The Hindu Business Line : Twelfth Finance Commission's report — Right emphasis on fiscal deficit and growth

THE Twelfth Finance Commission (TFC) under Dr C. Rangarajan's Chairmanship has submitted its recommendations to the Government . They have been accepted and incorporated in the latest Union Budget. While building on the work of its predecessors, the Rangarajan Commission has chalked out a unique programme of fiscal reconstruction, both for the Centre and the States.

The report itself bears ample evidence of the touch of Dr Rangarajan, whose erudition and experience in macroeconomic management are legendary. It is no wonder that the report has been accepted by both the Centre and the States without demur or protest, as happened in the Eleventh Finance Commission.

The Twelfth Finance Commission has also adopted principles of distribution of Central revenues, almost similar to those adopted by the Eleventh Finance Commission. It has recommended a total devolution of Central divisible taxes at 30.5 per cent as against 29.5 per cent in the earlier Commission (see Table). So far as the inter se distribution between States is concerned, the TFC has followed the principle of assigning weights to area population, income distance, tax effort and fiscal discipline.

It will be seen that the TFC has blunted the edge of richer States' potential criticism by moderating the role of the distance criterion. Backwardness does not have per se as high a weight as in the earlier Commission. It has also discarded the weight for infrastructure.

The net result has been that the so-called advanced States do not seem to have as much a cause for complaint as on the last occasion. Or is it a case of States having learnt to live with the discomfiture of favoured treatment for the backwardness!

The emphasis laid by the TFC on fiscal prudence shines through all its recommendations. In particular, in its recommendations on debt relief — on which it has been quite liberal — it has linked the write-off of debt to the performance of States in respect of reduction of revenue deficit and fiscal deficit. This is a tough requirement, but the logic of the TFC is impeccable. If the States do not have such incentives, it is difficult to keep them on the straight and narrow path of fiscal rectitude.

The TFC has made a far-reaching proposal that will affect the Centre and the States — in respect of Plan financing. So far, State plans used to be financed by a mixture of grants and loans — loans partly from the Centre and the rest from the market.

In its recommendation, the Central assistance has been radically recognised to be grants only. The Centre, so to say, saves the loan component of the Central assistance for States, and the States are expected to go to the market for the same.

This recommendation has two benefits. One is that it imposes a market discipline on the States. More importantly, the Centre's loans to the States carried a spread over of its own cost of borrowing from the market — of nearly 4-5 per cent. The States can borrow from the market at lower rates than the Centre used to charge, provided their credit rating is good. Fiscal balance feeds into credit rating. This is an additional bonus to fiscally prudent States.

There is also an advantage to the Centre from the deficit point of view. To the extent it borrowed the money which it on-lent to States, its fiscal deficit was higher by another Rs 25,000 crore or so in the current year. The States borrowing directly means the Central fiscal deficit goes down.

This is not a gimmick. The States' fiscal deficit remains unaltered by this change since they borrow the equivalent amount from the market. Critics who tried to fluster the Finance Ministry representatives in the post-haste press conferences were on the wrong track.

The Twelfth Finance Commission was also charged with a debt-restructuring mandate. I have already referred to the linkage the TFC has made with deficit reduction, so far as the debt restructuring is concerned. It rightly rejected the suggestions in the terms of reference to link the debt restructuring to indices of human development and investment climate, considering the difficulties in their objective assessment.

The TFC has also recommended sizeable grants to backward States to upgrade their health and education services — these are of course related to their performance levels.

While the recommendations of the TFC have been quite liberal insofar as the backward States are concerned, there is an apparent conflict with the announcement which the Finance Minister, Mr P. Chidambaram, had made in his July 2004 Budget, setting up a Backward States' Grant Fund with a corpus of Rs 25,000 crore.

As a result of liberal devolutions by the TFC, it seems to me that there is no need for a separate Backward States Commission. However, this is a requirement of the NCMP. Will the resources come through the Finance Commission or the Backward States Commission?

The State Governments have been used to dealing with the Planning Commission for approval of their annual Plans and returning to their headquarters with announcements of large blocks of Central assistance. In future, the glory will be confined to announcing the approval for a large Plan only.

They will have to negotiate with the banks, insurance companies and other investors for their market loans. Whether the Planning Commission will see a diminution in its role as a result depends on how the managers will coordinate with the Finance Ministry.

The TFC has made suggestions regarding the current method of accounting for Government expenditure. So far as I can see, the recommendations are to introduce accrual accounting. Accrual accounting is in vogue in certain European Governments.

Whether a switchover to accrual accounting will enable a more transparent exhibition of expenditure and revenue remains to be seen. Expert opinion has been divided on this before. But, the TFC has come out in favour of the change. Before the Government embarks on this change, it will surely examine the pros and cons, including the problems of change from an established system and training of the officials at all levels.

Whether the change will have proportionate beneficial effects is, however, debatable. The TFC is aware of the problems that will be faced in the transition, but still recommends the same.

On an aside, I wish to make a comment on one of the important aspects of the TFC's report, which has a bearing on the whole issue of fiscal deficit. The report has an elaborately argued segment defending the Government's current stance in favour of fiscal deficit reduction in terms of specific targets for deficits as a percentage of GDP.

The master of macroeconomics that Dr Rangarajan is, he has no difficulty in disposing of arguments for deviation from such fiscal stability targets. He mentions, however, the UK practice of the Golden Rule which, so to say, prohibits borrowing for current expenditure. By extension, it would seem that public sector borrowing for investment may not be such a sin, provided it guarantees returns — which in today's scenario are of doubtful nature.

The key to good fiscal management is to ensure not only the trimming of fiscal deficits but if deficits are incurred they should be only for investment in projects of remunerative nature.

While it is true that fiscal deficit targeting by States is desirable, it has to be ensured that it does not rule out essential infrastructural funding, if need be, by borrowing in the market, provided the projects price the services rightly.

Ultimately, the secret of successful economic management lies not in the mantra of fiscal deficit being zero, but in achieving economic growth with enhancement of job opportunities and alleviation of poverty. I would like to think that Dr Rangarajan as Chairman of the Prime Minister's Economic Advisory Council will endorse this approach, although he has focussed on reduction of fiscal deficits in the report of the Twelfth Finance Commission.

An enlightened mind has to accommodate apparently conflicting points of view. I am sure D Rangarajan does share this admirable characteristic with all accomplished intellectuals and can produce a synthesis.

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