Devolution for growth: 16th FC rejigs inter-state formula with care

The Sixteenth Finance Commission had to perform its function amid considerable scrutiny. Over the past decade, relations between the Union and the state governments have declined — and not just for partisan political reasons. A broad range of issues, from the role of governors to the redrawing of parliamentary constituencies, has placed the federal structure of the country under strain of the sort it has not seen in four decades. The Commission thus had the onerous task of ensuring that the division of government revenues would not contribute to these tendencies. Its report, tabled in Parliament on Sunday, needs to be welcomed precisely because it seems to have achieved that purpose. It has re-examined the formula by which the taxes under the divisible pool are calculated, and has included “contribution to gross domestic product” as a factor. This has ensured that the share of some southern states, including Karnataka, as well as of more developed states on the western coast, such as Gujarat, has in fact increased. 

State governments have long argued that their space for policy experimentation and autonomy has been shrinking. Goods and services tax was a necessary reform but it unquestionably reduced their fiscal autonomy. Meanwhile, of the revenue that remained available to them, a larger and larger part was taken up in financing and implementing schemes that were developed and chosen by the Union government — and for which local politicians would receive no political credit. Reduction in their resources would thus have been a dangerous step to take at this point. The Commission has maintained the states’ share in the divisible tax pool at 41 per cent, the ratio chosen by its predecessor. But it should be noted that this is taken out of a pool that is smaller than it should be, because of the Union government’s tendency to resort to various cesses that count as taxes but which it can retain in toto. Thus, the Commission’s recommendations will not end the demands from the states for a larger share — but it may have pre-empted complaints about unfairness. 

The states’ more limited space to manoeuvre may be one of the reasons why their debt is once again beginning to be a concern at a macro level. The Commission has urged that off-Budget borrowing by state governments be stopped. The controlling of state fiscal deficits at around 3 per cent of gross state domestic product (GSDP) was a major reform, and no short cuts around that should be permitted to take hold. Off-Budget borrowing creates more complications. For one thing, this has led to a great loss of transparency about the liabilities of many of these governments. For another, it serves to weigh down the broader bond market. For states themselves, servicing a heavy debt can be a major part of why they feel themselves unable to institute new policies that involve expenditure. The Commission has also done well to recommend the discontinuation of the revenue-deficit grant, which will help improve fiscal discipline. The Commission, which was led by economist Arvind Panagariya, needs to be appreciated for having swum against the political tide and ensured that the more productive states will have resources, and that incentives for fiscal probity and growth-enhancing policies are restored.