The 14th Finance Commission (FFC) recommended a fundamental rebooting of centre-state fiscal relations. On Tuesday, the government accepted the FFC’s report, effectively putting in place a new paradigm for federal polity in the country.

At the core, the FFC’s recommendation is for a change in the formula for revenue-sharing between the centre and the states.

At present, the state’s share of revenue is fixed at 32% of net tax receipts of the central government. The new formula bumps this up to 42% , which also implies that any buoyancy in tax collections will now benefit the states.

The change is in keeping with the Bharatiya Janata Party-led (BJP-led) National Democratic Alliance’s repeated articulation of what it calls cooperative federalism.

Interestingly, the move restricts the government’s own fiscal space—its share of net tax receipts of the centre will drop from 62% to 55%—and gives greater play to the principle of equity in centre-state relations.

More clarity on this radical change will emerge once the NDA presents its second budget over the weekend.

The FFC, headed by Y.V. Reddy, former Reserve Bank of India (RBI) governor and a finance ministry veteran, has taken the bold step in an effort to give more fiscal room to states, instead of sticking to the safer realm of incrementalism.

The move isn’t without political implications—it re-sets the equation between the centre and the states. The final outcome will depend upon what both the centre and states do with the new fiscal equations. States now acquire unprecedented space to design and manage their own spending.

The downside is that given the differing capacities and capabilities of the states, the new formula could exacerbate regional inequalities.

The context

The idea of the Finance Commission, a key institution in the federal governance structure ordained by the Constitution of India, is to address the asymmetry between taxation powers and functional responsibilities.

While the centre has greater taxation powers, the states, which oversee law and order, public health, sanitation, agriculture, education and building of roads and bridges, have far more functional responsibilities.

The commission’s recommendations are meant to bridge the gap between the resources of states and the cost of funding their responsibilities.

Aside from addressing this vertical imbalance between the centre and states, the commission has also addressed the principle of horizontal equity between states.

Besides the funds transferred by the Finance Commission, states have also received non-statutory transfers effected through the Planning Commission and central ministries that fund centrally sponsored schemes like the Mahatma Gandhi National Rural Employment Guarantee Scheme.

The FFC’s radical prescription—preferring greater devolution over grants—comes in the backdrop of the disbanding of the Planning Commission. Together, this has created a new template for centre-state fiscal relations—particularly significant at a time when the two are working towards implementing the single goods and services tax that will economically unify the country for the first time.

The recommendations of the FFC are as seminal as that of the 10th Finance Commission, chaired by K.C. Pant, which proposed pooling all tax revenues.

Till then, the centre shared only income tax and excise revenues with states. But actual pooling of tax revenues had to await the 80th Constitutional Amendment in 2000.

Accordingly, the 11th Finance Commission, which was set up immediately after, recommended a share of 29.5% for states from the divisible pool.

“We have not categorised states for the purpose of devolution (of tax revenues). We have minimised the use of conditionalities and incentives. We have also increased untied transfers. This reflects our trust in all tiers of governments," the FFC report said.

Rewarding efficiency

The 10 percentage point increase in the tax share of states is the largest increase ever proposed by any commission.

What it does right away is reward efficiency. Since states are now free to design their own spending, more efficient states will be able to manage their resources better.

In the process it makes the states a key stakeholder in the growth process and reaffirms that the next round of policy action will emanate from the states. Given that they have such a big stake in the central tax pool, the incentive for states to contribute to the national kitty will be that much greater now on.

At the same time, it also frees the central government to focus on its own agenda, even while preempting bickering of the kind seen recently between the government of West Bengal and the centre.

Abandoning one size fits all

The result will also be a pruning of national programmes. The proliferation of centrally sponsored schemes has often meant that states have only a limited amount of so-called untied resources. Given the shift initiated towards greater devolution and the squeeze on the centre’s finances, it is obvious that the funding of centrally sponsored schemes will shift partially to states. The finance ministry, in a statement, said that it will start by delinking eight such schemes from central assistance.

The principle of equity

A key principle that the Finance Commission is also required to pursue is the principle of horizontal equity between states. In a radical departure, which may not go down well with some states, the FFC has done away with the distinction between special (like North-Eastern states, Jammu and Kashmir) and general category states (like Maharashtra, Tamil Nadu). Instead it has provided for a category of 11 states, which include the North-Eastern states, that have a post-devolution deficit and hence will be entitled to special grants.

A new dynamic

With greater resources being devolved to states, their relationship with the centre is likely to be more equal. This is because the centre’s discretion will be severely diminished.

In a letter addressed to state chief ministers, released immediately after the FFC report was tabled in Parliament, Prime Minister Narendra Modi outlined the direction of the new federal polity of India.

“This is all towards the fulfilment of my promise of co-operative federalism," he said. “As you have already seen, we have decided to involve states in discussing and planning national priorities. This is being done so as to maximize the outcome from every rupee spent either at the centre or the state."

He added that it was with “this spirit of Team India" that all state chief ministers have been made equal partners in the governing council of NITI (National Institution for Transforming India) Aayog, which has replaced the Planning Commission.

Anil Padmanabhan is deputy managing editor of Mint and writes every week on the intersection of politics and economics. His Twitter handle is @capitalcalculus.

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