The Hindu Business Line : Institutional reforms — Challenges facing the economy

With the markets playing a far greater role in the economy since the reforms of 1991, the Planning Commission and its role have become all but anachronistic. T. N. SRINIVASAN suggests the creation of a fiscal review council to monitor the policies and performance of the States and the Centre and outlines a new role for the Planning Commission as a fund for public investment.

The framers of India's Constitution, adopted in 1950, opted for a centralised, `quasi-federal' system because of concerns about the country's unity and stability, as well as the risk of inequality and resources being captured by the elite. In the early years, with the Congress party in power at the Centre and States, the State governments functioned basically as "corporate divisions" of the party. But with regional parties emerging in the States and participating in coalitions at the Centre, the rationale for the Constitution's unitary features has eroded.

The Planning Commission was established in March 1950. There was then a consensus across the political spectrum on the need for planning for national development and for a dominant role for the state in the economy.

Also, Nehru and other leaders were admirers of Soviet-style central planning and wanted to replicate it in India. There was also a consensus that the economy would be insulated from world markets, reflecting in part the disastrous experience of the world economy between the two World Wars and the perception of liberal foreign trade as a colonial imposition.

With the collapse of the Soviet Union in 1991 and central planning going out of fashion even earlier, the Planning Commission and its role have become all but anachronistic. The markets have come to play a far greater role in the economy since the reforms of 1991. With globalisation, India is now far more open to external competition and foreign investment. The exchange rate of the rupee is largely market-determined, the rupee itself being convertible for current transactions. Domestic fiscal and monetary policies now have to be consistent with foreign sector policies to avoid financial crises and ensure rapid and sustained growth.

Fiscal roadmap

As a roadmap for making the rupee fully convertible is being considered, institutional reforms have to be undertaken to ensure that India's federal fiscal system does not create crisis-provoking conflicts.

There are some problematic aspects of the Finance Commissions as well. The recommendations of each commission apply for a five-year period. However, the sustainability of public finances cannot be judged and appropriate recommendations made without a longer-term perspective on revenues, expenditures and interest rates. There is no way one commission can commit future commissions to adopt its own perspective. Neither can a government in power commit future governments. Thus, myopia and short-term considerations would tend to bias the thinking of the commissions and governments.

The Twelfth Finance Commission (TFC) viewed its mandate as recommending a scheme of fiscal transfers that serve the objectives of equity, stability and efficiency. Vertical imbalances in the constitutional assignment of tax bases, resulting in more revenues to the Central government and large expenditure responsibilities for the States, are to be corrected by appropriate revenue-sharing between Centre and States and grants from the Centre to the States.

Horizontal imbalances, arising from the differential capacities and needs of the States and in the differences in the costs of providing services, are to be addressed by an appropriate division of Central grants among the States. Recent Commissions have recognised that revenue-sharing and grants, unless carefully designed, could blunt the incentives of governments to improve efficiency of revenue generation and expenditure.

Finance Commissions have not examined the rationale for the existence of many public sector units (PSUs), though their operations have had a significant impact on the finances of governments at all levels. State governments have borrowed from the market through PSUs under State guarantees, creating contingent liabilities and avoiding the normal budgetary process to raise resources in a non-transparent manner. Given that India's many PSUs do not produce public or merit goods, a serious analysis of the social rationale of PSUs is called for, rather than a meaningless debate over whether profit-making (at distorted market prices) public enterprises should be privatised or not.

Equalisation concept

The TFC refers to the concept of `equalisation' as the guiding principle for fiscal transfers for promoting equity and efficiency in resource use. Equalisation transfers aim at providing citizens of every State a comparable standard of services, provided its revenue effort is also comparable. The conventional argument for decentralised service provision, that lower level governments are better informed of, and responsive to, the heterogeneous preferences of their residents is less salient in the contemporary informationally-connected world.

The constitutional provisions regarding assignment of tax bases, expenditure responsibilities and the Finance Commission need reconsideration. This would involve a long process of thought, debate and constitutional amendments.

In the meantime, a consultative and cooperative forum for designing fiscal policies of the States and the Centre should be created. The Planning Commission now discusses State Plans with each State separately. On the other hand, the National Development Council (NDC), in which State chief ministers are represented, discusses the National Five-Year Plans. This discussion is perfunctory and non-operational as the NDC is not presented with a menu of policy choices.

There are ad hoc forums for discussion, such as the Empowered Committee of State Finance Ministers (ECSFM) and the meetings of State Finance Secretaries organised by the Reserve Bank of India, that do provide an opportunity for each State representative to be informed of and comment on other States' policies. These forums do not discuss the Central government's fiscal policies. I suggest the creation of a Fiscal Policy Review Council (FRC), consisting of the Prime Minister and Finance Minister, Chief Ministers and Finance Ministers of States and Union Territories and experts appointed by the Prime Minister in consultation with the Chief Ministers.

The FRC would meet at an appropriate frequency to review the medium and long-term fiscal policies and performance of the States and Centre as well as make recommendations. The Council's rankings and recommendations would not only have greater political weight but also provide a commitment mechanism for the Centre and States to undertake reforms which each may not be able to do unilaterally.

Financial transfers

There are essentially three types of transfers that call for a unified approach: current transfers through the Finance Commission, capital transfers for financing investment through the Planning Commission, and transfers through State's fiscal Centrally-sponsored schemes. In a unified framework, first, it would make sense to eliminate transfers through Centrally-sponsored schemes and for the Centre to assume full responsibility for financing them. The current system of Centrally-sponsored schemes, under which the Centre partially finances the capital cost of each scheme cost and pays for its operational cost for a limited period, has the unfortunate effect, that after the scheme is completed, the assets created are not fully utilised because States do not have resources to meet the costs of operating them once they became their exclusive responsibility.

Second, since economy-wide planning has lost its relevance, while public investment has not, the Planning Commission should be reconstituted as a Fund for Public Investment (FPI) for both the Centre and States, with the State and Central governments as shareholders. The FPI will operate much like a development bank for providing long-term development finance. It will borrow its loanable funds from domestic and foreign capital markets with guarantees from its shareholders and appraise investment projects for which the Centre or State wishes to borrow from the FPC, for their feasibility, economic and social returns.

Fund for public investment

The FPI is not meant to be the financial intermediary between State governments and capital markets at home and abroad as well as external aid agencies. The States will have the freedom to borrow directly from the capital markets and to negotiate with foreign aid agencies. Such freedom could lead to some States being able to borrow on attractive terms and attract aid donors to fund their projects and others not being able to do so.

If their failure arises from the pursuit of poor policies, the FPI, by declining to lend, could provide an incentive for the failing States to reform policies to make them more attractive to lenders and donors.

On the other hand, if the FPI finds that the failure has occurred not because of policy inadequacies and for reasons beyond the control of the State, it could recommend capital transfers from the Centre to such States if it finds the projects proposed by such States worthwhile from an economic and social perspective. However, such FPI-recommended capital transfers should not carry any subsidy (relative to the cost of borrowing to the Fund) on interest rates. Thus, FPI should not open a soft lending window since there is no economic rationale for it.

The suggestion to create the FPI builds on the RBI's ongoing exploration of the development of institutions to support a shift to market borrowing by the States. However its creation would not address some other transitional issues such as inadequate capacity in some States for generating viable and `finance-able' project proposals and also the transitional issue of restructuring existing public debt of States.

(To be concluded)

(The author is Samuel C. Park Jr. Professor of Economics at Yale University.)