Providing incentives and closing loopholes

The Twelfth Finance Commission marked a watershed in the use of incentives, which clearly improved state finances. The government was finally arbitraging the renowned Indian ability to arbitrage. We are quick to respond to incentives but for a long time the system misdirected our efforts.

The Thirteenth Finance Commission widens and deepens the use of this potent weapon. The focus of earlier Commissions was on half-hearted rewards for efficiency, with equity as the prime criterion. As a result, neither efficiency nor equity improved. Incentives are forward-looking, and by directing behaviour in productive directions raise future equity.

Many special purpose grants are designed to motivate desired outcomes in critical areas —education, power, water supply, environment, connectivity, GST, standardisation, justice, funds for local bodies — all necessary to empower citizens. The devolution to states from the central pool has been raised to 32 per cent (from 30.5 per cent) to compensate for differing elasticity of Central and state tax revenues. The formula itself rewards better revenue raising efforts. The criterion of equalising ability to deliver standard public services through the country remains. The distribution across states does not differ too much from past awards.

Rewards require better data and better monitoring. Therefore, there is a focus on improved statistical systems and accounting, and on setting up many expert commissions and reviews. The latter have often served Indian democracy well, but it is necessary to pay more attention to their design and independence.

The Commission also seeks to close loopholes the Centre has itself been arbitraging. For example, it discourages the use of cesses and surcharges (which escape the central pool of taxes) and centrally sponsored schemes (in favour of untied formula based transfers). But here it is restricted to a weak “should”.

The proposed new path of fiscal consolidation draws heavily on and seeks to maintain India’s growth dividend. There is only a gentle attempt to close the Centre’s favoured loophole of reducing capital expenditure. Stricter constraints on the revenue deficit and more bite for the medium term fiscal plan are suggested. Incentives have worked well for States but remain weak for the Centre.