Who Should Get the Centre's Money?

From Financial Express, October 3, 2013

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.”