Finance Commission’s ToR is not so much unfair to southern states as unfair to all states

Yesterday, a group of state finance ministers met in Andhra Pradesh to discuss the terms of reference (ToR) of the 15th Finance Commission (FC). Representatives from Punjab, Bengal and Delhi joined those from some south Indian states who initiated the meeting. This geographically diverse grouping disproves the ongoing narrative of friction between south and north in resource sharing. The anxiety is more about the Narendra Modi government’s attitude to tax devolution.

The Constitution gives the bulk of taxation power to the Centre, but leaves most of the responsibility for providing basic services to states. Consequently, it mandates the periodic creation of an FC to recommend a formula to split a part of central tax revenue with states.

This mandate necessarily requires an uneven distribution of tax revenue between states. Poorer and more populous states get a larger share. Therefore, a state’s population influences its share in the devolution of taxes.

FCs are guided by the ToR set by the Centre. Controversy over the 15th FC’s ToR first erupted over the direction to use Census 2011 as the reference point for population. This upset some southern states, who are also unhappy with other aspects of ToR.

The controversy over choice of census has played out as a case of conflicting interests between better off southern states and poorer states in north India. There is no basis to this controversy.

For four decades, Census 1971 has been the benchmark as it was in sync with the National Family Welfare Policy. The shift this time to Census 2011 has been interpreted as an intrinsic bias in ToR to help states in north India which have higher fertility rates. The Centre’s response, articulated by finance minister Arun Jaitley, is that the shift to 2011 will help poorer states. Who is right? Neither side, as it turns out.

UPA’s ToR for the previous commission, the 14th FC, gave it discretion to move beyond Census 1971 and account for subsequent demographic changes. Consequently, states in their presentations to 14th FC revealed the strength of their preference for 1971 and 2011 as a criterion to distribute taxes.

Of 29 states, 13 opted for 1971, nine for 2011 and seven didn’t want any weightage to be given to population. Who expressed the strongest preference for 2011? Haryana and Gujarat, two better-off states. In the case of 1971, it was Punjab and Maharashtra, two of the richer states.

Among southern states, Andhra Pradesh, Tamil Nadu and Karnataka opted for 1971. Telangana chose 2011 and Kerala didn’t assign a weight to population. A look at some poorer states shows that Bihar and Madhya Pradesh preferred 2011, while Rajasthan, Jharkhand and Assam opted for 1971.

It’s impossible to discern a neat pattern that can lead to a conclusion that all southern states are disadvantaged by the shift to Census 2011, or that it helps all the poorer states. The reality is messy which makes the ToR crucial in finding a balance between conflicting interests of states. Therein lies the source of the current problem. The shoddy effort by NDA in designing the ToR as well as its underlying message seems to be the source of states’ anxiety.

A term of reference which best captures this anxiety is one which asks the 15th FC to keep in mind the impact of its predecessor’s recommendation to increase the unconditional tax devolution to states from 32% to 42%. This ToR suggests that the higher devolution is incompatible with the Centre’s financial need to fund development.

The backstory is that the 14th FC concluded that given the Centre’s obligations, it was not possible to increase the overall devolution from the divisible pool of taxes by more than two percentage points to 63.9%. But within this, it enhanced the unconditional transfer to states from 32% to 42%. The remaining money is transferred for earmarked spending.

This was termed path breaking by experts, giving a decisive momentum to federalism. Prior to 14th FC’s recommendation central governments, particularly during the UPA years, encroached into states’ domains through centrally sponsored schemes. Among other things, it restricted fiscal space of states who often protested. As Gujarat’s chief minister, Modi wanted unconditional devolution to the states to increase to 50%.

After becoming prime minister, Modi seems to have changed his mind. This should worry all chief ministers because when 15th FC’s ToR are seen in their entirety, there are unmistakable signs that NDA has the same approach as UPA. What’s worse now is that states have given up their unilateral taxation powers to facilitate GST.

This problem is aggravated in other ways. The ToR asks 15th FC to look at ways to incentivise states for “efforts and progress made in moving towards replacement rate of population growth”. Replacement level needs a total fertility rate (TFR) of 2.1. As many as 18 of 29 states have TFR of 2.1 or below, with two more states likely to join this list soon. Most states, therefore, will be ineligible for incentives as they have passed the point of “progress”.

The main problem, therefore, is not that the ToR are unfair to southern states. It isn’t. The disquiet has been caused by signs of Modi government’s reversion to fiscal centralisation and overall ineptness in designing the ToR. This has fed into an unrelated set of anxieties in south India. It’s now up to the 15th FC to untangle this knot.
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