The Indian Constitution has a built-in mismatch between revenue-raising and expenditure responsibilities, and has provided for the institution of a Union Finance Commission (UFC) to address this problem with quinquennial reviews.
Although it wasn’t a constitutional body, the erstwhile Planning Commission had powers to allocate resources to states and enjoyed considerable political clout. The UFC’s tasks were compromised. With the abolition of the Planning Commission in 2014, the economy plunged into a market-mediated system, with its inherent bias towards regional imbalances and considerable changes in resource allocations.
The 16th Finance Commission is at a crossroads, particularly because its terms of reference (ToR) are not constrained by Article 280(3)(d) with ‘any other matter in the interest of sound finance’ and free from the burden of the pandemic. In this context, revisiting the design of the transfer system seems to be in order.
Restoring fiscal balance both vertical and horizontal to promote sustainable development goals (SDGs) and the critical constitutional goal of providing every citizen the minimum basic services of standard quality irrespective of their choice of residence is the key.
But inter-state disparities in per capita income and human development index (HDI) have widened since 1990. This makes the commission’s task more onerous. It is in this context that I take up the question of rewards, performance and penalties as a strategic approach, with a focus on Kerala.
A well-designed transfer system to promote constitutional goals with appropriate rewards and penalties is needed in India, which has deep territorial inequity in the provisioning of minimum public services. Although the last five UFCs have used the strategy largely to serve the ToRs given to them, the disgusting narrative is that none of their ToRs sought to reward constitutional goals nor did they act keeping these fundamentals in view.
Look at the ToR of FC-15, which mentioned nine items to be rewarded, one of which was to “control or lack of it in incurring expenditure on populist measures”. The items and their rewards and penalties leave many things to be desired. FC-11, the first since the 73rd/74th constitutional amendments, asserted: “Our overall scheme of resource transfers is characterised by providing a structure of incentives designed to reward fiscal prudence.”
This pattern of ‘incentivising and disincentivising’ was continued in the recommendations of the 12th, 14th and 15th commissions. FC-13, which gave performance-based grants for reduction in infant mortality rate, improvement in the delivery of justice, etc. besides strongly promoting decentralisation reforms, stands out differently.
Many UFCs seem to believe that the Fiscal Responsibility and Budget Management Act is a magic bullet to discipline states while the Union can pursue off-budget borrowings with impunity. To be sure, ‘fiscal discipline’ is more than expenditure pruning and is only a part of governance policy, particularly to facilitate the achievement of constitutionally mandated goals or goals of national consequence like population policy and eradication of poverty.
The lack of an appropriate reward and punishment approach can adversely affect the fiscal prospects of a state, like Kerala, which achieved close to 100 per cent literacy rate and has world-class records in other HDI components, topped millennium development goals, SDGs, rural-urban equity, a well-functioning public distribution system, enviable performance in decentralisation, and on female-male ratio compared to any European nation. As far back as 1987, I recall writing that the state will land in fiscal crises unless supported by maintenance grants.
Instructively, the Centre transferred as a percentage of revenue expenditure, 32.6 per cent in 1982-83. It stands at 21.8 per cent in 2023-24, with a negative CAGR of 1 per cent from 1983 to 2024. Indeed, FC-16 has to revisit the intergovernmental transfer system changing its inter-se devolution criteria.
A recent paper by D Narayana of the M S Ramaiah University of Applied Sciences shows how almost all the devolution criterions, particularly income distance and environment conservation, are flawed in ensuring a fair distribution of resources to the states.
The shining social statistics of Kerala is in disturbing contrast to the steady fall in the divisible pool share from 3.95 percent by FC-7 to 1.92 percent by FC-15, with a negative compounded rate of 4.9 percent. The most disquieting episode is the story of Kerala’s demographic transition from a demographic danger spot in the 1960s with a total fertility rate (TFR) per woman at 3.4, to the replacement rate reached in 1988 and stabilising around a TFR of 1.7-1.9.
The adverse impact is that Kerala lost its demographic dividend as far back as 2001, when its Index of Development Benefit reached its peak inflexion point of 40.8, and declined to 10.2 in 2021. It is projected to take a value of (-)1.2 in 2041, well-illustrated by the former World Bank demographer K C Zachariah in his book Changing Kerala.
Pathanamthitta and Idukki districts have already recorded negative population growth during 2001-2011. With increasing elderly population and dramatic changes in disease pattern and morbidity, with longevity demanding new healthcare along with the highest out-of-pocket expenditure in the nation, while the state is losing its tax potential, it is not an optimistic spectacle.
It is important for the 16th commission to know that over the last three decades, Kerala has been the job market for about 3.1 million migrants from West Bengal, Assam, Uttar Pradesh, Bihar and other states. As State Planning Board member K Ravi Raman and others have shown, the migrants’ need for healthcare, education of their children, and measures to counter security hazards take a heavy toll on the state.
Kerala needs to be rewarded for the huge money outflow per year. Performance must be rewarded. It is in this context that the plea for a fresh look on the theory and practice of rewards and penalties to intergovernmental transfer arrangements require to be revisited.
(Views are personal)
M A Oommen | Former Chairman, Fourth State Finance Commission, Kerala, and Distinguished Fellow, Gulati Institute of Finance and Taxation, Thiruvananthapuram