Some Notes on the 14th Finance Commission’s Recommendation

Basically, when you spend your money, you’re very careful how much you pay; but when you spend someone else’s money, you aren’t that careful. Further, when you’re spending the money on yourself, you try to get as much value for money as possible; but when you spend it on someone else, you aren’t that careful to get as much value.

Milton Friedman, who won the 1976 Economics Nobel, has a wonderful way of explaining how one spends money. According to him, there are four ways of spending money as depicted in the table below.

Whose money you spend On whom you spend it
Yourself Someone else
Yours I.You pay less

You get more value

II.You pay less

They get less value

Someone else’s III.They pay more

You get more value

IV.They pay more

They get less value

 

Basically, when you spend your money, you’re very careful how much you pay; but when you spend someone else’s money, you aren’t that careful. Further, when you’re spending the money on yourself, you try to get as much value for money as possible; but when you spend it on someone else, you aren’t that careful to get as much value.

Friedman talks about this in his Free to Choose in the context of welfare schemes, but I think this can be used to analyze government spending in general. All governments spend someone else’s money. That is, all governments would like to claim that they operate only in Quadrant IV above. From the table, it is clear that the people ultimately pay more than what they’d pay if they were spending the money themselves (instead of the government). However, in reality, they ultimately do operate in Quadrant III also, i.e., they do end up spending someone else’s money on themselves, too (this is called operational cost).

So what happens in all government spending is that the people pay more and get less value. It’s the most inefficient way to spend money. The best option is to be in Quadrant I. Of course, governments have to exist and they have to spend some money, so ultimately the moral of the story here is that government spending must be minimal.

Let me now go to the next step and bring in two layers of government. In India, the central government sits in Quadrants III and IV. Clearly, Quadrant III spending should be minimal, which means the size of the central government and the projects it undertakes should be minimal to begin with. Coming to Quadrant IV, the central government is the ultimate spender of all the tax revenue it collects irrespective of what the finance commissions declare to be the best revenue-sharing formula between the centre and the states.

As per the recommendations of the 14th finance commission, the centre continues to get 58% of the tax revenue. This means 58% of the money paid as tax by the people of India will be spent in Quadrants III and IV by a government which is two layers above the people (the state governments being one layer above). That’s someone else’s someone else spending your money.

As far as the remaining 42% is concerned, this revenue will be spent in Quadrants III and IV by state governments, but this doesn’t automatically mean that your money will be spent by your state government, or that your state government is spending your money. This is because the basis for distribution of central tax revenue to states is not clear from the emerging news reports about the 14th finance commission. Historically, people in the more productive states have tended to pay for those in the less productive ones, and it is doubtful that that has completely changed this time around. In short, what we need is a way for central spending to further reduce.