The Narendra Modi government wants some of the funds it transfers to states to be linked to how they perform on its pet programmes such as Digital India, Ease of Business, Direct Benefit Transfer and Swachh Bharat. It also wants to monetarily penalise the states that undertake “populist measures”.

Additionally, the government has asked the Fifteenth Finance Commission to recommend “performance-based incentives” for states for widening the Goods and Services Tax net, steadying population growth, implementing the sustainable development goals, eliminating power sector losses, reforming labour laws, and “removing layers” between the state and the beneficiaries of its schemes.

Finance Commission is constituted once every five years to recommend how much of the money collected by the central government in taxes should go to states annually, and how. This money is in addition to what the Centre sends states for running its pre-designed social and development schemes.

The Fifteenth Finance Commission was notified on November 27 and it will submit its report by October 2019. Its recommendations, once accepted, will dictate the Centre-state revenue sharing for the five financial years starting 2020-21. Although the commission has only recommendatory powers, governments have always accepted its devolution formulas.

Source: Notification of the Fifteenth Finance Commission, November 27, 2017.

Changing tack

The terms of reference for the commission suggest a change of heart by the Modi government. In 2015, the prime minister patted his government’s back for giving states greater autonomy in utilising central funds, saying it was in keeping with his administration’s “cooperative federalism” mantra. He said this while accepting the award of the Fourteenth Finance Commission, which had recommended that states should get 42% and not merely 32% of the central tax collection a year, and unconditionally. It was a radical decision, giving states an additional Rs 1,78,000 crore in 2015-16.

At the same time, the government cut funding for some of the Centrally Sponsored Schemes – social development programmes related to health, education and agriculture based on criteria and conditions set by the Centre – that are implemented by states.

But now the Modi government has asked the new commission to review the higher devolution of funds to states. While the commission’s recommendations will decide the exact nature of conditions the Centre eventually imposes on the funds transferred to sates and the quantum of funds linked to these conditions, the terms of reference show the Modi government wants to redefine its mantra of “cooperative federalism”.

This means states would have to reassess where and how they spend their money and that received from the central government.

Source: Notification of the Fifteenth Finance Commission, November 27, 2017.

The commission’s terms of reference suggest the Modi government wants to use a fiscal carrot and stick policy to compel states to follow its agenda more closely – incentivising them to follow its pet themes and social schemes and disincentivising them from having their own “populist measures”. The term “populist measures” is not defined in the Indian administration system. It’s often employed by market-friendly economists to disparage subsidised schemes and services that governments run for disadvantged citizens.

Ironically, while he was chief minister of Gujarat, Modi would complain about the now-disbanded Planning Commission putting conditions on central grants to states. He was not alone. Most state governments have long demanded greater flexibility to shape social and economic development programmes according to their specific needs and priorities.

Revamping relations

Since the Modi government took power in 2014, Centre-state fiscal relations have been overhauled at various levels.

By disbanding the Planning Commission, the Modi government did away with the mid-term evaluation that the commission did of development programmes across the country. The Fourteenth Finance Commission set a different path for central-state fiscal relations by enhancing the unconditional sum of money that states got from the central revenue collection – specifically, the divisible tax pool, which is the Centre’s total revenue collection minus the cess it charges – from 32% to 42%. The hike was unprecedented; finance commissions generally recommended an increase of 1%-3% every five years.

The government accepted the arrangement but didn’t effect the structural reforms the commission had asked for to serve this new Centre-state fiscal relationship.

It did, though, set up a committee to rework the Centrally Sponsored Schemes. The idea was that since states now received funds unconditionally, they could draw up their own plans, thereby allowing the Centre to limit the amount of money it gave them for running the central schemes. The problem was that a decade of overcentralised planning had left states with little capacity to draw up their own plans.

It is for such reasons critics say the government has not gone far enough in revamping Centre-state fiscal relations. “The Fourteenth Finance Commission recommended setting up a new institutional mechanism to act as a platform for identifying specific grants by the Union to states and help design schemes with appropriate flexibility,” said Yamini Aiyar, president and chief executive of the Centre for Policy Studies. “But that did not happen. Instead, states have become dependent on the finance ministry to decide allocations for schemes. The finance ministry’s rightful role is to keep a check on funding and that is what it’s doing. What we have now is the same schemes running without real changes but with curtailed funds for some.”

Some experts, however, argue that it is too early to understand how states have dealt with their changed financial relationship with the Centre. Therefore, they warn against tinkering with it yet again.

Pinaki Chakraborty of the National Institute of Public Finance and Policy and others have shown that states have used the additional unconditional central funds they got in 2015-16 to increase allocations towards social sector, such as education.

But, as both Chakraborty and Aiyar pointed out, data on actual expenditure made by states after the Fourteenth Finance Commission’s award is available for only 2015-16. There are only revised numbers for 2016-17 and budgeted allocations for 2017-18. There are huge fluctuations between these different sets of data.

“Greater autonomy for states to design their development agenda is the right way to go,” Aiyar said. “The Centre should have done more to build states’ capacities. In principle, performance incentives, if designed right, are a good fiscal instrument. However, I think the terms of reference for the finance commission are framed to impose more conditions on states linked to central government priorities, such as performance on flagship schemes, savings due to DBT. This is problematic.”

But Chakraborty warned against reading too much into the terms of references. “The unconditional devolution from the divisible tax pool constitutes more than three-fourth of the total funds that are transferred to states from the award of the commission,” he explained. “The new conditions would apply only to rest of the funds and the commission will decide how. Conditionalities were attached earlier too. In a way, the Fourteenth Finance Commission broke from the trend. It is premature to say what would happen. We have to wait for the new commission to give its recommendations.”

Indeed, the terms of reference for the commission limit the parameters it can study to make its recommendations but it is free within that canvas to draw its conclusions however it wants. The impact of the Fifteenth Finance Commission would be much greater if recommends both a reduction in the states’ share of unconditional funds from the divisible tax pool and imposition of conditions on other fund transfers from the central government.

In the past eight years, the Centre has transferred 44.7% to 53.7% of the funds it collected as central taxes to states through both the finance commission and its own schemes. The finance commissions’ award has guided the transfer of 50.2% to 59.6% of the funds the Centre has provided to states annually.

Although previous finance commissions too suggested parameters for conditional funds transfers to states, the terms of references for the past four commissions show they were neither as detailed as the terms for the Fifteenth Finance Commission nor linked to specific schemes, ideas and programmes of the ruling party.