Inching federal transfers towards maturity

The report of the Twelfth Finance Commission (TFC), recently made public, marks another slow step towards the maturing of India?s system of intergovernmental transfers. The bottomline of the TFC is, of course, its recommendations on states? relative shares in the Consolidated Fund of India, with the Centre?s share determined somewhat by default. In his Budget speech, the finance minister (FM) highlighted the proposed increase in transfers and the implications for fiscal consolidation at the Centre. Studying the report of the TFC, however, it seems they have been relatively conservative and the proposed overall allocation to the states does not represent a significant increase. Of course, when every level of the government is badly in hock, every rupee counts, particularly in making the accounts look better on paper, so one can understand the FM?s concern.

In any case, the TFC has only tinkered with the tax devolution formulae, increasing some weights and decreasing others, increased the states? share slightly and upped grants-in-aid somewhat more. Targeting these particularly to poorer states and earmarking some grants for priority areas such as health and education. Much of this is in the spirit of previous Finance Commissions.

The TFC also follows the precedent of the Eleventh Finance Commission, the first to be given broad terms of reference with respect to assessing the overall fiscal situation of the Centre and the states. It is useful to have this done independently of the finance ministry, though one would like to see more in-depth analysis and comparison with other assessments and projections. As it is, the report complains of the Commission being short on time and resources. The plea for a permanent secretariat and proper funding, articulated often in the past, ought to be finally heeded by the central government, if it is serious about the terms of reference it gives these Commissions. The marginal benefit of proper analysis would be worth the expense.

The key missing ingredient in the report, typical of such exercises in India, is the lack of any well-specified behavioural models that are empirically operational at a level permitting informed policymaking. For example, the increased grants-in-aid are accompanied by a statement that these are not ?gap-filling? grants, with adverse incentive effects, because they are based on normative projections of state government revenues and expenditures?what the states ought to be doing. Yet, the only thing clear about these projections is that they are not based on any clear criteria of what a state government, operating with a particular set of characteristics, might be expected to achieve in its taxation and spending. Nor is there any estimate of the degree of fungibility of earmarked grants.

There are several mentions of what Australia and Canada do in the arena of federal devolution, but there is no obvious attempt (that I could see) to apply such lessons to Indian practice. It would be much better, for example, to overhaul the tax devolution formulae to incorporate horizontal equity criteria explicitly, rather than tinkering with the formula to reduce transfers to the worse-off states. And then dealing with horizontal equity again, in a more ad hoc manner, with various grants, as the TFC has done.

Of course, only so much is politically feasible and the TFC has done a great job of highlighting some tough areas for reform. The continuing reform of India?s indirect tax system gets considerable attention, and the fact that central service taxes, being introduced by the 88th Amendment, are not part of the shareable pool, is rightly highlighted as a retrograde feature of the new law. The FRBM Taskforce?s recommendations on indirect taxes are discussed quite sensibly. The TFC also says several right things about the muddle that constitutes the Planning Commission?s transfers.

The report is clear and sensible on the need for proper accrual accounting in government (though this shift will not, of course, remove the need to track cash flows as well). The most significant recommendation is in its push for market borrowing by states for Plan expenditures, rather than loans from the Centre. This recommendation is not a novelty, of course, but the TFC?s strong support is useful in nudging along this institutional reform. There will be a huge amount of effort in making this happen in a manner that actually works, as the RBI is already recognising and preparing for.

The biggest challenges will be in ensuring transparency and monitoring, so that market liabilities of the states do not simply replace central loans as regular bailout candidates. Ultimately, the real issue is making the government at all levels (Centre, state and local) less wasteful and better at serving their constituents. Finance Commissions cannot directly achieve this goal, which will require more transparency, better monitoring and clear accountability of governments to their constituents (as well as constituents who care about these goals, rather than just opting out of their own public responsibilities). However, the TFC?s recommendations with respect to accounting and market borrowing are very important enabling steps.

It will be nice to see the next Finance Commission do some serious behavioural modeling of India?s public finances, as an additional component of making its governments and federal system work better. Doing this outside the confines of the finance ministry and Planning Commi-ssion, but with official access to data, will be a unique contribution of the Finance Commissions and enhance the value of their work. After all, it is better that this kind of analysis be done within India, by those who understand its institutions, rather than at the World Bank or International Monetary Fund.

The writer is professor of economics, University of California, Santa Cruz