Successive Finance Commissions (FCs) have kept the Indian federation going by judicating between the Centre and the States. As a non-political body above conflicts of interest it is one of the sterling institutions that sustain Indian democracy.

But as Plan expenditures were prioritised under planning, the original constitutional mandate, which was to equalise opportunities for every citizen by ensuring uniform public services, got diluted.

History can be a trap. Past FCs were normally reluctant to rock the boat and lose credibility by doing anything very different. And the average Indian continued to suffer from poor public services.

Improving the level and uniformity of public services can be a useful lens through which to look at the terms of reference (TOR) of the 15th FC.

Today when institutions associated with planning have finally been disbanded, and Centrally Sponsored Schemes (CSS) are being rationalised, the 15th FC has the opportunity to revert to the original mandate. After a critical mass of change has taken place small steps can make a big difference to correct inadequacies in the functioning of India’s federation.

Carrot and stick

The emphasis in TOR 4 on incentives has created considerable unease. Tax share is regarded as a right, and therefore States resist conditionalities in devolution. But States themselves have not devolved funds and functionaries to the third tier as required in the 73rd and 74th Amendments to the Constitution, or in some cases even set up State finance commissions (SFCs) to do so.

There are no limitations, moreover, on imposing conditionalities on grants in aid of revenue and in CSS. These can, therefore, be used to design incentives for future action or to reward capacity building, including at the third tier, as well as institutional improvements such as setting up SFCs or proper accounting processes.

States delay giving the final urban status to rapidly growing census towns because of tax and municipal service provision issues. Towns themselves do not want to lose rural development funds. One reason public services are so poor is that facilities tend to be cut to match the funds available, rather than raising funds to provide a uniform level of services. The required change can be incentivised.

The 13th FC introduced incentive payments but since capacity constraints prevented some States from utilising them, the14th FCs shifted to payments towards capacity building. Data is required on what worked. Ten years is a long time — it cannot take forever to build capacity.

The 12th FC had the most success with a combination of carrots and sticks — debt restructuring conditional on acceptance of State-level Fiscal Responsibility and Budget Management (FRBM) legislation. Therefore the 15th FC could give funds conditional on implementing devolution to the third tier, with payments made for improvements in rather than for levels of services provided.

The CSS can be rationalised and clubbed further. The ₹3.5 lakh crore paid currently could be partly replaced by well-targeted central direct benefit transfer (DBT) to individuals. Economies of scale from pooling and coordination efficiencies may reduce costs in health and education where dual responsibilities have eroded the delivery the Constitution mandates. There are many CSS in these areas, for example, piped water, Swachh and Ayushman Bharat.

A major issue is that of independence versus uniformity for States. Richer States or those with competitive own schemes may want to opt out of CSS; they could be given the choice, conditional on outcomes being above a threshold. This may encourage healthy competition in schemes. Appropriate compensation in devolution could be on the basis of quality adjusted least cost schemes.

All this requires good measurement. A rich database is needed, also for other TORs such as 3 and 7 on assessing revenues and needs. But this is the age of big data. NITI Aayog has long been ranking States on various criteria.

A Permanent Fiscal Council could be set up and be made responsible for conditional data-based fund devolution to States with other functions as a non-political fiscal watchdog. The Inter-State Council could be revived in order to get participation and feedback from States for a vibrant fiscal federation. The smooth working of the GST Council shows it is possible. Sanctioning delays may also reduce. The taking over of erstwhile Planning Commission functions by central ministries, has created resentment among States.

Research at IGIDR suggests that incentives work. Intergovernmental transfers, given tax capacity, have a negative association with tax effort of States. FRBM improved States’ tax effort. Although now there is GST, user charges are a major area where States still have to make efforts. Larger expenditure responsibilities are followed by higher tax effort. Ring fencing productive expenditure, therefore, could also raise revenue effort.

An award in line with broad principles of justice, such as linking incentives to delivering constitutional responsibilities, would generate less resistance.

Reducing States’ debt

TOR 2 covers reducing States’ debt. The FRBM review committee’s focus on debt and fiscal deficits has led to a rise in revenue deficits. It is necessary to safeguard expenditure that creates future income. Encouraging higher growth brings down debt ratios as growth rates normally exceed interest rates on catch-up growth paths. Fiscal deficit directly adds to borrowing but rise in revenue deficit decreases growth and therefore slows reduction in debt ratios. Any deficit path should itself have some counter-cyclicality built in.

There is now also more market discipline on States. There are plans to increase it further by releasing more high frequency data on State finances to enhance rating. Currently borrowing costs remain similar despite widely varying levels of debt. There is no default risk and an automatic debit from RBI on payment date. But earlier they relied on FCs to cover gaps, now they have FRBM caps.

To borrow from markets they have to get consent from the Centre under Article 293(3) of the Constitution. An indicator of the hard budget constraints they face is that while State revised expenditure estimates often exceed budget estimates, actuals are less than revised.

Expenditures are cut, and these are often developmental and capital expenditures. Incentives must, therefore, also protect the quality of expenditure.

The writer is Professor, IGIDR, and Member EAC-PM