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Mainstream, VOL LIX No 43, New Delhi, October 9, 2021

Fifteenth Finance Commission Recommendations: Economics mixed with Politics? | Govind Bhattacharjee

Friday 8 October 2021

by Govind Bhattacharjee*

The terms of reference (ToR) of the Fifteenth Finance Commission (FFC) had said it all, that the Centre should be more equal than the States, and that this was what it meant by cooperative federalism. The ToR was heavily skewed in favour of the Centre — and one could not be accused of prejudice to think that like in every other aspect of economic policies, here too the vote-bank politics might have played a part in suggesting an elaborate set of guidelines to the FFC. This was nothing new, irrespective of the party dispensation, past history shows that the Centre has always tried to use the Constitutional mechanism of Finance Commission (FC) to further its own agenda.

Finance Commissions are constituted once every five years under the first two clauses of article 280 of the Constitution. They recommend transfer of central resources to the states by two mechanisms provided in the third clause of article 280: transfer through devolution of taxes and transfer through grants, keeping in mind the redistributive considerations as well as fiscal needs of the states. A sub-clause, 280(3)(d), also allows the Centre to refer “any other matter” to the Commission “in the interest of sound finance”. The transfers are determined by three guiding principles of equalisation, equity and efficiency, though this was specifically mentioned for the first time in the ToR of the FFC. These criteria are reflected in the parameters which have been used by the successive FCs: (1) equity in the weightage given to need-based criteria like the population or the area of a state, (2) efficiency in the weightage given to tax effort (defined by the State’s own tax to GSDP ratio), financial performance, or fiscal discipline (defined by the ratio of own revenue of a state to its revenue expenditure), and (3) equalisation in the weightage given to what is called the distance criteria — like distance of per capita income from the highest per capita income state, or distance of fiscal capacity, also related to the ratio of State’s own tax to its income, from the highest fiscal capacity state. Equity was introduced as a parameter by the FC-III, the weightage attached to equalisation has increased since FC-VII and the weightage attached to the efficiency parameters varied with successive FCs, with FC-XIV completely ignoring it, which cost the poor states dear.

The ToR of the FFC was criticised severely for distorting the delicate balance in federal financial relations between the Centre and the states and there was much substance in the criticism. The ToR of the FFC included many issues beyond its constitutional authority and even competence, like asking it to propose “measurable performance-based incentives for States” in respect of “progress made in moving towards replacement rate of population growth”, “achievements in implementation of flagship schemes” of the Government of India, “progress made in promoting ease of doing business”, “progress made in sanitation, solid waste management and bringing in behavioural change to end open defecation”, “expansion and deepening of tax-net under GST”, or “control or lack of it in incurring expenditure on populist measures”. These are much larger issues of public financial management beyond the expertise or authority of the Commission, to decide which the bodies of elected representatives are the only proper fora. Some of the issues are highly questionable too, like control of expenditure on populist measures since there will never be any agreement between the Centre and the States on what constituted populism, and even otherwise, both the Centre and the states would be equally guilty of it. It was grossly unfair to ask the state governments to control their “populist” expenditure while giving the Centre a free hand to continue to indulge in it. Many of the issues are also beyond the capacity of the states to control.

But the clause that generated the most heat was the change in the population criteria which mandated the FFC to use the 2011 census figures instead of 1971 census, which would reduce the shares of all states outside the Hindi heartland. Except the six Hindi heartland states, all other states in India have succeeded in controlling their population to the extent that their fertility rates are either below the replacement level of 2.1, as in the case of all southern states, or very close to it, for which they genuinely felt they were unfairly being penalised. This is where politics probably comes, because the states which would benefit most from these change in the base year are the six Hindi-belt states of Uttar Pradesh, Madhya Pradesh, Bihar, Jharkhand, Rajasthan and Chattisgarh, which together share 42.85 percent of India’s population as per the 2011 census. Higher population means higher number of seats in Parliament, and these six states, of which three (UP, Bihar and MP) are ruled by the NDA, share among themselves as many as 198 MPs in Parliament. In contrast, the five southern states which would stand to lose on this account share among them only 129 seats, of which only one — Karnataka - is ruled by the NDA. The respective shares of the different groups of states are shown in

Table 1.
Table 1: Respective shares of States in population, tax —devolution, and no. of MPs

Group of States Share of Population (2011) Share of Tax Devolution by FFC (%) Total number of MPs in Parliament
Hindi Belt (6)UP, MP, Jharkhand, Rajasthan, Chattisgarh 42.85 48.57 198
Southern (5)Tamil Nadu, Karnataka, Kerala, Andhra Pradesh, Telangana 21.32 15.80 129
Western (3)Goa, Gujrat, Maharashtra 14.37 10.18 76
Eastern (2)Odisha, West Bengal 10.98 12.05 63
Northern (2)Punjab, Haryana 4.37 2.90 23
Special category States (10) 5.32 10.48 33

Of course, it would be preposterous to suggest that the FFC has deliberately catered to the political agenda of the ruling coalition, but it would lend some semblance of a credence to the criticism that such calculations might have entered the framing of the ToR, in which case it was the duty of FFC to draft their recommendation in such a way as to be seen to be above all political ramifications, as all FC recommendations have always been. But the FFC’s recommendation did little to address the concerns of the non-Hindi belt States, and its report also seems to have compromised to some extent the objectivity expected of any Finance Commission, though by and large it tried its best to strike a fine balance between the competing demands of the Centre and the States.
The horizontal distribution formula used by the last 4 FCs to determine the inter-se share of the states in total devolution is summarised in table 2:

Table 2: Criteria used by different Finance Commissions


Criteria Weights (%)
 
Equity
Population (1971) 25 25 17.5  
Population (2011)       15
Demographic Change since 1971 (2011 Population)     10  
Area 10 10 15 15
Equalisation
Income Distance 50   50 45
Fiscal Capacity Distance   47.5    
Efficiency
Demographic Performance       12.5
Tax Effort 7.5     2.5
Fiscal Discipline 7.5 17.5    
Environment
Forest and Ecology     7.5 10
Total 100.0 100.0 100.0 100.0

Source: Reports of the Respective Finance Commissions

As can be seen from the above, equalisation criteria commanded the major share of the tax transfers for all the past four FCs, with FC-XI giving it an even higher weightage of 62.5 percent (not shown in the Table). This had attracted the criticism that there was no incentive for fiscal performance of a state and it bred complacency among the backward states in the absence of any performance criterion. FC-XII had given a total weightage of 15 percent to the efficiency criteria and FC-XIII increased it further to 17.5 percent, justifying this by stating emphatically:

“There is a strong case to incentivise states following fiscal prudence, particularly in the context of the need to return to the path of fiscal correction. We have, therefore, assigned a weight of 17.5 per cent to fiscal discipline.”

These criteria were strangely dropped altogether by FC-XIV, and it affected the poorer states - Assam, Bihar, Odisha, Rajasthan and UP - which had performed better in this respect, expecting a reward for their adherence to fiscal discipline. Table 3 shows the respective shares of the states in tax devolution in the awards of successive FCs.

Table 3: Share of major States in Fc recommendations (percent)

State FC12 FC13 FC14
Union Taxes (excluding Service Tax) Service Tax Union Taxes (excluding Service Tax) Service Tax Union Taxes (excluding Service Tax) Service Tax
Andhra Pradesh 7.356 7.453 6.937 7.047 4.305 4.398
Assam 3.235 3.277 3.628 3.685 3.311 3.371
Bihar 11.028 11.173 10.917 11.089 9.665 9.787
Chhattisgarh 2.654 2.689 2.470 2.509 3.080 3.166
Goa 0.259 0.262 0.266 0.270 0.378 0.379
Gujarat 3.569 3.616 3.041 3.089 3.084 3.172
Haryana 1.075 1.089 1.048 1.064 1.084 1.091
Jharkhand 3.361 3.405 2.802 2.846 3.139 3.198
Karnataka 4.459 4.518 4.328 4.397 4.713 4.822
Kerala 2.665 2.700 2.341 2.378 2.500 2.526
Madhya Pradesh 6.711 6.799 7.120 7.232 7.548 7.727
Maharashtra 4.997 5.063 5.199 5.281 5.521 5.674
Orissa 5.161 5.229 4.779 4.855 4.642 4.744
Punjab 1.299 1.316 1.389 1.411 1.577 1.589
Rajasthan 5.609 5.683 5.853 5.945 5.495 5.647
Tamil Nadu 5.305 5.374 4.969 5.047 4.023 4.104
Uttar Pradesh 19.264 19.517 19.677 19.987 17.959 18.205
Uttaranchal 0.939 0.952 1.120 1.138 1.052 1.068
West Bengal 7.057 7.150 7.264 7.379 7.324 7.423
All 100.000 100.000 100.000 100.000 100.000 100.000

Source: Reports of the respective Finance Commissions

FC-IX recommendations were criticized on this account and it was expected that FFC would address this issue. But FFC gave efficiency as measured by tax effort only 2.5 percent weightage, and that too was distorted by the formula used by it, which again favoured the Hindi belt states because population again entered the calculations. Tax effort is defined in terms of the ratio of average per capita tax to average state income (GSDP) for three years but it was scaled to the 2011 population. This resulted in bizarre anomalies - like Bihar’s share in terms of tax effort exceeded that of all states except Uttar Pradesh and Maharashtra, as seen from Table 4.

Table 4: Per capita share of states vis-à-vis Tax effort 

States Overall share of states in devolution (%) Tax Effort Performance
Tax : GSDP ratio (f) per capita f*2011 population Per capita share (%)
UP 17.939 7.00 13983008 18.825
Maharashtra 6.317 6.97 7833503 10.546
Bihar 10.058 5.46 5682760 7.651
West Bengal 7.523 5.44 4963550 6.682
MP 7.850 6.72 4881533 6.572
Tamil Nadu 4.079 6.47 4667354 6.284
Rajasthan 6.026 6.12 4192976 5.645
Karnataka 3.647 6.63 4051084 5.454
Gujrat 3.478 5.94 3587565 4.830
Punjab 1.807 6.30 1748247 2.354

Source: Report of the FFC, Vol 2, Annexure 6.5

Of course FFC has reckoned demographic performance as a performance criteria which has nothing to do with fiscal performance. In fact, it did not consider the fiscal performance criteria at all in its approach which only focussed on equity and equalisation criteria:

“The horizontal devolution formula is designed to focus on specific objectives to be achieved through such devolution, such as: (i) to help bridge the vertical fiscal gap of the States; (ii) to provide horizontal equity (by providing higher share to poorer regions); (iii) to equalise fiscal capacities of States (revenue equalisation); (iv) to provide for cost differentials among States for providing basic public service (expenditure equalisation).” (Para 6.33, FFC Report, 2021-26, Vol I).

While noting that tax effort was necessary to incentivise the states to improve their performance, it was silent on why it was given such a low priority:

“The FC-X, FC-XI and FC-XII have used tax efforts of States as a criterion in the devolution formula to reward State’s own tax performance. Many States have suggested inclusion of tax performance criteria to incentivise States with higher efficiency of tax collection. This Commission is of the view that the inclusion of tax effort as a criterion will reward the States with higher tax collection efficiency and, at the same time, will also encourage all States to be more tax efficient.” (Para 6.55, FFC Report, 2021-26, Vol I).

It thus seems that fiscal efficiency of financial performance is no longer a priority for the Finance Commissions and considerations of equalisation will continue to dominate their thinking. While removing regional imbalance should of course be a top priority for any FC, sacrificing efficiency altogether goes not only against the spirit of fiscal and cooperative federalism, but also works against the long term interest of all states.

Even in respect of demographic performance, scaling it to 1971 population again benefited the same Hindi-belt states. The Demographic performance criterion used by the FFC was defined as the inverse of the total fertility ratio multiplied by the 1971 population, and inter-se share of the states in determined by the its demographic performance divided by the sum total of demographic performances of all states. This has curiously resulted in UP’s share exceeding that of all other states; even Bihar’s share looks quite respectable compared to Gujrat’s, as can be seen in table 5. The true demographic performance would be adequately measured by the inverse of fertility ratio alone, but using a twisted formula that the FFC did resulted in this inexplicable scenario. It certainly raises doubts in our minds, since it is inconceivable that such a simple logic would have escaped some of the finest minds in the country who served as its members.

Table 5: Per capita share of states vis-à-vis demographic performance 

States Population Share 2011  Demographic Performance
(%) Reciprocal of TFR (f) f*1971 population Per capita share (%)
UP 16.959 0.38 32.126 12.318
Maharashtra 9.538 0.52 26.394 10.120
West Bengal 7.747 0.60 26.376 10.113
Tamil Nadu 6.124 0.63 26.075 9.998
Karnataka 5.186 0.55 16.187 6.207
Bihar 8.836 0.34 14.378 5.513
Gujrat 5.130 0.49 13.151 5.043
MP 6.164 0.38 11.413 4.376
Rajasthan 5.818 0.36 9.202 3.528
Punjab 2.355 0.54 7.286 2.793

Source: Report of the FFC, Vol 2, Annexure 6.1

Apart from these anomalies, however, the report contains many positive points, which would substantially improve the public financial management in the country as everybody recognises; these include reducing the off-budget borrowings, rationalisation and simplification of the GST structure, its emphasis on healthcare expenditure — a perpetually neglected area whose price the country is paying now. While time alone will prove how many of these recommendations would be acted upon by the Government, the FFC recommendations fell short of expectations in respect of the Centrally Sponsored Schemes (CSS) which were a legacy from the Planning Commission Raj. Most of these schemes lacked any economic logic and could produce no visible impact. Even after restructuring of the CSS by the NDA government, there are still a large number of schemes clubbed together under several umbrella schemes — these ought to have been rationalised and their numbers reduced. But the FFC merely recommended a re-evaluation of the need to continue such schemes. Leaving it to the politicians to scrap something they perceive as politically pragmatic is bound to be pointless. For the same consideration, the FFC’s recommendation regarding setting up of an independent, advisory Fiscal Council with powers to access governmental records is also likely to be ignored by the Government, which may not like its absolute control of finance to be diluted in any manner.

(Author: Govind Bhattacharjee is a former Director-General from the Office of the Comptroller & Auditor General of India and currently a Professor at the Arun Jaitley National Institute of Financial Management. )

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