GSDP Share as a Criterion for Central–State Transfers: A New Direction in India’s Fiscal Federalism

India’s system of fiscal federalism is undergoing a crucial transition. With the introduction of the Goods and Services Tax (GST), the traditional relationship between where taxes are collected and where economic activity takes place has weakened. This has reopened an important debate: should Gross State Domestic Product (GSDP) be used as a primary criterion for Central–State transfers?

The idea is gaining traction because GSDP reflects the real economic strength of a State more accurately than tax collection figures, which have become increasingly distorted in the post-GST era.

What Are Central–State Transfers?

Central–State transfers are financial resources transferred by the Union government to States through:

• Tax devolution based on Finance Commission recommendations

• Grants-in-aid

• Centrally Sponsored Schemes (CSS)

Between 2020–21 and 2024–25, about ₹75.12 lakh crore was transferred to States, making the choice of distribution criteria extremely significant for State finances, development planning, and federal trust.

Why Tax Collection Is No Longer a Reliable Indicator

Earlier, tax collection was often used as a proxy for a State’s economic contribution. However, structural changes have weakened this link:

1. Destination-based GST

   • Tax is collected where goods and services are consumed, not where they are produced.

   • Producing States lose their direct revenue linkage.

2. Corporate Tax Distortion

   • Corporate taxes are paid where company headquarters are registered, not where factories or operations exist.

3. Multi-State Economic Operations

   • Supply chains, labour migration, and inter-State transactions blur geographical attribution.

4. Practical Example

   • Automobile companies pay tax in States where offices are located, not necessarily where manufacturing occurs.

   • Plantation and mining firms report profits centrally despite production being geographically dispersed.

Result: Tax figures reflect administrative locations, not economic value creation.

Why GSDP Is a Better Proxy

GSDP measures the total economic output generated within a State. It:

• Represents real production and income generation

• Reflects consumption potential and employment creation

• Is free from GST accounting distortions

• Is easier to verify and compare

• Is policy-neutral and transparent

Empirical evidence supports this:

This shows GSDP aligns far better with real transfers than current Finance Commission formulas.

How Current Transfers Compare with GSDP Shares

• Redistribution Bias Exists

  • Maharashtra contributes over 40% of direct taxes but receives only ~6.6% of transfers.

  • Bihar receives ~8.6% of transfers despite having only ~4.6% GSDP share.

• Interpretation

  • Current system strongly prioritizes equity and redistribution.

  • GSDP-based allocation would align transfers more closely with economic output.

Equity vs Efficiency: The Core Dilemma

Finance Commissions emphasize:

• Population

• Income distance

• Area and forest cover

These promote regional balance but dilute incentives for growth-oriented States. GSDP corrects this by linking fiscal rewards to productivity.

Winners and Losers Under a GSDP System

Likely Gainers

• Tamil Nadu

• Karnataka

• Maharashtra

These States have strong production bases but lose revenue due to GST consumption accounting.

Likely Losers

• Uttar Pradesh

• Bihar

• Madhya Pradesh

These benefit heavily from redistribution under the current framework.

Post-GST Relevance

The GST Compensation to States Act, 2017 guaranteed States a 14% annual revenue growth.
COVID-19 exposed its weaknesses:

• Compensation fund collapse

• Borrowing disputes

• Heightened Centre–State tensions

This revived debates on transparent and sustainable transfer mechanisms, strengthening the case for GSDP-based sharing.

Policy Way Forward

A balanced framework is needed:

1. Hybrid Model

   • GSDP for efficiency

   • Income distance and grants for equity

2. Statutory Recognition

   • Use GSDP explicitly in Finance Commission formulas

3. Targeted Equalisation Grants

   • Support poorer States without distorting economic incentives

4. GST Reform Linkage

   • Align GST data reporting with production-side metrics

Conclusion

Using GSDP share as a criterion for Central–State transfers reflects the realities of India’s post-GST economy. It restores the connection between economic activity and fiscal rewards, improves transparency, and strengthens trust in cooperative federalism.

While redistribution remains essential for equity, a calibrated shift toward GSDP-based allocation—supplemented by targeted grants—offers the most balanced and sustainable model for India’s fiscal future.

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