India needs to move away from centralization-decentralization thinking, and embrace genuine fiscal federalism by permanently creating a fiscal power centre in the states
The possibility of the 15th Finance Commission (FC) using the 2011 census for revenue allocation has the political class and policy experts riled. The reason is simple; since the 1971 census (used by the 13th and 14th FCs), there has been a significant demographic divergence. Using 2011 census data will give states with the greatest increase in population an advantage in their share of revenue, relative to prior revenue allocations. And political decisions are already tilted in favour of the demographically rich because of the voting system.
Population, however, is not the only divergence between states. States that have gained the greatest numbers, like Bihar and Uttar Pradesh (UP), are also among the poorest. And states like Kerala and Tamil Nadu, that have gained tremendously in gross domestic product and welfare indicators, are experiencing reduced fertility rates, and have gained a lot less in population. The FC considers multiple factors at different weights, including demographics, in its allocations. And if the 15th FC uses the currently estimated 27.5% as the weight for the 2011 census (instead of 10% used in the 14th FC), the consequences would be dire for Tamil Nadu and Kerala.
There are arguments in favour of both approaches—using the 1971 census data or using the 2011 census data. Since the demographically powerful states are the poorest, a case may be made for fiscal assistance from the Union government, and therefore a larger share in the distribution by the FC. Using the 2011 census aids states like UP and Bihar, and in theory, benefits the greatest number of people.
An equally powerful case can be made in favour of using the 1971 census. States like Kerala and Tamil Nadu made investments in female literacy, healthcare, and reduced infant mortality, which led to a decrease in the rate of population growth. Investments in education, healthcare and infrastructure along with sensible governance, have led to prosperity and therefore a larger fiscal contribution. Using the 2011 census would mean that their policy successes are punished and the policy failures of badly governed states are rewarded. Taking away the resources of successful states at this crucial juncture of their development also affects their future development and welfare outcomes.
A third idea argues for tinkering with the weights and formulas of the 15th FC until all parties are satisfied, highlights the typical babu mindset.
These ideas help resolve the immediate distribution of resources one way or another. But the problem will only get worse in the future. Both the demographic divergence, as well as the prosperity divergence, are expected to persist, i.e. the gap between states like Bihar and Tamil Nadu will increase, not converge. So what can be done?
The only long-term solution is to foster genuine fiscal federalism where states largely raise their own revenue and face hard budget constraints, i.e. fiscal autonomy accompanied by fiscal responsibility. Creating a fiscal structure where the states have greater revenue-raising authority, as well as greater decisionmaking power on spending, implies a lower reliance on the Union government in fiscal matters as well as governance decisions. It means reducing, if not eliminating, the system of the Union government receiving a large proportion of all revenue and then allocating that revenue among the states.
The problem with the suggestions for the 15th FC is their focus on the current revenue-sharing system, which is extremely centralized. Instead of federalism, India witnessed complete centralization in the initial years of the republic, followed by some decentralization more recently. Decentralization implies that the power devolved by the higher-level government may potentially be taken away, whereas genuine federalism requires that power cannot be “given" to a sub-national government by another higher level. Genuine federalism requires dual centres of fiscal authority.
India needs to move away from centralization-decentralization thinking, and embrace genuine fiscal federalism by permanently creating a fiscal power centre in the states. For the richer states, this is an excellent solution. They raise a larger share of the revenue and will benefit immediately. It allows these governments to take on long-term infrastructure and governance projects to benefit its citizens.
But what about the poor, more populous states? They will also benefit in the long run and not suffer too much in the short run. Citizens of these states will benefit in the long run because fiscal autonomy will put pressure on these governments to put their house in order. If these states do end up getting their fiscal priorities in order, a larger populace if governed well implies greater revenue, and therefore greater power for state parties governing these states in the long run. Budgetary crisis in these states in the short run need not harm citizens adversely because India constitutionally guarantees freedom of movement. While the governments of Bihar and UP may flounder, their citizens can move to greener pastures. Citizens of Bihar and UP already move to richer states for employment. This trend will strengthen with fiscal federalism.
The use of the 2011 census in the 15th FC is merely revealing the symptoms caused by the problem of centralizing fiscal decisions. The solution is genuine fiscal federalism, where Indian states have both greater responsibility as well as greater control in their fiscal decisionmaking and outcomes. India is, after all, a union of states. It’s time we acted like one.
Shruti Rajagopalan is an assistant professor of economics at Purchase College, State University of New York, and a fellow at the Classical Liberal Institute, New York University School of Law.