Simplicity. Objectivity. Logic. Efficiency. The SOLE of policy making. In theory. Indian policy makers have just issued the Eleventh report on how the tax bounty should be shared among the states. Surely enough time to fine-tune whatever logic is ostensibly present in the recommendations over the years. We are told that a primary purpose is redistribution from richer to poorer states. Further, that states should be subsidized for developing infrastructure. Further, that states should be rewarded for fiscal performance. All laudable statements of purpose. Let us examine if the EFC has met any of its own stated objectives. Do they pass the SOLE test?

There are 25 states in India out of which 10 can be termed either small (e.g. Goa) and political (North-Eastern states and Kashmir). The Eleventh Finance Commission (EFC) has provided the small (mostly political) states with an average per capita transfer of taxes from the central pool of Rs. 851 per year, compared to Rs. 562 for the big states. The national average is Rs. 571. Average incomes are almost identical across the big state/small state divide - Rs. 11180 vs. Rs. 11138. So income redistribution - the most important avowed goal of the EFC - is not at play here. So much for the first attempt at SOLE verification.

It can be legitimately argued that the small states are affected by politics. Thus, the analysis below is only concerned with the operation of SOLE for the 15 big states. Unfortunately, like the invisible hand, SOLE is nowhere to be found. But what is the SOLE criteria ? Most of the objection to the EFC awards, and the breast beating that has accompanied the fanfare, is that the "performing" (read richer) states have been penalized and are receiving lower per-capita allocations than the poorer non-performing states. To which the EFC's counter is, in hoarse historical tones, "Aare Bhai, the purpose of a federal system is to redistribute, so obviously the rich states will get less. Stupid Question. Next question".

But there is a problem with the EFC's glib counter to its critics. The problem is that the EFC logically double counts the effect of income. In other words, the EFC first penalizes the rich states for being rich, but if one redistributive penalty were not enough, it penalizes them again for being rich. Consider a family of two sisters - one rich and contributing Rs. 10000 to the family (taxes) and the other poor and therefore contributing half the amount, Rs. 5000. The average family (tax) income to be distributed is therefore Rs. 7500. Now a highly progressive rich to poor system would award both sisters the same amount - Rs. 7500. Note that an equal per capita allocation has a built in transfer mechanism - the rich give in more in taxes (by definition) and receive less back. The poor give in less, and get considerably more in return. A simple, efficient, transparent, redistributive system. To argue for an additional rich poor criteria for allocation, as the EFC does and other ten other Finance Commissions have done, is double counting of the worst sort.

The first three columns of the table report the actual EFC transfer, the "predicted" EFC transfer , and the predicted SOLE transfer. The second is based on stated EFC criteria and EFC data i.e. the allocations are based on how poor you are (the poor get more), the state of infrastructure (less infrastructure means more transfer) and fiscal improvement (more fiscal correctness means more money). The predicted SOLE award is based only on infrastructure status and fiscal correctness - to avoid double counting, per capita income is not a determinant.

The first major result is that there is zero, zilch, shunya relationship between the EFC awards and either infrastructure development or fiscal correctness. In other words, if a state has poor infrastructure it does not get more money, and if a state has improved its finances, it does not get more money. So go out and be inefficient, and you will not be penalized (except verbally). The only calculation that matters, despite 300 pages of EFC prose, is the state's per capita income - and the EFC double-whammy-double- adjustment means that a 10 % higher income for a state means a 9.5 % lower allocation of EFC transfers.

The above is obtained via a simple regression relationship between the EFC allocation and per capita income (both in logs), and the (insignificant) EFC's own infrastructure and fiscal variables. The SOLE model is identical except for the important difference that per capita income is not an explanatory variable i.e. if two states are identical in all respects except per capita income, they obtain the same allocation. In the SOLE model, for each 10 % that infrastructure is below the mean, the state obtains an extra 10.5 percent. The fiscal improvement index remains insignificant!

The EFC allocations have been criticized by several politicians, most notably by Chandrababu Naidu of Andhra Pradesh. The SOLE allocations suggest that Mr. Naidu has very little to complain about. His state is receiving Rs. 551 per capita whereas, given its infrastructure development and fiscal incorrectness, it should be getting only Rs. 519 per capita. Thus, AP is obtaining 6 percent more than it should. The states that really benefit according to the "behind the scenes" SOLE calculations are the following (with the EFC largesse percentage in parentheses): Assam (16%); Bihar (9 %); Kerala (49 %); Orissa (20 %); Tamil Nadu (19 %); UP (27 %) and West Bengal (33 %).

This is not the occasion to delve into the important missing component in the SOLE calculations - politics. But the Kerala result is intriguing - how is it obtaining such a high percentage. Is there an error? Its per-capita income is Rs. 13091 compared to a national average of Rs. 11179 i.e. 17 percent higher! So it should, according to the "EFC model", obtain 16 percent less than the national EFC average of Rs. 571 i.e. Rs. 462. It's fiscal improvement index is 109.56 some 10 percent better than the average, so it should get more. But as stated above, the impact coefficient of the fiscal index is not different than zero. Kerala's infrastructure index at 179 is amongst the highest in India - and thus it should receive substantially less than other states.

Contrast Kerala (a state soon to have state elections) with Karnataka (a state which recently had state elections). On the fiscal side, Karanataka is comparable with Kerala with an index of 106. The infrastructure index, at 105, is almost half of Kerala. Per capita income, at Rs. 12367, is also some 6 percent lower. So all the EFC and other pious redistributive logic should state that Karnataka should get substantially more. Instead, Karnataka obtains a paltry 4 percent more than Kerala - Rs. 522 versus Rs. 500.

As usual, the only explanation for India's economic policy lies in its politics. Perhaps a day will come when the situation will reverse. The same day when the financial control raj (read administered interest rates and exchange rates) will end; the same day when privatization will begin. The same day when economic freedom like the rest of the politically free world (and China) will be a reality. The same day when India will grow at 10 percent per annum rather than struggling to grow at slightly more than half its potential.