The 15th Finance Commission (FC15) has been entrusted with the constitutional responsibility of recommending the vertical split (among Centre and states), and, further, a horizontal split (between states) of the divisible pool of tax resources. This is as per the terms of reference given to it by the President of India. Unlike the previous FCs, the FC15 has been additionally asked to propose measurable performance-based incentives to add to the resources at various levels of government (i.e. up to the third tier).

The FC14 had sharply increased the overall vertical share of the divisible pool for states from 32% to 42%, in what is seen as a sharp departure from earlier practice. In doing so, the FC14 had also done away substantially with the language of incentives, and instead implicitly handed over the bulk amount into the hands of the states, with no strings attached, to do as they wish. The assumption of the FC14 being that the states, as sub-sovereign entities, were the best judges of their development priorities and destinies, and it was pointless to link their funding or expenditure to conditionalities from the Centre. In particular, the several hundreds of centrally-sponsored schemes (CSS, a legacy of the Planning Commission era), which had a 60:40 split of expenditure between states and Centre, were to be totally wound up, and it was up to the states to decide whether to continue with the CSS or not. The extra funds released due to the discontinuation of the CSS were to benefit both the Centre and states.

This column had argued last fortnight that the devolution jump from 32% to 42% was too much too soon for at least three reasons, all of which are “market failures". The first reason was climate change and environmental concerns, which requires the Centre to take a holistic national view, to correct for state-level externalities. The second reason was myopia at the state or local levels, which might inhibit large multi-generational spending or projects that cross state borders. The third reason was lack of capacity in planning and coordination at local levels, which may need a Central intervention.

The last two reasons may seem controversial, but the first one is not. In addition to these reasons of market failures, we now find that the assumption made by the FC14 that CSS would be wound up, releasing extra funds to states, has been proved wrong. The states and their people want CSS to continue. Almost no scheme has been stopped. Additionally, the Centre has taken on large legal obligations like right to employment, food, education, and now health, all of which are primarily states’ responsibilities. These extra obligations plus CSS mean that the Centre needs to retain many more funds in the vertical split than implied by the FC14. That’s why the column called for a swing back to some more paternalism. Indeed, the terms of reference to the FC15 ask it to review the Centre-states split.

Here, however, is a counterpoint. No, this is not in the spirit of a two-handed economist, but just to provide a more complete perspective. Firstly, as put very strongly by a former FC chairman, the states’ record in expenditure efficiency and delivering governance is vastly superior to the Centre’s. States get a bigger bang for their tax rupees. For that reason alone, more funds should be entrusted to states. This is a matter of empirical record. Look at expenditure norms across states, and compare with the Centre.

Secondly, in terms of numerous public service commitments (roads, schools, fire safety, police, law and order, sewage, lower judiciary, drinking water, electricity, etc.), two-thirds of the expenditure happens at the state and local level, and only one-third happens at the Central level (national defence, interstate highways, etc.). But conversely, two-thirds of the pre-devolution revenue goes to the Centre and only one-third remains with the states. So, on a pre-devolution basis, all states run a revenue deficit, in terms of their public services obligations. They cannot even meet their basic obligations with that. This is hardwired into the tax structure of the country, not made any better in the goods and services tax (GST) regime.

The 50:50 split of GST between Centre and states is arbitrary. Should the a priori split of GST (between state GST and Central GST) not be 66:33 rather than 50:50 in favour of the states? If that were so, then that would mean a smaller pool of “divisible resources", of which a larger portion (than 58%) can perhaps be retained by the Centre. The FC can then look at the pre-devolution situation of zero revenue deficit across states. This would be a good starting point, and the FC then simply has to ensure adequate funds to all levels of government. In doing so, the FC can be agnostic about the revenue deficit, and refuse to do “gap filling" towards it.

The principle here is that states (and local governments) should be able to meet their basic obligations based on their “own" resources, and not based on what the FC has additionally devolved to them. Of course, the ideal situation would have been more tax autonomy at lower levels of governments, including cities and village councils. But these lower tiers, which have major obligations, are at the mercy of their state governments, which routinely flout state finance commissions. That ideal (seen in more developed economies) is a distant one for India, where cities struggle for finances, and can’t even decide their own property tax rates. But in the meantime, perhaps, the FC15 can be kinder and more generous to states, and especially to lower tiers.

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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