ToR of 15th Finance Commission: It pays to look beyond the population criterion and work out a performance-based formula

The terms of reference of the 15th Finance Commission opens room for debate. The bone of contention is the use of the Population Census of 2011 as part of the criteria for computing the terms of allocation of funds. Population has been one of the parameters but has become controversial as it has been interpreted as being discriminatory on account of the change in the base year from 1971 to 2011 for calculating allocations. While the political twist given is that it appears to be biased against the southern states, the fact remains that when such a change is made, the states which controlled their population growth over the years through progressive measures appear to be penalised.

India has a federal structure and the collection of revenue by the Centre depends on the economic activity in various states. As some taxes like income, corporate, central GST and customs are levied by the Centre; it is but natural that it has to be shared since states provide the actual infrastructure for business. Hence, Maharashtra, which is the most prosperous state would tend to provide high revenue to the Centre. The state has contributed to this growth and hence can claim a part of it. However the Constitution says that what is collected by the Centre in the form of union taxes has to be distributed equitably across states and hence a Finance Commission (FC) decides the formula. To maintain parity, there has to be a tilt towards the worse-off states that would otherwise find it hard to develop. One can’t refute this logic.

The result is that as states become more prosperous, they automatically received lower allocations from the Centre, which has a bias towards states that do not perform. The ‘poorer the state, the better the rewards’ becomes the doctrine, which in turn could create a perverse incentive to remain slow on development. In the private sector such logic would never work, but once it comes to government, the spirit of equality pervades economic thinking. There is no right or wrong here.

Population. Representational image. Reuters

Population. Representational image. Reuters

The FC could work towards bringing out a structure that makes states perform. This means that while there are static parameters that are being used like population, income, forest cover and area, certain dynamic norms have to be introduced and monitored so as to ensure that states perform.

The 14th Commission had a bifurcation where the weight of population was split between the 2011 and the 1971 census with the latter having a weight of 17.5 percent and the former 10 percent. It is assumed that now the full weight (which could go up or down) would be on the 2011 census. The southern states have controlled their population over the last four decades and would hence receive lower allocations if the 2011 census is used.

Performance-based formula

In the past, there is precedent that finance commissions have used performance measures when evolving a formula for devolution, such as fiscal discipline, tax collection and infrastructure progress. Therefore, there is a case for pushing for a performance-based formula that changes every year.

First, the criteria can be established whereby the weights are allocated based on the importance of the parameter. This can include variables like fiscal discipline defined as revenue surplus, fiscal deficit and debt to Gross State Domestic Product (GSDP) ratio. It can cover social standards like health, education and water facilities being provided and economic criteria like infrastructure -- power or roads -- where a direct connection can be made with state effort.

Second, once the criteria are drawn up, the FC can start with an initial allocation of say 15 percent for a state to begin with in the first year. In the second year, if there is an improvement, the share can go up by 25 bps (or any other such increment) or lowered by say 10 bps in case progress is not made. This way, the state has to perform on the standards laid down in order to get more revenue. These norms can be applied to even the more developed states and hence would be inclusive. This would be a fair way out.

At present, there is a premium attached to non-performance because as long as a state is populous and has a lower per capita income, it tends to get higher allocations. This should change. In fact by doing so, state governments have to perform continuously and will have to answer to the electorate at the end of five years in case their allocation has come down because of non-performance. This would provide a positive incentive to perform.

The allocation of resources to states, by the Centre, is always going to be interesting and debatable because the highest collections would be coming from the most productive states.

Ironically, those productive states would receive a lower allocation from the Centre because they are doing well. The rationale is that such states would anyway have more avenues to earn their ‘own revenue’. Therefore redistribution is necessary. On the other hand, those that are less developed have reason to remain so, to garner more resources. By putting in a performance criteria which is monitored every year, the state can be compelled to perform. And they would also put in the extra effort.

It may be recollected that the FC has already given some leeway to states to run higher fiscal deficits, above three percent of GSDP in two slabs of 25 bps each provided they meet a criteria relating to revenue account and interest payments. A similar translation into this space will help to improve the finances of states.

Quite clearly, we need to look beyond the present discord over the population criterion and look at ways to improve the performance of states. The FC should take this opportunity to focus on performance based allocation of resources


Updated Date: May 19, 2018 08:38 AM

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