15th Finance Commission terms tilt fiscal scales in favour of the Centre

NDA government, Narendra modi, modi government, economy, indian economy

The challenge has been to achieve this without unduly damaging state government incentives for raising their own revenue, and for spending with profligacy. (Reuters)

The current ruling coalition has shown a propensity for bold moves in its attempt to reshape India’s polity and society to match its vision of the nation. The economy has sometimes received similar treatment, with the GST finally being implemented; demonetisation, and public sector bank mergers are two other examples. The last Union Budget was somewhat timid, perhaps, given the growth slowdown, but recent economic policy changes have shown more willingness to respond vigorously to the problem.

Of course, boldness does not guarantee that a decision is the best possible, or even that it is a move in the right direction. The Terms of Reference (ToR) for the 15th Finance Commission (FC XV) reflect that cautionary observation. Finance Commissions have been one of the success stories of India’s constitutionally created institutions. Despite shortcomings, they have established precedents, mostly dealt well with challenges and changes in the country’s federal finances, and retained some degree of independence and integrity. The central government has not always adopted their recommendations wholeheartedly, but overall, it has respected the institution. The current challenge, however, is whether the ToR will push FC XV into problematic territory.

The main job of the Finance Commissions has been to recommend tax sharing rules between the Centre and the states, and among states, supplemented by other kinds of fiscal transfers. A major goal has been to help poorer states fund adequate levels of public service. The challenge has been to achieve this without unduly damaging state government incentives for raising their own revenue, and for spending with profligacy. Given the large transfers required by the constitutional assignments of tax authority, and India’s heterogeneity, the outcomes have not been too bad, certainly better than in some other large federal nations, which have seen sub-national governments spin out of control.

So, what is the problem with the FC XV ToR? I would argue that they are too expansive, and that this expansiveness is in the direction of tilting the fiscal balance further in favour of the Centre. In particular, the call to revisit the previous FC’s decision to increase the share of the states is worrying—that decision made a great deal of sense in putting the states on a firmer fiscal footing, while also reducing the scope for discretion, and political wheeling-and-dealing that comes with it. As Govinda Rao had pointed out in 2017, the net increase in the states’ share was much smaller than what still gets reported, and going back on what the last FC did will be damaging. The ToR also places emphasis on providing performance incentives to states, and controlling “populism,” but that raises all kinds of difficulties in defining that term, and could lead to a complex mess, just when the last FC had succeeded in simplifying, somewhat, the criteria for fiscal transfers. Incentives of this nature had been tried earlier, and did not seem to work particularly well.

Perhaps the most striking example of pushing the envelope of the ToR is the recent, last-minute addition of asking FC XV to suggest ways of allocating non-lapsable funds for defence and internal security. Aside from issues of process, the aspect of concern here is that a technical panel that has already almost completed two years of consultations and analysis is being asked to weigh in on issues of expenditure that have a high level of political sensitivity. It fits in with an approach to the ToR that seems to push FC XV into serving as a political tool of a particular national agenda.

It is certainly possible that the final report, now due at the end of November, will manage to finesse the political difficulties. Certainly, FC XV has extraordinary technical issues to deal with after the introduction of the GST, the elimination of the Planning Commission, and the proposal to change the base year for population weights (which poses its own set of political challenges). But, I would argue that the Centre’s ToR have been bold in the wrong direction, towards greater central control. What is needed is a fiscal federal system in which states and local governments (particularly cities and larger towns) have greater autonomy to decide on their own revenues, perhaps by piggybacking on the central income tax, or by strengthening local property tax systems, or other avenues that will allow sub-national governments to be judged, by their constituents, on whether they are raising these revenues effectively, and translating them into higher quality public services. Centralisation of fiscal authority merely allows sub-national governments to go on contending that the Centre is the source of their problems.

Increasing the fiscal authority and autonomy of state and local governments will require constitutional changes, but these have been implemented before in the realm of fiscal federalism, and the government has demonstrated its willingness to be bold in other arenas. Given the timing of the FC cycle, perhaps the Centre, through the NITI Aayog, should immediately consider structural reforms in India’s fiscal federalism that will promote efficient sub-national spending on health, education and infrastructure, and lay the groundwork for the kind of broad-based growth that India needs.