Ensuring autonomy to subnational governments with incentives and accountability is the key to the success of fiscal federalism.

The recent trend in Central transfers to states has two distinct features. First, there has been an increasing use of discretionary and specific-purpose transfers. Secondly, a significant proportion of transfers earlier given to states for passing on to autonomous agencies (including Panchayats) for implementing various Central schemes is now directly given to the latter, bypassing the states. Constitutional experts and scholars in federalism find this intrusion an affront to the states' autonomy and unhealthy for the future of Indian federalism.

On the contrary, those believing in the Central government's superior role justify this as necessary to improve the states' fiscal management and altering their spending priorities. They believe that all transfers to  states should be for specified purposes, and question the relevance of the Finance Commission's recommendations on tax devolution and general-purpose grants.

The fact of the matter, however, is that this trend existed for long and got intensified a decade ago with the emergence of coalition governments at the Centre and regional parties at the helm in many states, and with regional parties becoming pivotal members of central coalitions.

Over the years, with the transfer system becoming more and more discretionary, the Constitutional agency meant to resolve vertical and horizontal fiscal imbalances has slowly, but surely, lost ground. With the Planning Commission emerging as a significant dispenser of assistance to the states, the Finance Commission's scope was relegated to recommending tax devolution and grants for meeting the states' non-plan current spending requirements.

Initially, the volume of plan assistance and the quantum of loan-grant components received by states were discretionary, but after 1969, it became formulaic with the adoption of the National Development Council (NDC) (Gadgil) formula. However, the third window opened up for discretionary transfers with Central ministries initiating several schemes under the Central sector and Centrally sponsored schemes. The claim to ownership of these schemes by the ruling parties at the Centre, on the one hand, and the inability of state governments to allocate sufficient resources for important social services, on the other, brought in legitimacy to the schematic assistance and the ramparts of Red Fort became the favourite place for announcing various "welfare schemes".

Thus, there are three different agencies making transfers from the Centre to the states. The Finance Commission recommends tax devolution and non-plan grants. They also give some specific-purpose grants such as for education and health care. The normal Central plan assistance is given in accordance with the Gadgil formula and this too is a general-purpose transfer. Since 2006-07, based on the 12th Finance Commission's recommendations, the plan assistance has consisted of only the grants. The specific-purpose grants are given by different Central ministries for various schemes and since 2002-03, significant proportions of such transfers are being given directly to autonomous agencies bypassing the states, though in some cases the latter are required to make matching contributions.

Is there a need for specific-purpose transfers? Surely, in any ideal transfer system, there should be a mix of both general- and specific-purpose transfers, because they serve different purposes. The objective of general-purpose transfers is to enable every state to provide a given level of public services at specified tax rates so that the citizens get comparable levels of public services at comparable tax rates. Horizontal equity requires that people with similar income levels pay taxes at similar rates and are entitled to equivalent levels of public services.

These transfers are meant to offset fiscal disabilities of states arising from a lower capacity to raise revenues and higher unit cost of providing public services. On the other hand, specific-purpose transfers are necessary to ensure that every state spends a minimum prescribed expenditure on the chosen meritorious services having nation-wide externalities. Indeed, basic education and health care have nationwide externalities and poverty is a concern everywhere. However, such specific-purpose transfers should not relegate the states to mere implementing agencies; the conditionalities should be broad enough to allow room for taking their own initiatives. Thus, a judicious mix of general- and specific-purpose transfers is necessary.

Who should make the transfers? According to K K Venugopal, a leading constitutional expert, the Finance Commission can make both conditional and unconditional transfers. It can also make grants for current as well as capital purposes. According to him, there is nothing in the Constitution that warrants the Commission to be a temporary body. It only requires the Commission to be appointed every five years or before; the Commission can function until another one is appointed.

However, the present practice is to have the Finance Commission as an ad hoc body. Nevertheless, it could be required to recommend all general-purpose transfers to cover the entire current expenditure needs. This will allow the Commission to take a holistic view of the requirements for expenditures on services such as education and healthcare and avoid segmenting the budgets. Indeed, as suggested by T N Srinivasan, the Planning Commission should be reconstituted as a Fund for Public Investment both for the Centre and the states and it will work much like a development bank, besides providing long-term development finance by sourcing funds from domestic and international capital markets.

It could also be involved in designing specific-purpose transfers along with the ministries and monitor the implementation, though the Finance Commission should have access to information on these expenditures while formulating its own recommendations. It is also important to ensure that specific-purpose transfers should not exceed 20 per cent of the statutory transfers as recommended by the NDC. Limiting the role of discretionary transfers and clarity in the roles and co-ordination among agencies are necessary to ensure that both general- and specific-purpose transfers are designed and implemented to serve their objectives.

Equally important is the need to channel the transfers to autonomous agencies through the states. While the states could be required to pass on the funds without any delay, both for accounting and for accountability, the states' intermediation is important. Indeed, the states should have clear activity mapping with local governments, and Central schemes should constitute part of grassroots planning. Ensuring fiscal autonomy to subnational governments with incentives and accountability is the key to the success of fiscal federalism in India.

The author is director, NIPFP. Comments at mgr@nipfp.org.in