A former chief minister of a state was irked with the conditionalities imposed by the erstwhile Planning Commission (PC). He said: “You earmark money for schemes that are not needed for my state. When I need money for water, you give it for roads." That chief minister became the prime minister, and one of his first actions was to shut down the PC. Of course, he wasn’t the only chief minister who had tiffs with the PC. The PC had no constitutional basis, nor was it set up with Parliament’s approval. It was the result of an executive order, and so was its shutting down. Over many decades, the PC acquired enormous fiscal power and implied discretion in the allocation of funds to various states for developmental projects and schemes. This clout coloured centre-state relations, since, technically, the PC was simply giving money that anyway belonged to the states, except that it came with strings attached. Its funding was carved out of the Union budget as gross budgetary support.
Unlike the PC, the Finance Commission (FC) is a creature of the Constitution, formed every five years by the president of India. Its primary task is to recommend the vertical divisio.n of tax proceeds between the centre and states. And then to further recommend the horizontal distribution of the states’ share among various states. With the passage of the 73rd and 74th amendments to the Constitution, the FC also has to recommend measures to augment states’ resources, in view of their obligation to fund the third tier of governments. The last two commissions (13th and 14th) have found small ways to directly fund the lowest tier within constitutional limitations. Large-scale explicit transfers will need constitutional amendments, and will also raise thorny issues of how much the centre can bypass state governments in directly funding urban local bodies and panchayats.
The FC is expected to be as clinical as possible in recommending the vertical and horizontal splits. It may lay down principles which are scientific or aligned with constitutional concepts. In doing so, it has to pay heed to issues of efficiency and equity. Since the commission is responsible for ensuring that governments have adequate fiscal space to discharge their obligations, it gives more to poorer states with lower self-financing capacity. In that sense, it is a gap-filling exercise. The overall aim of balanced development too requires a skew in favour of backward regions. The commission’s terms of reference may specify additional considerations. For instance, the 14th FC was asked to take into account the roll-out of the unified goods and services tax (GST), and also the implications of the division of the state of Andhra Pradesh into two. By and large, the FCs stick to principles of sound economics and finance.
However, since the 12th FC, there has been a tendency to use “incentives" in the formula. Reward for fiscal discipline, or a nudge towards population control, recognition of improvement in the human development index. Thus, in the garb of being a neutral referee, the FC is, in fact, pushing a policy agenda. It is not supposed to be an instrument of economic policies or reforms. It is simply a neutral arbiter of how to split the pie. The language of incentives is not very far from the language of conditional grants, the very concept that annoyed chief ministers during the heyday of the PC. Perhaps that is why the reward, of a much higher share, given to the states by the 14th FC was welcomed by all. The states’ share went up sharply from 32% to 42%. The prime minister too called it a shot in the arm for cooperative federalism. The 14th FC was unencumbered by the categories of Plan versus non-Plan funds (from the era of the PC). It also envisaged that most of the centrally-sponsored schemes (CSS’) would be handed over to the states to run, or not run, as they deemed fit. In this handover, the centre would save its cost share, and those resources could then be used to bolster starved national priorities like defence and other public goods.
The fact of the matter is that most of these schemes are intact, or that those which have been closed down have caused much anguish. Secondly, the obligations of the centre in areas that are predominantly the states’ domain, such as employment, education, food security, smart cities, and now the National Health Protection Scheme, have increased vastly. So the centre needs a bigger, not smaller, share of the national kitty.
But, more importantly, there are important considerations from the point of three market failures or externalities. The first is due to climate change, which requires much higher resources for mitigation (such as forest cover), which may diminish an individual state’s resources. This was recognized by the 14th FC. Secondly, myopia may prevent states from pursuing a longer-term, multi-generational spending agenda (e.g. in large infrastructure projects whose benefits spill over state boundaries, and over generations). Thirdly, there is a large variance in the state-level economic, planning and decision-making capacity. To that extent, central support and intervention is needed.
Added to these issues are increasingly difficult interstate issues like river waters, and a growing need for paramilitary and central security forces, which also need a higher level of planning and coordination. Thus, it is clear that more resources will be needed by the centre to address externalities and national coordination. The sharp jump from 32% to 42% was perhaps too much too soon. Thus, the 15th FC could do well to restore a bit of paternalism and go back to a share of, say, 37% to the states.
Ajit Ranade is an economist and a senior fellow at the Takshashila Institution, an independent centre for research and education in public policy.
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