Tag: finance commission

Bob and Ronald Come to India, Part II

The Story So Far

Today’s post is a continuation of yesterday’s. We learnt in yesterday’s post about the problems with the upcoming delimitation exercise, and how the Southern States feel that they contribute “too much” to Union government taxes, and get “too little” in return. The reason the phrases in the previous sentence are in quotation marks is because there are major differences of opinion about whether this is the case or not.

Asking a politician about this question is a useless endeavor, at least in public, because they’re optimizing for answering the question in a way that maximizes their current electoral benefits. If it is more important (for the moment) to win state elections, they will say that it is true that states doth give too much. If it is more important (for the moment) to win national elections, they will say it is true that the Union government doth take too little. This is not a criticism of politicians, please note. It is an application of one of the simplest principles in economics: incentives matter.

And by the way, for those of you thinking I’m throwing shade at a particular political party, perish the thought. All politicians in all countries have done this in the past, regardless of their ideology, they’re doing it now, and they’ll do it in the future. You and I would do it too, in their place, for those have become the rules of that game. So it goes.

Well, can us economists do a better job? How do economists think of the answer to the question of how much is the “correct” amount to be transferred from a given state to the Union government? How do economists think of the answer to the next obvious question – how to think through vertical and horizontal devolution?

In today’s blogpost, I am going to try and answer this question, but in terms of frameworks, not in terms of data. My job today is to help you develop a framework about thinking through this issue. Once you have a framework, the data tends to make much more sense – or so some economists hope. I’m one of them.

Let’s begin!

Trade is a non-zero sum game

You’ve heard me say this before, and you’ll hear me say it again. Today is a good day to reiterate this point – it is as important as the point “incentives matter”:

Trade is a non-zero sum game

People just don’t get this point. When two parties engage in trade voluntarily, both parties are better off. When I pay the chai-tapri owner ten rupees for a cutting chai, he’s grateful for the ten rupees I give him, and the lord knows I’m grateful for the chai I get in return. This is equally true for an overpriced cup of Americano at Starbucks. Sure it’s over-priced, over-roasted and over the top, but you know what you don’t see outside Starbucks? You don’t see Starbucks baristas kidnapping people and then forcing them to buy coffee (venti, naturally). It is voluntary trade, and the reason folks step in to a Starbucks is because they want to buy that coffee. The trade is worth it to them.

And that simple idea underpins modern economics. Why, you might say it defines who we are as a species!

So I would urge you to think of the “problem” of the Southern states as a trade between the states and the Union government. We’ve heard from the Southern states side of this debate – they think they give too much to the Union. Well, if this is a trade, it is worth asking the obvious question.

What do the Southern states get in return?

There are two questions at play here, not just one. And it is important to think through both of these questions:

  1. What do the Southern states get in return from the Union government?
  2. What do the Southern states get in return by being a part of a Union?

Think back to the young man who plaintively called up his uncle from yesterday’s post. Everybody in that young man’s house contributes half their salary to run the house, and our young friend feels hard done by, because he earns the most (and therefore contributes the most). Worse, once the money is pooled in, he doesn’t get a bigger say in how it is to be spent – that decision is purely democratic. So he feels he pays in too much, doesn’t get enough in return, and doesn’t have enough of a say in how the money is spent.

But as an economist, I would urge him to be more holistic in his thinking. Young man, I might harrumph in his direction, should you not be accounting for the pleasure of having your friends stay with you? The emotional benefits? The security you get by staying together? The ability to call on the help of near and dear ones when the time arises? You may still feel hard done by, and maybe you should, that’s not for me to say – but I would urge you to do a complete cost benefit analysis.

The Cost Benefit Analysis Framework

Weird tangent alert – you’re going to feel I’ve flown off the handle here for a bit, but I’ll circle the discussion back to the topic at hand, I promise. But for now, let’s talk migration. Say you are an unemployed youth in a rural part of our country, with not much education. Should you migrate to the city in search of a job?

Here’s a framework to help you think through the answer to this question:

Source: https://ucsbecon114help.wordpress.com/2013/06/10/todaro-migration-model/


It looks like a pretty complicated picture the first time you take a glance at it, but all that it is really saying is this:

  1. How much will you earn by living in the city?
  2. How much do you earn now?
  3. How much will it cost to be in the city?
  4. How much does it cost to stay where you are?
  5. Not just economic costs and benefits, mind you! Note the boxes that talk about psychic costs and psychic returns!

Net all of this out, and if you’re in the black, move to the city. If you’re in the red, stay where you are. Easy-peasy.

It never is that easy, of course, and cost-benefit lists aren’t always the answer. But us economists will always give poor ol’ Ross a sympathetic pat on the shoulder. He was wrong, of course, but still. Brownie points for using a framework (and god help you).

What framework can we use?

So, OK, here is where we are now:

  1. Think of the delimitation and devolution exercise as a trade between the states and the Union government.
  2. The Southern states are quite clear about the fact that they think they’re contributing too much.
  3. But they should also think about what they’re getting in return from the Union government, and by being a part of the Union.
  4. A cost-benefit analysis will help, as will a cost-benefit framework.

So let’s go find a framework!

And what framework am I going to use? I’m going to call upon the ideas of the great Canadian economist, Robert Mundell (and those of Peter Kenen). A very accessible discussion of these ideas is to be found in a lovely little essay by Paul Krugman, called Revenge of the Optimum Currency Area. The title is a play on important work done by Robert Mundell in the late 1950’s on the topic of Optimum Currency Areas (OCA’s).

What are OCA’s? Have you ever wondered why, say, all SAARC nations don’t have the same currency? If you are going to break out in spots and rashes at the thought of having anything at all to do with Pakistan, calm down, and think of why all the ASEAN nations don’t have a single currency. And then think of how and why all of the states in the United States of America chose to have a common currency.

What are the conditions, Robert Mundell was asking, under which having a common currency across different political jurisdictions is optimal. And (very) long story short, Paul Krugman’s take on the issue, courtesy Mundell and Kenen’s ideas, is this:

It makes sense to have the same currency (a monetary union) across political jurisdictions if:

  1. These jurisdictions have labor mobility
  2. These jurisdictions have capital mobility
  3. These jurisdictions have a fiscal union

What if we “flip” this around? For those of you familiar with linear programming, think of the “dual”. It is not an exact analogy, I’ll be the first to admit, but try this on for size:

It makes sense to bear the costs of being in a fiscal union across political jurisdictions if:

  1. These jurisdictions have labor mobility that proves to be beneficial
  2. These jurisdictions have capital mobility that proves to be beneficial
  3. These jurisdictions have a monetary union that proves to be beneficial

That is, so long as the net benefits that accrue from having labor mobility, capital mobility and being in a monetary union are more than the net costs of being in a fiscal union, it is more than worth it.

(This is worth emphasizing again: net benefits and costs. Sure there are costs to being in a fiscal union, but there are benefits too!)

Labor mobility means being able to count upon (freely!) accessing surplus labor from other parts of the country. Capital mobility means ditto, but for capital, not labor. And a monetary union is, of course, having the same currency across all states. What is the net benefit from all of these? So long as this is more than whatever the (actual and perceived) costs of being in a fiscal union are, well, all izz well.

But kahaani abhi baaki hai mere dost!

Heresy for an economist, but counting is problematic

My head hurts just thinking of the number of academic papers that can be churned out in terms of trying to quantify the previous section. We can keep the paper mills churning for years on end, and LinkedIn will drown in a deluge of “Delighted to share that our paper on…” messages.

But I would say that such exercises will ultimately be futile. Why, you ask? Here’s Paul Krugman’s take on this:

Now, what we need to say right away is that this “weighing” takes place only in a qualitative sense: at this point nobody says that the benefits of joining the euro are x percent of GDP, the costs y, and x > y, so the euro it is. Instead, it is more along the lines of arguing that Florida is a better candidate for membership in the dollar zone than Spain is a candidate for membership in the euro zone. This does not necessarily say that Spain made a mistake by joining the euro—nor does it necessarily refute the argument that Florida would be better off with its own currency! But the theory does at least give us some insight into the trade-offs.

https://www.journals.uchicago.edu/doi/full/10.1086/669188#

And my own take is this: remember psychic costs and benefits from our migration example? Drill this into your head – just because these cannot meaningfully be measured doesn’t mean they don’t exist!

What are the psychic benefits of being in a monetary and a fiscal union? In English, if you prefer (and you should, because economics is a most unpoetic* language):

What are the psychic benefits of being part of a nation?

Equally, because being analytical requires being evenhanded, what are the psychic costs of being part of a nation? Factoring in the answers to these questions is impossible very, very difficult. So very impossible difficult, in fact, that I would be of the opinion that it cannot and should not be done.

So how to think of a solution?

Ronald, the OG, will tell us all about it on the morrow.

*It’s a word, and I will not be taking any questions.

Bob and Ronald Come to India, Part I

The Penny Drops

Imagine this:

Let’s say a young man calls you up. Could be your cousin, or your nephew.

I’ve got a problem, he says.

Temme, you say.

Well, it’s like this, he says. I work in an MNC in Bangalore, and make a lot of money.

Great, you say. What’s the problem?

Well, I stay with roommates, and it’s complicated. We were all together in college, and we’d sworn while in college that we’d be roommates. Problem is, all my friends earn nowhere near as much as I do. We’d sworn to live as one big happy family, so we’re all staying together, and that’s awesome. But…

Yeah, you say. But what?

Well, our motto was and is “All for one and one for all”. The problem is that what that ends up meaning is I contribute a lot to run our home, because I earn a lot more than the others. My contribution goes into a common “kitty”, proportionate to how much I earn. We all contribute half of our salary to run our home, but because I earn much more than the others, I contribute much more.

So what’s the problem, you yawn. If you contribute more, you should also get a bigger say in how that money is to be spent, no?

But that’s the problem!, comes the response from the other side. How the money is to be spent is not up to me. There, the principle is one person, one vote.

Wait a minute, you say. When it comes to pooling in the money, it is a function of what you earn. But when it comes to distributing the money, it is a function instead of how many of you are there?

Exactly, says the young, troubled whippersnapper. Now what?

If you contribute more, should you (or should you not) get a greater say in how your contribution is to be spent? And if not, should you be contributing more in the first place?

What is fair, what is just, what is desirable, and what is best? And for whom?

I don’t know if you’ve noticed, but there has been a bit of a kerfuffle recently about southern states saying it’s all very unfair. What exactly is unfair, you ask? Buckle up, because this is going to be a long ride.

The Background

Like I said, this is going to be a long story, but because this is one of the most important things we have to tackle as a country, let’s set about learning more about it. Let’s begin with the 42nd Amendment to the Indian Constitution:

Up until 1976, after every Indian Census the seats of Lok Sabha, Rajya Sabha and State legislative assemblies of India were re-distributed respectively throughout the country so as to have equal population representation from every seat. The apportionment was done thrice as per 1951, 1961 and 1971 population census. However, during The Emergency, through Forty-second Amendment the government froze the total Parliamentary and Assembly seats in each state till 2001 Census. This was done, mainly, due to wide discrepancies in family planning among the states. Thus, it gives time to states with higher fertility rates to implement family planning to bring the fertility rates down.

Even though the boundaries of constituencies were altered in 2001 to equate population among the parliamentary and assembly seats; the number of Lok Sabha seats that each state has and those of legislative assemblies has remained unaltered since 1971 census and may only be changed after 2026 as the constitution was again amended (84th amendment to Indian Constitution) in 2002 to continue the freeze on the total number of seats in each state till 2026. This was mainly done as states which had implemented family planning widely like Kerala, Tamil Nadu and Punjab would stand to lose many parliamentary seats representation and states with poor family planning programs and higher fertility rates like Uttar Pradesh, Bihar and Rajasthan would gain many of the seats transferred from better-performing states.

https://en.wikipedia.org/wiki/Delimitation_Commission_of_India

What does this mean, and why does it matter?

Let’s talk about a Lok Sabha constituency from Tamil Nadu, and a Lok Sabha constituency from Uttar Pradesh. If the Lok Sabha Member of Parliament (MP) from Tamil Nadu represents a 100 people (let’s assume this), how many people should the Member of Parliament from UP represent?

Should it be around the same number, 100? Is a little bit more OK? Is a lot more OK? At what stage do you say “whoa, this is too much!”? Let’s rephrase the question: should each state in our country send the same number of Members of Parliament to the Lok Sabha, or should larger states send a higher number of MPs? Larger defined in terms of total population, please note.

And one of the tenets of democracy is that each Member of Parliament should represent roughly the same number of people. We can’t have – or shouldn’t have, at any rate – a very large number of MPs representing very few people. Nor should we have a very small number of MPs representing very many people.

Malapportionment from 1971-2021 (based on census data till 2011 and author’s calculation thereafter) Source: Shruti Rajagopalan’s essay

This chart has been taken from Shruti Rajagopalan’s excellent essay, called Demography, Delimitation and Democracy. And what is shows us is one way to answer the question I have raised above. By her calculations, when the delimitation freeze ends*, Uttar Pradesh will have 12 to 13 seats short of what their population should merit. Or put another way, Tamil Nadu will likely have 11 seats more than what their population should merit.

Here’s another way of thinking about this: if a state has (say) x% of a country’s population, it should have (say) y seats in the Lok Sabha. If that be so, another state that has 2x% of a country’s population should have 2y seats in the Lok Sabha.

Why? Because otherwise, the second state will have a smaller number of MPs arguing for it in the Lok Sabha – smaller relative to the number of people in that state. And the first state, of course, will have a larger number of MPs representing that state in the Lok Sabha – a larger number relative to the number of people in that state.

As Shruti puts it in her essay:

One aspect of the “one person, one vote” concept, as envisioned by Ambedkar, was about granting every single Indian over 18 the right to vote in elections. India has adopted universal adult franchise since the birth of the republic in 1950. But to give the principle of “one person, one vote” any meaning, constituency sizes must be roughly equal. The random circumstance of being born in Bihar means that the constituency size is about 3.1 million, but if the same person is born in or moves to Kerala, the value of their vote increases because the constituency size is 1.75 million.

https://srajagopalan.substack.com/p/demography-delimitation-and-democracy

So in essence, each state should send a proportionate number of MPs to the Lok Sabha. And the number of these MPs should be proportionate to what? To the percentage share of the total population in each state. That way, we can make sure that each state gets proportionate representation in the Lok Sabha. Right now, there is an imbalance – the people of Tamil Nadu are over-represented, and the people of Uttar Pradesh are under-represented.

Of course, Tamil Nadu and Uttar Pradesh are used to represent, generally speaking, states in the less populous south and the more populous north respectively.

What is the scale of the problem?

Right, now that we have established this, let’s ask the next obvious question: how many people are there in each state in our country? Here’s one way to answer that question:

https://www.visualcapitalist.com/population-of-india-compared-with-countries/

Here’s another way of putting it – the Indian Prime Minister is in effect the Prime Minister of the populations of all of these countries put together.

You know how we keep saying that hey, we have one-sixth of the population of the world in our country, and it is therefore unfair that we don’t have a permanent seat on the UN Security Council?

Uttar Pradesh can say the same thing (kinda – you know what I mean), but at the national level.

So What Are We Waiting For?

Well, ok then, a layperson might say. All this is good to know, and er, carry on and all that – but why don’t we just go ahead and, you know, change the distribution of the seats in the current Lok Sabha? If UP gets to send 84 MPs to the Lok Sabha, up that number. And If Tamil Nadu gets to send 39 MPs, well, adjust that number downwards. What’s the problem?

Well, the endowment effect, for starters. But more importantly, it’s all well and good to talk about demography and all that, but this is, after all econforeverybody. Sooner or later, rokda must enter the building.

How does this country of ours function when it comes to finances? Well, back when we got independence, we decided that we would organize finance in the following way – states would get to levy some taxes, and they could spend that tax revenue on stuff they were responsible for, such as health, among other things. We call this Own Tax Revenue. The Union government would get to levy some taxes, and part of this revenue would be kept for the Union Government’s expenses (army related expenditure, for example, among other things). And there’s other complications, but we’ll skip that part for now.

But ah, there is a small part of one of the sentences in that last paragraph that hides a world of pain. Note that I said “part of this revenue would be kept for the Union government”. Now, the part that is not kept for the Union Government – how is it distributed to the states?

For example, let’s say the Union government collects 100 rupees in taxes.** How much should it keep with itself? Should it keep 40 with itself and give the rest to the states? Or should it keep 80 with itself and give 20 to the states? Or some other number? How do we decide? How should we decide?

Dr. Arvind Panagariya and his band of merry men and women shall answer this question for us in the months to come, as mandated by the law. They shall answer two questions (and do a whole lot of other things too, of course!)

  1. How much should the Union government keep with itself?
  2. Of what can be distributed to the states, which state should get how much, and why?

It is that second question that is tricky. Oh so very tricky. And figuring out how best to answer it is, as it turns out, what we’re all waiting for.

So How Do We Decide Which State Should Get How Much?

Of all of the taxes collected by the Union government, we first have to decide the split between what the Union Government keeps for itself and what is given to the states. This is called Vertical Devolution.

Then, of what is given to the states, we have to decide how much each state gets. This is called Horizontal Devolution.

The predecessors to Dr. Panagariya’s merry band came up with this formula:

https://fincomindia.nic.in/asset/pdf/commission-reports/XVFC_202021%20Report_English_Web.pdf, p. 29

The higher the population in a state, the more it should get when it comes to horizontal devolution. How important is this idea? It gets 15% weightage.

The larger the physical area of a state, the more it should get (15% weightage)

The greater the forest cover in a state, the more it should get (15%)

The poorer a state compared to average incomes in our country, the more it should get (45%)

The better a state at lowering it’s Total Fertility Ratio (demographic performance) the more it should get (12.5%).

The better it is at mopping up taxes, the more it should get (2.5%).

So while other factors apply, as they should, the primary consideration is this: the poorer a state, the more help it should get.

“Well, of course” you might say, channeling your inner Mahi.

And your inner Mahi would be right, of course. This is how it should be. Except, as our little story at the start of this blogpost helps us understand, it is a bit more complicated than that.

This is a multi-part series, to be continued! In later posts, we shall learn about how to think about this problem from an economic perspective, and how to think therefore about resolving the problem. But this point is worth emphasizing: if you are an Indian citizen, you should be thinking long and hard about this issue.

*Quite when the delimitation freeze will end is a matter of some conjecture. As Shruti says in her blogpost: “The Eighty-Fourth Amendment extended the 1971 census freeze on the total number of seats per state in the Lok Sabha/state legislatures until the publication of the census figures after 2026 (which is expected in 2031, unless the 2021 census is delayed so much that it is only published in 2026).”. I’ll go a step further and say that there is no guarantee, of course, that the 2031 census will be conducted as per schedule.

** How it collects these taxes is a story involving VAT, MODVAT, CENVAT, GST and other horrific acronyms. As with other inconvenient acronyms (such as, say, CRS) so with these acronyms in this blogpost. We shall simply assume that they don’t exist for now.

Links for 17th May, 2019

  1. “Despite the 73rd and 74th Constitutional amendments, except in a few states, there has been little progress at decentralization—to both rural and urban local bodies. Most state governments have been reluctant to devolve the functions, funds and functionaries for delivering public services at the local level. The functions assigned are unclear, funds uncertain and inadequate, and decision-making functionaries are mostly drawn from the state bureaucracy. Local bodies do not even have powers to determine the base and rate structure of the taxes assigned to them. The states have not cared to create institutions and systems mandated in the Constitution, including the appointment of the State Finance Commissions, and even when they are appointed, states have not found it obligatory to place their reports in the legislature. In fact, the local bodies are not clear about delivering local public goods, with the prominent agenda of implementing central schemes obscuring their functions.”
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    M. Govinda Rao pulls no punches in pointing out how and why decentralization hasn’t (and likely will not) taken place in India. This is a conversation more people need to be having in India – and in particular, to aid meaningful urbanization.
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  2. “I love this paper because it is ruthless. The authors know exactly what they are doing, and they are clearly enjoying every second of it. They explain that given what we now know about polygenicity, the highest-effect-size depression genes require samples of about 34,000 people to detect, and so any study with fewer than 34,000 people that says anything about specific genes is almost definitely a false positive; they go on to show that the median sample size for previous studies in this area was 345.”
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    Slate Star Codex helps us understand the importance of learning (and applying!) statistics. The website is more than worth following, by the way.
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  3. “Sucking the life out of a mango is one of those primal pleasures that makes life feel worthwhile. The process is both elaborate and rewarding. The foreplay that loosens up the pulp inside, the careful incision at the top that allows access without a juice overrun, and then the sustained act of sucking every bit juice from the helpless peel. Senses detach themselves from the body and attach themselves to the mango, and even mobile phones stop ringing. The world momentarily rests in our mouths as we slurp, suck and slaver at the rapidly disappearing pulp. The mango is manhandled vigorously till only the gutli remains which is scraped off till it has nothing left to confess. As is evident, there is no elegant way to eat this kind of mango, no delicate and dignified method that approximates any form of refinement, which is just as well, for the only way to enjoy a mango is messily.”
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    An excellent column about an excellent fruit – there isn’t that much more to say! I completely agree with the bit about serving aamras front and center, rather than as an afterthought, by the way.
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  4. “Welcome to the 4th Annual Top Economics Blogs list. For the 2019 edition, we’ve added many newcomers, as well as favorites which continue to provide quality insight year after year. Like lists in previous years (2018, 2017, 2016), the new 2019 list features a broad range of quality blogs in practically every economic discipline. Whether you are interested in general economics or prefer more specific topics such as finance, healthcare economics, or environmental economics; there is something here for you. You will also find blogs which focus on microeconomics, macroeconomics, and the economics of specific geographical regions.Whether you are a student, economics professional, or just someone with a general interest in how economic issues affect the world around you, you’re certain to find the perfect blog for your specific needs.”
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    The most comprehensive answer to that most perennial of questions: what should I read?
    Bonus! If you’re wondering how to keep up with all of this, this might help.
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  5. “India should do the same with our state capitals. The Union government can create fiscal and other incentives to encourage state governments to shift their capitals to brown- or green-field locations. Mumbai, Bengaluru, Hyderabad, Chennai, Jaipur or Lucknow, for instance, will continue to thrive even if the state government offices move out. Their respective states will benefit from a new urban engine powered by government.”
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    I have been sceptical about the feasibility of doing something like this – my reading of urbanization has always been that it more of an organic process – cities grow (or not) of their own accord, and rarely as a planned endeavor. But maybe I’m wrong?