The role of finance commissions in sustainable development

Live Mint, March 04, 2019

By Pradeep S Mehta and Amol Kulkarni

They need to play their part by recommending empowerment of local governments to enable good governance

IIrrespective of controversies around the remit of 15th Finance Commission (FC), it is evident from its terms of reference that the government wants it to play a key role in fostering sustainable development in India. Indeed, constitutional status and the ability to suggest far-reaching reforms on financing, allocation and use of funds by three tiers of governance makes the central (and state) FCs completely capable to discharge this role. However, effective implementation will be the responsibility of the three tiers, which is an issue of good governance.

Education and health expenditure by states play a key role in improving developmental outcomes. Additional financing requirements of ₹12.1 trillion and ₹53.6 trillion have been estimated for health and education, respectively, to meet the sustainable development goal, or SDG targets, by 2030. Aware of the importance of social sector expenditure, over the years, poor states including Rajasthan, Bihar, Jharkhand, Uttar Pradesh and Madhya Pradesh, have increased their expenditures in social services, education and health as a percentage of gross state domestic product (GSDP).

Despite such increase in education and health spending, experts indicate that efficiency of education spending has deteriorated in Rajasthan, Uttar Pradesh, Madhya Pradesh and Odisha between 2002 and 2015. Similarly, it has been suggested that there was no evidence of poorer states “catching up” with richer states in quality of human capital formation and health-related expenditure. A recent report by Crisil also highlights that while Rajasthan, Jharkhand, Uttar Pradesh and Telangana spent most out of their budget on capital expenditure, health and education sectors remained impoverished. Good governance, coupled with growth, is key in achieving spending efficiency in education, health and social sectors.

Alas, these states may no more be left with sizeable funds to consistently invest in human development. Punjab, Rajasthan and Kerala already have their debt ratios over 30%, which are not only highest across states, but deteriorating. In recent years, some of these states have experienced declines in grants-in-aid and their own revenues as a percentage of GSDP, consistently reporting revenue deficits and fiscal deficits of over 3% of GSDP. Takeover of debt of distribution companies under the UDAY scheme and farm loan waiver announcements were key reasons for several state governments experiencing high deficits. Achieving long-run sustainability of debt and deficits continue to be a major challenge for such states.

Consequently, states such as Rajasthan were faced with a double whammy. Not only did they not have adequate funds to spend on sustainable development, their existing expenditure has not been delivering desired outcomes. This calls for a radical course correction.

The role of local governments has often been ignored in human development, despite them being closest to ground and having the ability to make investment choices based on evidence and consistently monitor outcomes. In the spirit of fiscal federalism, while the Constitution envisages a bottom up approach in determining resource allocations among the three tiers of governance by mandating state FCs to take into account requirements of local governments and inform the central FC, it rarely happens. Local government expenditure as a percentage of total public sector expenditure is only around 7% compared with 24% in Europe, 27% in North America and 55% in Denmark.

The term of several state FCs has been repeatedly extended and there is no coordination between central and state FCs to understand a consolidated account of the reality at the sub-state level. FCs will need to look within and improve internal processes for better coordination, making realistic assessment of ground realities and improving outcomes.

Over the years, several suggestions have been made on mechanisms, which FCs can adopt to empower local governments. For instance, Swaminathan A. Aiyar recommended that central FCs propose substantial rewards for states that are serious about decentralisation, and penalties for those that are not.

Noted econocrat Vijay Kelkar recently suggested some radical changes in our fiscal federalism framework. He recommended creating a consolidated fund for municipalities and panchayats to ensure that revenue allocated by central and state FCs flow directly to it. He also advocated that states and the Centre should share an equal percentage of their respective goods and services tax collection with the third tier. This will lead to creation of better public goods resulting in growth of economic activities, resident citizens’ incomes and consumption which, in turn, will provide high fiscal resources to the local governments.

Suggestions have also been made to create market-based mechanisms for financing government expenditures and fixing accountability. At present, states are neither rewarded nor penalised for their debt management. An index of debt sustainability and fiscal prudence performance indicators for measuring performance can be created, wherein fiscally strong governments can get themselves rated to get better rates in auction of bonds. Cash surplus state governments can be allowed to lend to those in deficit at a market-linked rate.

Similar market-based mechanisms allowing inter-municipality borrowing and lending, and performance measurement on predefined indicators could be designed to incentivise productivity and fix accountability of local governments.

FCs need to become agents of change. To this end, they must examine these suggestions, and make appropriate recommendations to empower local governments, enable good governance and play their part in fostering sustainable development.

The writers work for CUTS International

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