Past finance commissions were reluctant to rock the boat and potentially lose credibility by doing anything very different to what they were doing in the past. As a result, the average Indian continues to suffer due to poor public service provision. The level and uniformity of public service improvement is a useful gauge by which one can measure the success of the terms of reference of the current 15th Finance Commission.

The emphasis in the Commission’s terms of reference on incentives is creating considerable unease among Indian states. Tax sharing is regarded as a right and so states resist introducing conditionalities when funds are devolved to states. But states often do not devolve funds and functionaries further, even though they are required to by the 73rd and 74th amendments to the Constitution. In some cases, even the state finance commissions (SFCs) that serve this function are not set up.

But there are no limitations from the Constitution to introducing conditionalities on grants-in-aid or on centrally sponsored schemes (CSS). Such conditionalities can be designed to incentivise future action or to reward capacity building, as well as improve institutions.

States delay upgrading their rapidly growing towns to urban status because of tax and municipal service provision issues. Towns themselves do not want to lose rural development funding. One reason that public service provision is so poor is that facilities tend to be cut to match the funds available, which dis-incentivises the provision of uniform levels of public service.

The 13th Finance Commission introduced incentive payments but capacity constraints prevented some states from utilising them. The 14th Finance Commission therefore shifted payments to capacity building.

The 12th Finance Commission had the most success because it used a combination of carrots and sticks — debt restructuring conditional on accepting state-level fiscal responsibility and budget management (FRBM) legislation. The 15th Finance Commission could give funds conditional on implementing devolution, with payments made for improvements rather than simply for provision.

The CSS can be rationalised and revised further. The Rs 3.5 trillion (US$49.7 billion) currently paid could be partly replaced by well-targeted central direct benefit transfers to individuals. Achieving economies of scale by pooling and coordinating efficiencies may reduce health and education costs where dual responsibilities between the centre and the states have eroded the successful delivery that the Constitution mandates.

A major issue is balancing independence and uniformity for states. Richer states, those with their own competitive schemes, may want to opt out of the CSS. They could be given a choice — conditional on threshold outcomes being achieved — which may encourage healthy competition. Distributing appropriate compensation when funds are devolved could be on the basis of quality-adjusted least-cost schemes.

A permanent fiscal council could be set up and made responsible for conditional data-based fund devolution to states. This body could also function as a non-political fiscal watchdog. The Inter-State Council could be revived in order to improve participation and feedback from states. The smooth working of the GST Council shows that something like this is possible. Reviving the Council could also reduce sanctioning delays.

Research at IGIDR suggests that incentives work. Intergovernmental transfers, given tax capacity, have a negative association with the tax efforts of states. FRBM improved states’ tax efforts. Despite the introduction of the GST, states still have work to do when it comes to user charges. Larger expenditure responsibilities are followed by higher tax effort. Ring fencing productive expenditure could also raise revenue efforts.

An award in line with broad principles of justice such as linking incentives to delivering constitutional responsibilities for public service delivery would generate less resistance.

The second term of reference of the 15th Finance Commission covers reducing state debt. The FRBM review committee’s focus on debt and fiscal deficits led to a rise in revenue deficits. It is necessary to safeguard expenditure which creates future income. Encouraging higher growth brings down debt ratios as growth rates normally exceed interest rates on catch-up growth paths. Fiscal deficit directly adds to borrowing but a rise in revenue deficit decreases growth and therefore slows the reduction in debt ratios. Any deficit path should itself have some counter-cyclicality built in.

There is now also more market discipline in states. There are plans to increase discipline further by releasing data more frequently on state finances, which will enhance ratings. Currently, borrowing costs remain similar despite widely varying debt levels. There is no default risk and an automatic debit from the Reserve Bank of India on payment dates. Earlier, the states relied on finance commissions to cover the gaps. Now they have FRBM mandated caps.

To borrow from markets, states have to get consent from the central government under Article 293(3) of the Constitution. An indicator of the hard budget constraints they face is that while state-revised expenditure estimates often exceed budget estimates, actuals are less than revised.

Expenditures are cut and often these are developmental and capital expenditures. Incentives must also protect the quality of expenditure. It seems clear that incentives contained in the 15th Finance Commission, despite the apprehension they generate, could prove vital to ensuring the adequate provision of public services across India’s federated states.

Ashima Goyal is Professor at the Indira Gandhi Institute of Development Research (IGIDR), New Delhi.

A version of this article was first published here by The Hindu Business Line.