16th Finance Commission's political challenge

There are fundamental issues to harmonious inter-governmental fiscal relations that the Centre must take into account when constituting the Commission

The Sixteenth Finance Commission will shortly be appointed and receive its terms of reference (ToR) from the Government of India (GoI). “Sixteenth” suggests a chronologically stable process, but the reality is quite the opposite. The current juncture in intergovernmental fiscal relations in India is vitiated by political and institutional contestation and emergent structural trends that make business as usual untenable. 

The Fourteenth Finance Commission report significantly increased the devolution of funds to states and abolished most grants. This was accepted by the Centre, which then sought to promote cooperative federalism. Over time, this has reversed. The abolition of the Planning Commission has given the central finance ministry supreme discretionary authority over capital grants. The central government has become more prescriptive and authoritarian in its dealings with the states. There is little political engagement in this process, which is bureaucrat-driven. Also, its actions signal a somewhat weak authoritarian regime. This signal was recently reinforced by the transfer of government audit officials who pointed out problems in the Prime Minister’s pet welfare schemes, while the bureaucracy responsible for these problems got away scot-free. No Prime Minister exercising strong political authority would defer to the bureaucracy by shooting the messenger.

Weak authoritarian regimes exercise coercive power wastefully with little understanding of the damaging consequences of misuse. There is no immediate consequence when engaging in petty coercion — locking up youth, the old and sick, or harassing think tanks and intellectuals. However, the consequences can be serious when it comes to intergovernmental relations.

The ToR of the Fifteenth Finance Commission was an embarrassment, drafted by a bureaucrat with little understanding of political nuance. It spoke airily of freebies and “wasteful” expenditure by states, tried to sequester money for central expenditures like defence, and opened a Pandora’s box on the population issue. It is to the credit of that Commission and its nuanced use of English language drafting skills that it averted what could have been a massive political storm.

This time round, the stakes have changed and are much higher. There are many points of conflict but three of these are particularly stark.

First, the central government is in a weak fiscal position. The central fiscal deficit is at an all-time high. Economic growth is sluggish and not inclusive. Efforts to significantly raise tax revenues and to sell public assets have failed miserably. Total public sector capital expenditure remains flat. The government is therefore unable to raise revenue or sell assets — but borrowing is peaking at levels above which macroeconomic stability would be jeopardised. To deal with the situation, the GoI has been systematically depriving the states of their rightful share of the divisible pool. The states’ share in gross tax revenue has been steadily declining due to the indiscriminate and lumpen resort to cesses and surcharges (instead of raising tax rates or levying fresh taxes), which are not shareable with the states. This illegitimate use of central power has generated considerable tension in inter-governmental fiscal relations.

Second, and perhaps most important, it calls into question  a political consensus that has been a hallmark of India’s fiscal solidarity. The largest weight (between 45 and 55 per cent) in the formula that determines which state gets how much tax revenue has, since 1950, been some version of the inverse of state per capita income. The poorer a state, the greater its share. It is quite remarkable that the rich states have never, in 70 years, objected to this. But today the gap in per capita incomes is stark. Uttar Pradesh is poorer than Nepal, with poverty and human development indicators as poor as a crisis-ridden African country. But Telangana and Karnataka are progressing rapidly. Tamil Nadu and Kerala have per capita incomes comparable to Indonesia, with almost zero extreme poverty, and medium-high human development indicators. But it appears that they are being punished for this success with the Damocles sword of population-based delimitation hanging over them, restrictions on further investments in health and education being proposed to bring them to the national average, and continual political irritants inflicted by the party in power at the Centre that has a limited footprint in these successful states.

The acceptance of any formula that transfers resources from high-performing states to low-performing states (as opposed to from rich to poor states) is contentious. It is contingent on improvement in performance of the laggards, a minimum ideological solidarity, and eschewing imposition of brute majoritarian will. At present, none of these conditions hold, which is a matter of great concern.

Third, the Goods and Services Tax (GST) debacle. The egregious record of the Centre in converting compensation cess into loans and the continued inability to resolve the Integrated-GST question, as well as the defenestration of the “Good and Simple Tax “into an regressive, unpredictable and complicated tax, has caused considerable friction and dissatisfaction. The states gave up considerable autonomy to agree to a GST that now appears moth-eaten and unworkable.

These issues are fundamental to harmonious intergovernmental fiscal relations, and the Centre would be well-advised to shed its arrogance, invest political capital, and constitute the Sixteenth Finance Commission, and its ToR sensitively. If it knows how to do so.

The writer is managing director, ODI, London. r.roy@odi.org. The views are personal