Who should get the Centre’s money?
A government is ideally supposed to use tax revenue to provide
public goods and services to its citizens, goods that the market cannot
do a good job of providing. Tax revenue can also be redistributed to
make poorer citizens relatively better off than before government
intervention. In a federal country like India, there is the complication
of different levels of government, each with its own responsibilities
and loci of authority. Because the Centre is more efficient at raising
tax revenue, there are provisions for sharing central tax revenue with
the states. The 14th Finance Commission is now hard at work on making
those sharing decisions. Like its predecessors, it will use a formula
justified according to a mix of economic and political logic and of
precedent. The Finance Commission is an explicit creature of India’s
Constitution.
Less firmly founded in constitutional directives, but more in the
middle of political bargaining, the Planning Commission (along with
various central ministries) also makes transfers to the states. These
are based on more varied and discretionary criteria, with its own
modified Gadgil formula playing a relatively small role. The Planning
Commission introduced the concept of Special Category states, and has
given them a healthy share of the pie that it disburses. These states
have been, as a natural consequence of the criteria used, mountainous
border states with populations whose ethnicity or religion are not part
of the “mainstream” Indian identity. They were ostensibly compensated
for having high cost structures for public good provision, but I have
always thought of their shares of the pie partly as payments for
sticking with the rest of the nation.
The Special Category designation has bothered the leaders of some
bigger, poorer states, which have been demanding to be included in that
classification, therefore getting more central money. Many committees
have looked into the criteria to be used for such transfers (which are
broadly thought of as promoting “development”) but not made much
headway. Hence, a new committee, headed by the ubiquitous Raghuram
Rajan, was formed, and has just given its report to the Finance
Minister. This committee has created a new index of underdevelopment,
combining 10 indicators into this index. In addition to the index, the
report also suggested a classification based on levels of development.
Indeed, Bihar and Odisha, left out of the Special Category pot, show up
as the least-developed. Headlines trumpeted the ranking of Gujarat as
“less developed,” despite its apparent economic success.
As anyone knows, and as a dissenting note in the committee report
elucidates, the ranking can be very sensitive to how the index is
constructed, and it is not clear that the committee has got everything
right, from the point of view of what it was trying to achieve. A
detailed conceptual discussion of the index is beyond my scope in this
column, but I want to point out a couple of things about the report.
First, the report is clear that it is not proposing to replace the
entire current system of Centre-state transfers with the new formula,
but to add another formula for making such transfers —presumably under
the existing Planning Commission channel. To my mind, this just adds
complexity to an already messy situation. Better to edge the Planning
Commission out of this role, let ministries make explicit specific
purpose transfers, and give the Finance Commission a bigger role. Better
yet, allow states the freedom to piggyback on central taxes such as the
individual income tax (this will need a constitutional amendment, of
course).
Second, the report notes that Finance Commission transfers are
only 54% of total Centre-state transfers (another source says 57%), but
of the rest, only a small fraction is governed by the modified Gadgil
formula and the boost for Special Category states. But the new index
would give much less to the Special Category states, and more to the
least-developed states. If this new index is heavily used, it represents
a big change. If it is not going to govern a major portion of
transfers, then why all the effort? To my mind, the new index is trying
to make a major conceptual change in how state shares of transfers are
done, without adequate contextual positioning.
To sum up, I don’t think the new index provides a superior guide
for Finance Commission transfers (and is not meant to). But it is also
not clearly the right way to go in guiding “developmental” transfers
either. Those should be simpler, project-based, with measurement of
concrete outcomes, not based on composite indices. Finance Commission
transfers should do a better job of improving horizontal equity across
states, but that also should be based on a small number of
criteria—states like Bihar and Odisha would still benefit. And Special
Category states should stay what they are—a politically sensitive group
of smaller, mainly border states. For rethinking Centre-state transfers,
I say, “back to the drawing board.”
