The Hindu Business Line : Tasks before the Twelfth Finance Commission

THE Chairman of the Twelfth Finance Commission, Dr C. Rangarajan, has come out with a characteristically clear outline of the challenges that face the Commission. I refer to his article on the subject in the Economic and Political Weekly of June 26-July 2, 2004. His challenge is how to reconcile the objectives of maintaining fiscal balance at the Centre and the States while rectifying vertical and horizontal imbalance.

The article covers the ground in a masterly manner. Dr Rangarajan has asked for responses from those concerned. Hence, this piece.

The article spells out the various issues, such as the growing size of fiscal deficit at the Centre and the States. It reviews the weak performance of the Centre and the States in reaching the goals for fiscal balance set out by the Eleventh Finance Commission. Dr Rangarajan addresses the controversy regarding the optimal size of fiscal deficit of Government and comes out predictably on the side of the angels.

He dismisses the arguments of certain advocates of Keynesian policies by pointing out that a rise in fiscal deficit should be matched by a rise in capacity to service the increased deficit. He notes that, argued that from this angle, borrowings for generation of assets may be justified.

Apart from the fact that a little less than 70 per cent of borrowing is not being spent on capital assets, at least of the physical kind, even where there is capital expenditure, the return on assets is negligible. Even the more indirect returns through higher growth have not been forthcoming. The answer may, however, lie in better governance at all levels.

Given this stance on Dr Rangarajan's part, it is predictable that the vertical balance issue — namely, the size of Central Government's overall transfers to the States — will not see much improvement over the 37.5 per cent, already recommended and in place. In this context, Dr Rangarajan takes note of the oft-repeated requests by various States that the Centrally-sponsored schemes (CSS) be transferred to States along with the funds.

The proposal, even if accepted, will not involve any increase in total transfers since CSS transfers are part of the total transfers. Centrally-sponsored schemes deserve to be transferred from other points of view as well.

On what he calls the horizontal dimension of fiscal transfers, Dr Rangarajan recognises that the issue has been discussed at great length by various Commissions. He notes that in designing a scheme of fiscal transfers, three elements have to be considered — needs, cost disability and fiscal efficiency.

The Chairman points out that cost disabilities are factors that are largely beyond the States' control. Fiscal efficiency concerns parameters such as maintaining revenue account balance, robust revenue effort, economics of expenditure linked to efficient provision of services and the quality of governance.

Dr Rangarajan notes that there are problems in choosing appropriate indicators of these dimensions. Revenue capacity is measured by State's GDP, though it is recognised that GDP estimates prepared by the States present contentious issues of comparability and accuracy.

Assessment of cost disabilities is also not straightforward. They are clearly related to exogenous circumstances, such as the nature of the terrain, susceptibility to drought, and distance from centres of economic activity. Besides, the composition of population may also be important. The Commission has a tough task to determine cost-based norms to cover these widely variant factors, difficult to quantify.

One of the issues that Dr Rangarajan has — rightly — not addressed in his piece is relevant from the point of view of the latest developments in regard to the politics of economic management. The Common Minimum Programme mandates certain obligations on the Central Government to bring up backward States.

These considerations will, no doubt, influence the Centre's presentations to the Twelfth Finance Commission. There is also the difficult question of how to allocate the funds promised in the Budget for poorer States, such as Bihar. Is this to be part of the Central devolution or grants recommended by the Twelfth Finance Commission or to be routed through the Planning Commission?

There is also the vexing question of the impact of the Eleventh Finance Commission's recommendations, which, in the view of many critics, penalised efficient States and rewarded the laggards. This issue gets further amplified in the light of the Centre's declared intention of placing large funds at the disposal of backward States.

The exercise of combining indicators of backwardness into a criterion for allocation of taxes and grants is, indeed, complicated. The Twelfth Finance Commission has an unenviable task before it, if it is to satisfy the aspirations of backward States without hurting the interests of the so-called forward States.

There remains the difficult issue of how to ensure that the additional transfers of resources for rectifying backwardness get efficiently used. Dr Rangarajan does not come out clearly in terms of conditionality in respect of grants, though he recognises that the reforms facility does incorporate some such requirement.

The answer to the problem will lie obviously in unifying the role of the Planning Commission and the Finance Commission. It would be the path of wisdom for the Twelfth Finance Commission to place its equalisation grants at the disposal of the Planning Commission so that it can disburse the amounts to various States and also monitor their utilisation for the purpose of rectifying the backwardness of States.

The piece by Dr Rangarajan does refer to a number of other issues, including the uncertainty created by the introduction of VAT. The picture of Centre-State transfers in India is complicated by the presence of the Planning Commission, which plays a significant role in the transfer of resources from the Centre to the States.

There is also the complex issue raised by the Plan-non-Plan distribution of expenditures. The earlier Finance Commissions have traditionally confined themselves to the gaps in non-plan revenue account. Fortunately, the Twelfth Finance Commission is not confined to such limited review.

The terms of reference of the Twelfth Finance Commission take a broad view and mandate the Commission to consider the various commitments of States, including such obvious liabilities as salaries of public servants, maintenance of irrigation facilities and the like. The only binding constraint is that the Commission shall keep in mind the objective of not only balancing the receipts and expenditures of all the States and the Centre but also generating a surplus for investment and for reducing the fiscal deficit.

The Twelfth Finance Commission has not only to balance the revenue account but also to ensure that the arrangement generates surplus for capital outlays and for curtailing the fiscal deficit. A tall order, indeed!

One of the terms of reference of the Twelfth Finance Commission specifically directs it to review the fiscal reform facility introduced in the light of the recommendation of the Eleventh Finance Commission. Doubts were expressed as to the desirability of introducing a reform agenda by the backdoor in the form of facility that enshrines such goals as privatisation.

Whether the Twelfth Finance Commission will feel itself entitled to recast the reform facility totally in keeping with the latest prevailing paradigm laid down in the NCMP, remains to be seen.

So far as the request of States for debt forgiveness is concerned, Dr Rangarajan is clear in his view that any debt relief will have to be linked to the desired path of deficits in the future. Importantly, he calls on the Planning Commission to ensure that the size of the State Plan is consistent with a sustainable level of debt inasmuch as the State plans are almost always financed by borrowing in one form or another.

It is easy to suggest that a normative solution will end the disputes between forward and backward States. But norms for expenditure and taxable capacity are admittedly difficult to evaluate and enforce. States will have different views on the methodology of evaluation of norms for both expenditure and revenue.

One of the earlier Finance Commissions — under the Chairmanship of Mr N. K. P. Salve — did try to introduce norms based on complicated econometric models. Opinions are divided on how realistic the norms were. In fact, considerable adjustments become necessary to fit in actual facts to estimates based on norms.

Caution is justified when technical expertise is not able to bridge the gap between norms and actuals. While logic demands that the normative evaluation of States' needs and capacities are the best, pragmatism demands that they be adjusted in terms of historical data, especially when the basis of determination of norms is not technically robust.

Obviously, the challenge before the Twelfth Finance Commission involves a tough balancing act. The report of the Commission will be a document that may not be able to please all the stakeholders. But it is obvious that with such an eminent person as Dr Rangarajan at its helm, the report will be a path-breaking one, which will attempt a solution to the vexed issues of meeting the conflicting objectives of vertical balance and horizontal equity, and at the same time help contain fiscal deficit at the Centre and the States.