Pushing State Reforms: Can The 15th Finance Commission Be A Game Changer?

The government announced the formation of the 15th Finance Commission last week, adding another chapter in its pursuit to reinvent India’s fiscal federalism. The commission, which held its first meeting on Monday, has the mandate to incentivise stronger governance and more reforms at the state level and this could prove to be a game changer.

Finance Commission (FC) is the most important federal body in India that decides how tax revenues will be distributed between the centre and all states for the next five years. One may recall that the 14th FC had increased the states’ share in central taxes from 32 per cent to 42 per cent. This and the discontinuation of central planning, has led to greater autonomy for states in deciding their expenditure priorities.

The terms of references (ToR) of the 15th FC have been released, in which the most notable feature is the mandate for the commission to devise performance-based incentives for the states. These could be across many aspects such as expansion in tax net, improvement in quality of expenditure, undertaking policy and regulatory reforms, and achievements in implementation of the flagship schemes of the centre.

This mandate is an important opportunity for the FC. The evolving economic research on federalism emphasises the role of fiscal incentives in promoting good governance by regional governments. The commission will be in the best position to take an integrated view of the transfers from the centre to states, and to determine how state governments could best be incentivised to continually improve their performance.

Rewarding Economic Growth Without Compromising on Equity

While it is too soon to comment on FC’s approach, one way to effectively reward states could be to link the incentives to their economic growth. Economic growth is easy to measure, and unlike incentives linked to specific actions, they give states the freedom to devise their own economic strategy.

How are fiscal incentives and economic growth linked? In any federal system, a regional government has inherent fiscal incentives to raise economic growth if it receives most of the consequent taxes generated. For example, in China’s initial reform period (1981 to 1992), the provincial governments were claimants to the residual revenues generated in their provinces after the national government retained only a fixed amount. This meant that the provinces got up to 100 per cent of the additional revenue realised from their local economic growth. Researchers have linked this system with faster development and more reforms by the provincial governments.

In India, state’s incentives for growth are relatively muted. States taxes account for about 38 per cent of combined tax collections of the centre and the states. The states do get a portion of the central taxes (equivalent to 22 per cent of total taxes in aggregate). But the transfer to individual states is decided on the basis of the FC’s formula, which is devised to mitigate regional economic disparities such that states with low per capita income receive higher per-capita transfers. So, if economic growth in a state led to additional tax revenue of 100, only 38 will be realised by the state government on average. The remaining will accrue partly to the centre and partly will be distributed among all states.

The 15th FC could consider raising stakes of the state governments in their economic growth, without compromising on objective of mitigating imbalances in states’ economic positions. It could introduce a new scheme where states individually receive fiscal transfers that vary according to their addition to the gross domestic product (GDP) in the previous year. Since this would be in addition to the fixed shares of tax revenues that states receive, revenues of the low-income states would be protected. At the same time, all states will have the opportunity to increase their transfer receipts by raising their economic growth.

Enabling Regulatory Reforms by States

One of the potential benefits of incentives linked to growth is that it will enable regulatory reforms by states, further promoting competition and ease of doing business at the state level. This is particularly important, as emphasised by the World Bank’s latest Ease of Doing Business report. India is still ranked poorly in many areas that are under states’ control. Often state governments may be hesitant in undertaking regulatory reforms such as dismantling existing monopolies out of concerns of loss in revenues collected through licensing fees, others charges, etc. But with higher growth leading to higher transfer revenues, the states may be compensated for the loss in revenues from the reforms.

There could be other benefits too, such as states may decide to spend more on productive public goods, such as physical and social infrastructure, law and order to improve economic efficiency rather than on populist measures.

Prime Minister Narendra Modi had remarked in his first Independence Day speech that “if we have to take India forward, it can happen only by taking the states forward”. The 15th FC could have an important role in driving the states forward.