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Finance Commission report: Modi's federalism gets boost with bonanza for states

The report of the Fourteenth Finance Commission, tabled in Parliament today, is the first major test of the sincerity of Prime Minister Narendra Modi’s frequent statements about promoting true federalism and making states equal partners in national development.

With his letter to chief ministers saying his government has "wholeheartedly accepted" the core recommendations, Modi has won this round.

 Finance Commission report: Modis federalism gets boost with bonanza for states

Prime Minister Narendra Modi. PTI

The Commission headed by former Reserve Bank of India governor, YV Reddy, has gone a step further beyond the resource sharing recommendations all Finance Commissions do and outlined a new paradigm of Centre-state relations.

The quantum of tax devolution - 42 percent of the taxes (not including sundry cesses and surcharges) collected by the Centre are to go to the states - is itself quite radical. This is a huge hike over the current 32 percent (though it is a little short of the states’ long-standing demand for a 50 percent share). This is also the largest increase in tax devolution since the Seventh Finance Commission doubled the states’ share of excise duties from 20 percent to 40 percent in the mid-eighties. It is also what the Prime Minister’s letter calls "a compositional shift in transfers from grants to tax devolution".

Along with its other recommendations relating to grants to local bodies — Rs 2,87,436 crore — and grants to states running revenue deficits, the Commission has also asked the Centre to ensure that the prevailing levels of transfers to states remain at around 49 per cent of gross revenue receipts. (The total transfer was 39.5 percent in the case of the Thirteenth Finance Commission.) Ouch. No wonder the Medium Term Fiscal Policy statement, tabled along with the budget in July, had indicated that the awards of the Finance Commission and Pay Commission (which is expected later in the year) could pose "significant downside risk to public finance".

In one stroke, the Fourteenth Finance Commission has done three things. One, it has provided a check to the Centre’s growing encroachment on the fiscal space of states. Two, it has made the states a little more equal vis-à-vis the Centre, leaving them less at the latter’s mercy dispensed in the form of conditional resource transfers. Three, in doing this, it gives them greater fiscal autonomy and policy space to pursue their own development models. After all, the bulk of developmental expenditure is done by the states. Even in the case of financing of disaster management through the funds envisaged under the Disaster Management Act, 2005, the Commission gives greater discretion to states in deciding the disasters these will be used for, even if they are not in the notified list of disasters.

The Commission has done something similar for the local government institutions vis-à-vis the state governments. Its recommendations are designed to increase the flow of resources to the local bodies in "an assured, objective and untied manner". With this huge amount for local bodies, states will have little excuse to deny them funds, something that is often done.

But all this is, in a sense, what the Commission itself calls "continuation of the past". But it has also charted a new course in some crucial respects, based on what it calls "assessment of an evolving environment".

The Commission has suggested breathing new life into the moribund Inter-State Council to create "a new institutional arrangement consistent with the overarching objective of strengthening cooperative federalism". This beefed-up Council, with "meaningful participation" by states, will identify sectors that will be eligible for grants from the Centre, help design schemes while providing states enough flexibility to implement them and identify and provide area-specific grants. This, in effect, will free states from the tyranny of cookie-cutter centrally-sponsored schemes, whose design may not be appropriate for their peculiar conditions.

Pointing out "that a compelling case has been made for reforming the existing system of fiscal transfers. . . in a comprehensive manner", the Commission has minimised the use of conditionalities and incentives in transfers from the centre to the states and in grants to local bodies. It has also increased untied transfers. This, it says, "reflects our trust in all tiers of governments".

There’s more. The report also recommends how states can be given more elbow room for developmental spending within an otherwise inflexible fiscal discipline framework and thinks it is quite fair for the states to get a small share from the proceeds of disinvestment.

"We believe that the recommendations of the Finance Commission should contribute to greater trust between the three layers of government . . . and promote cooperation and competition," the Commission has said in its report. The Commission appears to have treated states and local bodies as mature adults who need to be given a larger measure of freedom than they now have. "We have proceeded on the assumption that. . . all three layers of government are equally endowed with wisdom, knowledge, integrity and effectiveness appropriate for the tasks assigned to them in the Constitutional and legal framework."

Modi’s prompt acceptance, however, should not be hyped up too much. Though, on paper, the Central government is not bound to accept the recommendations of the Finance Commission, there has been no history of any government not implementing the core recommendations on tax devolution.

(The core mandate given to Finance Commissions by the Constitution is to recommend how taxes collected by the Central government are to be shared with, and distributed among, states for a period of five years. Other mandates also get added on but recommendations on these have not always been implemented.)
There was an issue during NDA 1 when the states were unhappy with the then Commission’s recommendations and wanted a discussion. But the government said any change could be done only by another Finance Commission.

But the Modi government has passed the test by immediately identifying up a list of 30 centrally sponsored schemes which should have been transferred to the states and deciding to delink eight from support from the Centre. The others are those involving the achievement of national priorities and certain rights-based entitlements which are now a law.

It's not as if Modi has not matched his words about genuine federalism with deeds. The setting up a more federal Niti Aayog in place of the over-centralised Planning Commission with a brief that is very similar to what the Finance Commission has recommended for the Inter-State Council, is a huge step. (Could some tips have been taken been borrowed from the Finance Commission report? The Niti Aayog was set up in January and the Commission report was submitted to the government in mid-December.) But many of the recommendations of the Finance Commission are quite radical and it will be interesting to see how the Modi government acts on them.

Though the government has accepted the recommendations, the tax devolution proposals may not have pleased Finance Minister Arun Jaitley, or indeed any finance minister at the Centre. Having 42 percent of the tax revenues taken away will mean having less money to play around with and to seriously figure out ways to rationalise spending. Jaitley refused to put a number to the amount that he will have to forego, but former finance minister Yashwant Sinha had said it could be around Rs 1.30 lakh crore.
Though it has been critical of the way in which the Centre has managed its finances and muscled in on the turf of the states, the Commission has recognised that the former has "a legitimate role" in effecting transfers to states and in pushing schemes in sectors with a high degree of externalities. So, hopefully, the report will push the Centre to limit its role only in such areas and leave the rest to the states.

Perhaps conscious of the criticism it might attract of having exceeded its brief, the Commission has explicitly stated that it has strictly adhered to its terms of reference, addressed issues that arose in its discussion with the Central and state governments as well as local bodies and that its approach has been one of continuity with change. "We did not have an agenda that was independent of the views and issues that were posed to us during our consultations. . . we respect the importance of continuity, even while being conscious of the need to change the nature of federal fiscal relations consistent with emerging challenges and expectations."

Over now to Narendra Modi.

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Updated Date: Feb 25, 2015 12:26:06 IST