The Thirteenth Finance Commission faces a challenging task. Despite an improvement in recent years, the fiscal situation continues to be a matter of concern when off-budget liabilities and other fiscal risks are considered. With rising oil prices on the one hand and a surge in capital flows on the other, calibrating the transfer system in tune with counter-cyclical fiscal policy stance is a formidable challenge. This paper argues that irrespective of the wording of the terms of reference, the Commission would do well to focus on its primary task of recommending transfers to serve the objective of equity and incentives. While it is required to take into account a number of considerations, the focus should be on the transfer system. As an impartial body, the Commission should make a fair assessment of the central as well as state governments, ignoring the asymmetries in the wording of the TOR. As regards the transfer system itself is concerned, the paper argues that although it may be difficult to make drastic changes in the relative shares of the states, the Commission should give up the gap filling approach. Instead, after recommending tax devolution, the Commission should recommend grants to fully equalise expenditures on elementary education and basic healthcare. It is also possible to incentivise the transfer system for even those states that have a better record of providing education and healthcare to improve the quality of these services.
