Every five years or so, the President of India, acting on the recommendation of the Union government, appoints a constitutionally mandated Finance Commission (FC). And so, in late 2017, the Fifteenth Finance Commission (FC15), led by the former member of Parliament and secretary to the Union government, N.K. Singh, was appointed. Most Indian citizens are generally not interested in the arcane topic of the terms of reference (ToR) for the FC. And yet, the ToR of FC15 have generated a fierce political debate that has spilled into newspapers.

The nub of the debate is a full shift from using 1971 census figures for the fiscal devolution among states to using census figures from 2011. This small technical detail has set off a firestorm of protest from the southern states, who claim that they will be penalized for having followed prudent population policies in the intervening four decades.

First, some context. Article 280 of the Constitution mandates that each FC make recommendations about the distribution of net proceeds of taxes between the Union and states (called vertical devolution) and also among states (called horizontal devolution). The FC has wide powers under the Constitution to (re)define financial relations between and among the Union and states. As a constitutionally appointed body, it has, within logical limits, the ability to “interpret" the elements of the ToR it receives. The Fourteenth Finance Commission (FC14) made a historic recommendation to devolve 42% of taxes to states from the previous 32%.

However, the Centre scaled back Centrally sponsored schemes in states at the same time, resulting in only a small gain to states in financial devolution of about 1%, but a meaningful difference in autonomy on how the money could be spent. The horizontal devolution among states uses a formula that weights factors such as population, area, forest cover and fiscal capacity/income distance. FC14, for instance, used a weight of 17.5% for the 1971 census population, 10% for the 2011 census population, 15% for area and 50% for income distance. In some senses, therefore, the 2011 census genie is already out of the bottle, with the FC15 ToR simply allowing for the possibility that the entire weight (say, 27.5%) for population be based on the 2011 census.

The technical discussion about the population base for horizontal devolution masks a deeper issue. Even though every FC tries to balance equity and efficiency, devolution in India has been weighted towards population, area and fiscal distance (backwardness). For instance, the ratio of Uttar Pradesh and Bihar’s population to Tamil Nadu’s is 3.0 and 1.5 times, respectively, but their share of tax devolution specified by FC14 is 4.5 and 2.4 times Tamil Nadu’s, respectively. Similarly, Bihar is 1.6 times larger than Gujarat in population, but received 3.1 times the tax share. It is only 86% of Maharashtra’s size but received 175% of Maharashtra’s tax allocation.

In theory, FC15 could come up with any factor and is free to set weights between the factors in any logically defensible manner it chooses. For instance, FC15 could choose to give fiscal discipline a large weight (say, 50%). If it chose the latest three-year average revenue deficit (RD) to gross state domestic product (GSDP) as the metric, it would positively weight states like Haryana, Punjab and Tamil Nadu and limit states like Bihar, Uttar Pradesh and Telangana. Karnataka and Gujarat would form the “neutral" states if this factor was used. Alternatively, FC15 could use a disproportionate weight for human development indicators (HDI). Kerala, Haryana, Tamil Nadu, Maharashtra would lead and Uttar Pradesh and Bihar would lag.

The reason why this has become such a hot political topic is that on indicators of efficiency (performance-based), the south and west lead, and on indicators of equity (need-based), the north. The North-East is considered a special category and will need special assistance regardless. This divide mirrors the Hindi-belt domination by the Bharatiya Janata Party (BJP) versus a mish-mash of opposition parties in the south in particular.

The political map (except for Gujarat and Maharashtra) plots on top of an equity-based FC devolution—there is natural anxiety that the equity bias will be exacerbated further—and hence the angst.

In a complex federal polity like India, it is to balance such considerations that the framers of the Constitution chose to put in a provision for an FC-like institution. In any large, heterogeneous democracy, there is a built-in bias towards gerrymandering and politics-based devolution. This bias needs to be periodically corrected by institutions whose very purpose is to establish natural justice and effectiveness.

Unsustainably biased financial devolution risks a “progressive-inclusive" divide and, in the extreme, civil war. India has been trending towards greater inclusiveness over the last few FCs. Notwithstanding the storm in the chaipot over the 2011 census definition, FC15 has the opportunity to incentivise better state behaviour by including a greater share of performance-based criteria—fiscal discipline, GSDP growth, HDI indicators etc.—at a much greater weight than past FCs. Whether they will have the wisdom and the fortitude to do this remains to be seen.

P.S: Efficiency is doing things right, effectiveness is doing the right things, said Peter Drucker.

Narayan Ramachandran is chairman, InKlude Labs. Read his earlier columns at www.livemint.com/avisiblehand.

Comments are welcome at narayan@livemint.com

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