16th Finance Commission must reward performance

The 16th Finance Commission must end the north versus south debate by shifting attention to performers versus laggards

The 16th Finance Commission (FC), chaired by economist Arvind Panagariya, has been tasked with deciding the formula for the distribution of the divisible pool of tax proceeds to different states and union territories for a five-year period starting April 1, 2026.

Past FCs have tried to balance equity with efficiency by placing weights on various parameters. Among them, the state's performance has been consistently assigned the lowest weight (17.5 per cent by the 13th FC, nil by the 14th FC, and 15 per cent by the 15th FC). The highest weights have gone to the needs of states based on their size, population, and economic backwardness. This has led to concerns that performance is not adequately rewarded, and has even been pitched as a north-versus-south divide. A similar concern was raised by Arvind Subramanian, India's former Chief Economic Adviser, at a function in Chennai.

It must be acknowledged that the devolution exercise is not about returning money that is owed by the Centre to the states. However, central taxes are ultimately a result of economic activity across India which is to be used for national development.

If some states do not perform, they limit the country's aspirations to provide every citizen with a higher standard of living. Therefore, the devolution exercise must strengthen the mechanisms that can incentivise economic activity.

The idea of supporting the needs of states was meant to help them catch up with the top performers. Unfortunately, this has not happened in many cases. For instance, Bihar and Uttar Pradesh enjoy a lion's share of the tax pool (10 per cent and 18 per cent respectively) but have clocked the lowest growth in per capita income. On the other hand, Gujarat and Karnataka have produced the highest growth rates but received only 3-5 per cent of the net proceeds.

If successive years of devolution could not produce a convergence in economic outcomes, then the devolution criteria need a serious rethink. The time has come to either increase the weight on performance, or introduce additional criteria that are linked to reforms by states.

Andhra Pradesh's share was 6.95 per cent till 2013-2014. After bifurcation of the state in 2014, Andhra Pradesh's share in 2014-2015 was 4.05 per cent and Telangana's was 2.90 per cent.

During the Covid-19 pandemic, the Union government allowed states to exceed their borrowing limits, contingent upon the implementation of specific reforms that the Prime Minister referred to as ways to improve ease of living of the public. These reforms covered areas such as simplifying ration cards, improving the ease of doing business, and reforming property taxes and subsidy regimes. It led to several states implementing the reforms and getting rewarded with enhancement of their borrowing limits.

This model can be replicated by the 16th FC by placing a sizable weight on desirable and measurable reform initiatives by the states.

Many FCs in the past had introduced weights on tax efforts and fiscal discipline which incentivised tax collection and fiscal prudence, but the incentives can be now extended to non-fiscal outcomes that directly impact the ease of living and doing business. One way could be to ask the NITI Aayog to rank states on their efforts or outcomes on the Sustainable Development Goals of the United Nations. Weights in the FC's devolution can be given to the rank achieved or improvement shown by states in each year.

This idea is not new. The 10th FC (1995-2000) had a 7.5 per cent weight for a state's achievement in providing economic and social infrastructure to its citizens. The areas included education, health, agriculture, banking, electricity, transport, and communications. Such an approach can be adopted with suitable improvements.

As for the quibble over populous states cornering resources, available research shows that health, education, and economic growth results in lower fertility and slows down population growth. Therefore, a focus on economic outcomes will eventually level the playing field.

The north versus south debate is overblown. There are so-called northern states such as Gujarat and Odisha which have delivered spectacular growth in per capita income during 2012-2022, and would be among the biggest beneficiaries if economic activity is further incentivised.

The real issue is to design a carrot and stick approach in devolution. States must not become permanently dependent on the needs factor but should aspire to earn their share based on demonstrated efforts or performance. States can play a big role in reducing red-tape and improving investment climates so that a conducive environment is created for jobs and businesses. After all, unless the states do their fair share of nurturing growth, neither will the divisible pool rise, nor will the nation be able to meet its developmental goals.

The 16th FC must seize the opportunity to make a course correction, or at least signal a 'glide path' over which the importance of needs would be reduced in a calibrated manner to make way for performance.

(Sthanu R Nair and Rudra Sensarma are Professors of Economics, Indian Institute of Management Kozhikode. Views expressed are personal.)

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.