The Finance Commission must be set up every five years by the President of India, as per Article 280 of the Constitution. The main purpose of this statutory body is to recommend the split of net tax revenues. Its recommendations are almost always accepted by the Union government. The commission is supposed to use its judgement regarding vertical and horizontal equity while deciding a fair split. The former refers to the split between the Union and states, and the latter across all states. There is no mathematical formula, but even then, every commission has tried to be as fair and transparent as possible. Since the first Finance Commission set up in 1951, the vertical split has gone from 10% of the divisible pool for states to 42% in the 14th, before retreating to 41% in the 15th Finance Commission.
While 42% might seem generous, it is not as much if you note the basic asymmetries in India’s federal structure. Purists who are peeved by my use of the word ‘federal,’ since the word is absent in the Constitution, might take a pause! Yes, India is a union of states, and the Union government can create, alter, divide and even extinguish states. The states of India did not pre-exist and nor did they come together voluntarily to form a federation. In that sense, they are the creation of the Centre and have very limited sovereignty. But for a country with a sixth of the world’s population, where several individual states are larger than most countries of the world, the fiscal autonomy of these sub-sovereign entities is a very important issue.
The first asymmetry relates to revenue raising capacity and expenditure obligations. Two-thirds of all government expenses for the delivery of basic public services are the responsibility of the local or state government. This excludes development or capital expenditures. But only one-third of the revenue-raising capabilities are at the state level. Local governments, i.e. the third tier below the state, have negligible taxing powers. This is a structural asymmetry. To the extent that the finance commission’s task is a ‘gap filling exercise’ of funding the deficit at the state level, it becomes imperative that the asymmetry be countervailed by a larger vertical split to the states.
The second asymmetry relates to states’ autonomy in raising debt. If a state falls short in its tax revenue raising capacity, can it access banks and bond investors? The short answer is no. If it is already indebted to the Union government (most states are), then it needs permission to borrow. And accessing foreign banks or bond investors is ruled out.
The third asymmetry arises from residuary powers as per the Constitution. Even in the concurrent list of the Seventh Schedule, the Union government has a greater say. And what is left unsaid or unspecified is automatically prohibited to the state’s legislative, executive or fiscal domain. All amendments to the Seventh Schedule since the 1950s have led to increasing centralization, and creeping expansion of the role of the Union government. Subjects such as agriculture, land, labour, employment and health, which were to be exclusively in the states’ domain, are increasingly dominated by national schemes such as an employment guarantee, health insurance and direct benefits. Not to forget the Pay Commissions and similar conduits of influence. As chairman of the PM’s Advisory Council, Bibek Debroy has written in these pages, “There was a history, legacy, (and a) centralization mindset and shortage syndrome behind the Seventh Schedule… (and hence) it deserves independent scrutiny.”
Under Arvind Panagariya, the 16th Finance Commission has its work cut out. It has to address these structural imbalances. Also, it has to contend with increased funding needs for the provision of national level public goods, such as meeting net-zero emission targets. Some states contribute disproportionately to forest cover and biodiversity. How can they be compensated, even as their own revenue-raising capacity remains constrained? This calls for a bigger central pool. But widening inter-state disparities call for more grants-in-aid. What conditionality will the Commission attach? Is more aid to backward states taking away from the welfare spending needs of advanced states?
A key area where the new Commission must focus, and where it can make a historic contribution, is strengthening the third tier. Even after 30 years of Panchayati Raj legislation, and even with increased demand for governance and accountability from local bodies, they remain helplessly hobbled, either without funds and functionaries or at the mercy of their state governments. The recommendations of most state finance commissions are routinely flouted or ignored. How can a city council or a panchayat have greater say in how the local school system is run? Or how can garbage collection improve? Can a local government levy a small property tax on an airport project in its precincts? The 16th Finance Commission must find a way to carve out resources from the Consolidated Fund of India. For starters, local bodies together must have access to at least 2% of GDP annually, as against 28% kept for the Union government alone. Let this transfer be unconditional, and bypass both the Centre and state machinery. Successive Finance Commissions since the 11th have referred to local bodies. The 13th did a lucid analysis of the issue. Its recommendations include amending Articles 280 and 243-I, which is eminently doable. The 16th Finance Commission should take this to its logical conclusion and empower the third tier.
