Perverse incentives

Centre-state financial relations have always been a contentious issue in India. The Constitutional division of powers between the two levels of government have imposed rather rigid restrictions on the ability of the states to impose taxes.

In theory, this is offset by some flexibility in the revenue-sharing arrangement between the Centre and the states, as reflected in the Finance Commission's recommendations every five years.

In reality, however, the condition of state finances has been steadily worsening, indicating that there is a limit to which this flexibility can compensate for weak powers of taxation and, perhaps more important, the ability and willingness to use these powers to the fullest.

One possible way to create an "incentive-compatible" tax scenario for the states is to make the flow of central funds contingent on improvement in tax collection performance by them. Successive Finance Commissions have built upon this notion and increased the weighting given to this indicator.

The central government is presumably trying to reinforce the message of joint fiscal responsibility by its intention to link transfers for schemes that it sponsors to funds that the state governments are able to raise themselves for these schemes.

In theory, this can generate the right kinds of incentives for states, giving them "ownership" over the schemes and increasing their commitment to implementation and effective operation. However, unlike in the tax realm, where the incentives will usually work in the right direction, such incentives linked to expenditure may end up with a less than desirable allocation of resources.

There are two kinds of pitfalls in this conditionality. One, schemes promoted by the central government may not necessarily be consistent with the development priorities of a particular state. However, it may be tempted to commit funds because that central resources that would otherwise not be available will now be so.

Two, a scheme may genuinely be beneficial for the state government, but its immediate financial position may not allow it to commit resources. Under the conditionality, the scheme will go unimplemented. It is all very well to argue that such eventualities can be dealt with through effective prioritisation and project design effort. The performance record of centrally sponsored schemes, however, does not give very much comfort on that score.

In fact, the whole "outlays vs. outcomes" distinction that the UPA government has set so much store by is motivated by widespread perceptions of government failure.

This concern is reminiscent of the old debate surrounding multilateral assistance. It was argued by many then that external funding was fraught with the risk of "adverse selection", i.e. projects that did not have much intrinsic merit would be undertaken simply because external funding was available.

The right way to use the matching funds concept is for the project concept to emerge from the "entrepreneur", in this context the state government or the agency within it which is going to implement the project. Only if the state government itself is convinced about the virtues of the scheme, to the point where it is willing to commit resources to it, should the central government step in to provide funding.

In this framework, the very notion of a "centrally sponsored scheme" would become redundant. Let the Centre exploit its resource mobilisation powers and advantages by all means. But ownership, implementation and commitment must be a bottom-up process if expenditure programmes are to succeed in achieving their goals.