27 February 2015

The revolution begins: With Finance Commission recommendations, Centre-state relations set to undergo dramatic change

February 25, 2015

Any big change requires big ideas, decisive leadership and happy coincidence of circumstances. Nothing illustrates this better than the unfolding story of cooperative federalism in India.

As chief minister of Gujarat, Narendra Modi had often argued that the central government implemented schemes were at odds with the state’s needs and priorities. For example, schemes that provided funds for electrification were at best of limited value to Gujarat since it had already achieved near 100% electrification. This state could have spent the money provided for such a scheme more productively if allowed to use it for other purposes.

In advancing this view, Modi was joined by other chief ministers such as Vasundhara Raje of Rajasthan who argued that the vast numbers of central schemes further restricted their fiscal space because many of them required matching contributions by them from their otherwise untied funds. Once these matching funds were committed to access central schemes, states were left with very limited funds for even the most important expenditure items such as enforcement of law and order.

Nevertheless, this system has remained entrenched in one form or another in the last several decades on account of coincidence of three factors. First, outside of state leaders and a few economists and policy analysts, advocates of the view that true federalism means giving greater fiscal space to states and trusting them in setting their own priorities have been few and far between.

Second, the Finance Commission – appointed once every five years – plays a key role in the division of tax revenues between Centre and states. Consistent with the first point, successive Finance Commissions held untied funds to the states at or below 30% of the divisible tax pool. Only the 13th Finance Commission exceeded this mark, setting the states’ share at 32%.

Finally, successive central governments have chosen to transfer the bulk of the remaining funds to the states via central and centrally sponsored schemes. With nearly 8% growth over an entire decade, tax revenues have significantly expanded. Alongside, central and centrally sponsored schemes and the revenue resources they absorb have expanded dramatically as well.

Two key factors have come together to dramatically alter this equilibrium. One, India now has a prime minister who was once a chief minister and strongly feels that cooperative federalism means greater fiscal and legislative space for states. And two, by a happy coincidence, the chairman and members of the 14th Finance Commission believe in genuine federalism themselves.

Moreover, they have recognised the opportunity offered by a prime minister at the helm who truly believes in the power of the states and their leaders. Accordingly, they have recommended that starting 2015-16, states be awarded 42% of the divisible pool of tax revenues to the states. This is a gigantic and unprecedented 10% jump in devolution.

Predictably, the prime minister and his Cabinet have accepted this bold recommendation of the 14th Finance Commission.

What implications does this change have? For starters, with larger transfers coming as untied funds, states also have greater responsibility in discharging their duties. It is likely that they will now have to take greater responsibility in areas that have been hitherto covered by the Centre, especially those falling on the state list. States will also have to do this in ways that are more consistent with their priorities and not according to “one size fits all” schemes. By the same token, with a lower share in the divisible pool the Centre’s fiscal space will shrink, requiring a rethink of central and centrally sponsored schemes.

One might ask where does Niti Aayog fit into this story? I am tempted to say that in replacing the Planning Commission by Niti Aayog, Prime Minister Modi may have anticipated the 14th Finance Commission. Under the previous regime, the Centre was often seen as “giver” and states as “recipients” thereby making the latter feel that they were less than equal partners. In replacing the Planning Commission by Niti Aayog, the prime minister sought to change that equation and forge an equal relationship between the two sides. As such the change represents a step towards cooperative federalism.

We will have a more complete picture of the emerging Centre-state relations this Saturday when the finance minister presents the budget. But even with what we now know, one thing is clear: in the years to come, Niti Aayog will have to play a much greater role in the knowledge space. Greater fiscal freedom combined with greater legislative freedom in areas covered by the concurrent list of the Constitution means that states will need to play a more active role in designing their own programmes and policies.

As they do so, they will need to reach out to data, analysis and expert advice. The design of Niti Aayog as per the Cabinet Note of 1 January 2015 positions it well to provide these services. By the same token, those of us at Niti Aayog have to work hard in the months to come to build new strengths so that we do not disappoint the states that reach out to us for advice and assistance. We shall see.

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