Rarely has so much controversy been generated even before a Finance Commission has got down to work fully, as is happening currently. The FC recommends the distribution of tax revenues between the Centre and states, and the allocation of the proceeds among states. The current unease — reflected most recently in a meeting of Andhra Pradesh, Karnataka, West Bengal, Kerala, Punjab and Puducherry last week — is because the Terms of Reference (TOR) for the Fifteenth FC says population data from 2011 should be used to make the recommendations, which are due by the end of October 2019 for the period 2020-25.
Using 2011 data will penalise southern states, which have made considerable progress in population control, and deny them reward for progress made in areas such as health, literacy, education and infrastructure. These states are also upset that the distribution of resources will be based on performance in areas like deepening the GST net, boosting tax and non-tax revenues, promoting the digital economy, and controlling expenditure on populist measures, which is difficult to define. They plan to submit a memorandum to the President to correct the alleged bias against performing — read southern — states.
N Chandrababu Naidu, who is at the forefront of the current protest, had raised this issue when he first became Chief Minister of undivided Andhra Pradesh in the mid-1990s as well. The concerns are, in fact, even older — indeed, for any Commission with a constitutional mandate, balancing the needs of equity and efficiency in a federal structure can be a formidable challenge at any point of time. Nearly 30 years ago, public finance and fiscal policy expert Amaresh Bagchi wrote, “Are we to believe that the population growth of the country will come down if the States experiencing a higher growth are punished with a lower share of Central funds than they would otherwise be entitled to?” (First Award of the Ninth Finance Commission: An Appraisal, National Institute of Public Finance and Policy, December 1988)
Back then, states had expressed unhappiness with the TOR of the Ninth FC, which said the Commission shall keep in view the special requirements of the central government and its committed liabilities, and the special problems of each state. Like now, the wording of the TOR of that Commission too, had been criticised as being insensitive, wit “Commission shall” being interpreted as a directive, rather than guidance, from the government.
The controversy then had also involved the fact that the TOR of the Ninth FC relied on 1971 population data for the devolution of funds. In his 1988 paper, Bagchi noted that using 1971 numbers in the devolution formula “blunts the equalising impact” of the FC’s awards. “As argued forcefully by (economist C H) Hanumantha Rao on more than one occasion, this is an instance of equity being sacrificed for no gain in efficiency,” he wrote.
However, Bagchi also noted that the biggest obstacle to bringing greater equity in the devolution of federal funds by reducing the tax component was opposition by the richer states, and the risk of subjectivity. It did not stand to reason, he said, that “one State can have revenue surplus in per capita terms, as high as 40 times that of another whereas their per capita income ratios differ(ed) by a factor of only 3 or 4”, making the point that richer — or better performing — states ought to be more generous.
Model for transfers
FCs have been mindful of these challenges. After being asked by the 13th FC to evaluate the impact of funds transfers, the Institute of Economic Growth and India Development Foundation created an economic model that classified the Indian economy into high-income, middle-income and low-income regions, and showed that well designed fiscal transfers from high- to low-income regions have net positive welfare implications for all three regions, given their deep economic interdependence. The impact will be higher, it said, if such transfers were utilised for higher expenditure on basic needs and capital formation.
Given that the last few FCs have had additional terms of reference, the states that are unhappy now, may have something to look forward to. Their pitch for a higher share should be seen against the backdrop of fewer greenfield projects, challenges of automation and job-creation, higher capital expenditure on building infrastructure, a less-than-buoyant economy, and the challenges for states in raising funds.