Q. Explain how the Fiscal Health Index (FHI) can be used as a tool for assessing the fiscal performance of states in India. In what way would it encourage the states to adopt prudent and sustainable fiscal policies?

Model Answer:

The Fiscal Health Index (FHI), developed by NITI Aayog, serves as a comprehensive multi-dimensional assessment tool that evaluates states’ fiscal performance beyond single-metric analysis like fiscal deficit alone. It provides a holistic evaluation framework through five critical sub-indices that capture the complete fiscal landscape of Indian states.

FHI as an Assessment Tool:

The index employs five key parameters for comprehensive evaluation:

• Quality of Expenditure: Assesses whether state spending prioritizes long-term growth through capital expenditure on infrastructure, health, and education versus non-developmental recurring items like subsidies and freebies. States like Odisha excel here.

• Revenue Mobilization: Measures states’ capacity to generate own revenue through taxes and non-tax sources, indicating self-sufficiency levels and reducing dependence on central transfers. Gujarat demonstrates strong performance.

• Fiscal Prudence: Evaluates deficit management (fiscal and revenue) against FRBM Act targets, ensuring states maintain discipline in borrowing and spending patterns.

• Debt Index: Tracks debt burden and servicing costs, measuring interest payments as share of revenue. Punjab faces challenges here.

• Debt Sustainability: Assesses whether economic growth sufficiently manages long-term debt obligations, crucial for states like Kerala requiring reforms.

Encouraging Prudent Fiscal Policies:

The FHI motivates states toward fiscal discipline through multiple mechanisms:

• Competitive Federalism: Creates healthy inter-state competition through rankings. Odisha’s 2025 top position sets benchmarks, motivating others to improve fiscal management for better reputation and investment attraction.

• Benchmarking and Peer Learning: Enables states to identify weaknesses and adopt best practices from high performers like Chhattisgarh, facilitating knowledge transfer across states.

• Policy Nudge: Highlights specific vulnerabilities requiring urgent action. Low scores in particular sub-indices signal immediate reform needs, prompting corrective measures.

• Transparency and Accountability: Makes fiscal data publicly comparable, holding governments responsible for financial decisions and reducing fiscal profligacy.

• Performance-Based Incentives: Informs Finance Commission recommendations for grants and transfers, rewarding states demonstrating fiscal discipline through improved rankings.

Conclusion: FHI transforms fiscal management from compliance to performance-oriented governance, balancing discipline with development imperatives effectively.