other states. In its deputation to the second finance commission, the state argued that while it produced great wealth, the state government also needs to provide services and infrastructure to help in the continued production of this wealth. “This great disparity between wealth and taxability is the biggest tragedy in the state”, West Bengal said. “This is the root of most of the malady from which the body politic of this State suffers. This is the problem peculiar to West Bengal and it cannot be solved without giving to the State Government a commensurate share in the tax on industrial wealth and industrial income”.
In its note to the third finance commission, West Bengal even argued that the finance commission needs to turn its method on its head. Rather than asses the needs of the state, the finance commission actually needed to assess the needs of the Centre and hand over that exact amount to Delhi, keeping the rest in the state from where it was collected. The memo argued:
“In our view one of the major tasks of the Finance Commission would be to assess the needs of the Centre according to the functions it is required to discharge under the Constitution and to allow it to retain so much, and much only, of the funds that are actually required for the discharge of those specially Central functions in an efficient manner.”
Unlike in the South today, however, West Bengal’s anger against what it saw as the unfair distribution of its resources to other states never made it to mass politics. While the then Chief Minister BC Roy made some strong arguments, since he was also a Congressman, he could not oppose the Union government openly and all his contentions were made behind close doors. This, as can be expected, had little effect. In fact, far from offering any concession to West Bengal, the Centre further tightened the screws. In 1959, the Nehru government renamed the tax paid by companies to “corporation tax” from “tax on income”. This bypassed the constitutional provision of sharing all income taxes with the states, increased the Centre’s share and further hurt an industrial state like West Bengal.