The author is former governor, Reserve Bank of India
CRangarajan has become the chairman of the twelfth finance commission at a critical moment of India’s fiscal history. The twelfth finance commission has a particularly difficult problem because of the high fiscal deficits of the states and the Centre.
The finance commission has been assigned the responsibility of allocating Central tax resources and recommending, in addition, grants to help the states to balance their budgets. A specific term of reference of the twelfth finance commission requires it “to review the state of finances of the Union and the states and suggest a plan by which governments may collectively and severally bring about restructuring of the finances restoring their budgetary balance, achieving macro-economic stability and debt reduction, along with equitable growth”. While this term of reference confers a considerable degree of freedom on the twelfth finance commission, it is not, however, within the remit of the finance commission to suggest means of raising fresh resources. It can, however, recommend incentives related to benchmarks of fiscal reforms and of established norms in respect of tax collections and effective governance.
This term of reference brings up the issue of norms to ensure fairness in assessing the needs of the states. The ninth finance commission had attempted an exercise for the evolution of such norms. But, subsequent commissions have not devoted much attention to this difficult task, given the fact that states have diverse problems and different resource endowments. It is to be hoped that the twelfth finance commission will resume the deferred issue of evolution of a set of norms both in respect of expenditure and revenue.
This is particularly important because of the tendency of the states to pad up their estimates of expenditure and abridge their expectations of revenue over the revenue period. The finance commission cannot totally eliminate a look at such estimates. For the same period, however, the states present different estimates to the planning commission, with a more optimistic picture of resources in order to get a higher plan. The twelfth finance commission, which includes a member of the Central planning commission, Som Paul, will hopefully rule out such inconsistencies.
The eleventh finance commission earned considerable obloquy by its allocation of Central revenues on the basis of a formula, which accorded too high a weight to the index of backwardness of states. While backwardness had been an important consideration, the eleventh finance commission went overboard in according a weight of 62.5 per cent to this factor. This resulted in a number of states, which were relatively advanced and had a better record of tax collection and growth, ending up with a lower share of taxes and grants than before. The Centre had to come up with a supplemental finance to alleviate this loss of the so-called advanced states.
While the twelfth finance commission has to consider backwardness as a factor, it has to avoid the error of excessive affirmative action. The dilemma before this commission is unenviable. If it reduces the weightage for backwardness, it will become a target of criticism that it has helped the better-off states to garner higher shares of the nation’s resources. But, it if keeps the weightage unaltered, it will perpetuate the problem which the eleventh finance commission created. It is a challenge to the ingenuity of Rangarajan and his colleagues to evolve a middle path, that will not harm the backward states while helping the more advanced states. The solution has to penalize states for their failure to perform, while giving incentives to them to put in their best efforts. There should not be a premium for being laggards.
This leads to a problem of how to help the backward states to overcome their problems. It is my view that the question of regional backwardness is best left to the planning commission, which gives adequate consideration to the problem of individual states. Its formula in assigning Central assistance adequately takes into account the backwardness of the states. It is not necessary that the finance commission revisit the same issue of inter-regional justice in its formulae in the allocation of taxes and grants. Whether such a straightforward approach of division of responsibilities will be acceptable to the twelfth finance commission, however, remains to be seen.
One important issue, which some earlier finance commissions had worried about, is that they were asked by implication to balance only the non-plan account of the states. The terms of reference of the twelfth finance commission do not make such a distinction. They refer to the budgetary deficit as a whole and not of the plan or non-plan. This is a sensible change. Whether the emphasis should be on the revenue deficit as such or the fiscal deficit as a whole is, however, a matter to be clarified.
In my view, the fiscal deficit problem has been compounded mainly because revenue deficits are on the increase. Borrowing for revenue deficit is unsustainable. While borrowing for investment may become self-financing if the investments prove right, this is not possible when states borrow to meet revenue deficits. True, the intangible gains of human development may get translated into higher revenue. But that is difficult. The finance commission should focus its attention on achieving balance on the revenue accounts of the states and leave it to them to finance their investment needs by borrowing either from the Centre or from the market or both.
The pattern of financing of the plan from the Centre to the states has also a great deal to do with the emerging imbalance on the revenue account of the states. The national plan is weighted in favour of revenue component both at the Centre and the states. The states have a higher revenue content because they are primarily charged with the responsibility for the soft sectors of health, education and poverty alleviation. The revenue content of the plan is, therefore, relatively higher.
At the same time, the tax resources under the command of the states are relatively inelastic, except for the sales tax and excise. The states inevitably fall into the problem of unsustainable revenue budgets. A permanent solution to this problem can be evolved only if the transfer of resources from the Centre to the states is weighted in favour of grants. The states’ dependence on loans both from small savings and open market to finance revenue deficit also accentuates their problems. This is further complicated by the fact that the states do not take the decision of raising user charges adequately to meet the interest expenditure which falls due on loans raised for their investment needs.
The public sector enterprises of states, particularly state electricity boards and transport undertakings, are often run inefficiently and unprofitably. The fiscal reform mechanism of the Centre has to link additional financial assistance to better performance of such PSEs. This finance commission should improve on these links.
In this context, a ticklish question that previous finance commissions have raised is whether it is within the province of the commission to link its devolutions to conditionalities. The expectation is that the tax devolution from the Centre to states should be without conditions. But, in the pursuit of a better fiscal structure, the twelfth finance commission will be well within its rights to link its devolutions of taxes and grants to specific performance goals achieved by the states. Such a condition has already been insisted upon by the previous finance commissions for their upgradation grants, given to states for improvement of administration. A linkage of overall devolution to performance should turn out to be a useful tool for ensuring that the admittedly large transfers from the Centre to the states are usefully and purposively employed.
It has often been suggested that the periodic establishment of finance commissions cannot serve the purpose of fiscal stability as effectively as a permanent finance commission can do. This idea gathers support, particularly in view of the need to maintain a constant review of the changing conditions and performance by different states. A standing finance commission on the lines of the planning commission will definitely improve the management of the nation’s financial resources and help achieve fiscal balance with due care for regional equity.
It would, at the same time, ensure that states are kept on their toes. There is no reason to object to this suggestion on the ground that it will increase the Centre’s organizational expenditure. Surely, the money spent on a permanent finance commission will be more than repaid by increased efficiency, fairness and equity in the Centre-state arrangements.