The 16th Finance Commission (FC) is about to be constituted for recommending the devolution of Central taxes and grants to States. The RBI’s just published report: “State Finances: A study of Budgets” has red-flagged the issues the FC will certainly be asked to look into, like States reverting to the Old Pension Scheme (OPS), and unsustainable subsidies flowing from the guarantees or freebies promised at the time of elections, regardless of the financial conditions of States.

Under Article 280(3) of the Constitution, apart from recommending the devolution of taxes and grants-in-aid to the States, the FC may be asked by the Centre to look into any other issue “in the interest of sound finance”.

The 15th FC proposed measurable performance-based incentives for States in “incurring expenditure on populist measures”.

Curbing populism

This attracted widespread criticism, because both States and the Centre indulge in populisms to serve their respective political ends. Besides the two may also differ on what constitutes populism. It also may amount to Centre’s intrusion into States’ legislative powers.

A better mechanism to control such expenditure would be through consensus between the Centre and the States rather than through FC devolution, but this is well-nigh impossible given the fractious nature of politics in India.

As the 15th FC noted in its report, States also stressed that the categorisation of schemes into populist and non-populist cannot be done objectively, as development requirements differ from State to State. Also since elected governments are accountable to the States’ people, it is they, rather than the FC, who should have the prerogative of deciding welfare schemes.

The FC’s response was only to lay down the principle that adequate incentives should be given to States based on outcomes, and the outcome-based indicators should be fixed against each incentive using credible and verifiable data.

The FC provided some sector-specific incentives on health, education, agriculture, etc., based on the above principles. The issue is almost certain to be referred again to the 16th FC in view of the deteriorating finances and rising debt of States post-Covid.

Other institutions, like the Supreme Court or the Election Commission before whom the matter came up, could also not do much.

After all, delivering welfare remains primarily a legislative function, not judicial. But the single-minded focus of political parties to win elections at any cost is driving the need and urgency of checking such profligacy.

Finance Commission may not be equipped or even mandated to deal with the political aspects related to freebies, but since in recommending transfers, it must consider the finances of both the Centre and the States, it can play a positive role in highlighting the strains in finances that freebies create, often forcing States to borrow beyond their capacity and passing on the burden to future taxpayers, affecting future growth.

FC transfers are generally based on the triple criteria of equity, equalisation and efficiency. But fiscal efficiency has been treated as dispensable by the FCs, while equalisation has taken the driver’s seat. While the 14th FC did not consider any efficiency criteria, the 15th FC gave only 2.5 per cent weightage to the fiscal efficiency as measured by tax effort (Own Tax to GSDP ratio). The RBI report rightly argued for fiscal efficiency parameters to encourage fiscal consolidation.

Of late, some Opposition-ruled States have reverted to the OPS under which governments incurred indefinite liabilities toward their employees’ pension, reversing the New Pension Scheme (NPS) introduced in 2004, whereby this liability was limited to the serving life of the employees.

Five States have already done so, while two others — West Bengal and Tamil Nadu — have never even implemented the NPS. An internal RBI study measured this liability to be 4.5 times more in case of OPS compared to the NPS, with the additional burden reaching 0.9 per cent of GDP by 2060. The RBI report pointed out that this retrograde step will restrict growth, undermine the benefits of past reforms and compromise the interest of future generations.

Excessive expenditure

FCs provide grants to States for bridging any post-devolution revenue deficit the States may face, which acts as a disincentive for States to undertake fiscal reforms.

Many States have deficits because of subsidies for populist measures like free electricity etc.

An assessment of the FY2022 Finance Accounts of all States show that States spent 0.87 per cent of their GSDPs on the average on subsides, but a few States spent much more (Punjab 2.35 per cent, Rajasthan 1.92 per cent, MP 1.69 per cent, Chhattisgarh 1.62 per cent, Bihar and Jharkhand 1.58 per cent, etc.). The argument that backward States need more funds to improve delivery of services falls flat in view of these data.

Populism of a particular State cannot be financed by taxpayers of other States which is what any FC transfer does in effect. The RBI report rightly argued for the FC to consider higher share of conditional transfers to States “based on reforms, quality of expenditure and fiscal sustainability.”

If populism is the choice of a State, it must be at its own cost and risk. If it passes the cost to future through unfunded borrowings, it must pay the price.

The writer is currently a Professor of Practice at the Arun Jaitley National Institute of Financial Management and former Director-General at the Office of the CAG of India,