The Hindu Business Line : Twelfth Finance Commission: The endless search for solutions

The Twelfth Finance Commission has tried to blend the objectives of fiscal prudence of the States, incentive for revenue deficit reduction on a State-specific basis, and debt sustainability. But the Commission has also sprung what some States may regard as a surprise. K. Venkataraman on some of the key recommendations of the finance panel.

THE CENTRE passes on some 40 per cent of its tax revenues to the States in some form or other. States depend on the Centre for some 40 per cent of their revenues, besides loans. The expenditure of the States amounts to some 14 per cent of GDP with a fiscal deficit of some 4 per cent. State finances have macro-economic implications and a bearing on good governance. Nevertheless State finances have not received much attention, except when a quinquennial Finance Commission submits its report, as now with the Twelfth Finance Commission (TFC) making its recommendations.

There was a point of departure in the terms of reference of the Eleventh and Twelfth Finance Commissions in that, besides recommending Central devolutions and grants to States, they were asked to go into the restructuring of Central and State Finances (in the interest of "budgetary balance and macro-economic stability") and suggest the steps to be taken by the governments collectively and severally; they were also asked to go into the augmentation of State revenues to supplement the local body finances. These considerations have the benefit of facilitating a more holistic view of the fiscal system.

Ideally, the extent of devolution would depend on what the States need vis-à-vis what they can raise themselves and what the Centre can provide — issues which involve complex calculations and judgments. The total amount in absolute terms available through devolution would depend on the elasticity of Central revenues which, in turn, would depend on the tax policies, the collection efficiency and the growth of GDP.

A higher GDP growth and/or a higher central tax-GDP ratio will benefit both the Centre and the States. The Eleventh Commission determined an overall figure of 37.5 per cent of the gross Central revenues for transfer to the Centre, of which 29.5 per cent of the net revenues were to be passed on through devolution, including 1.5 per cent for additional excise duties.

Now the TFC has taken 38 per cent of gross revenues as the indicative aggregate with 30.5 per cent of the net revenues for devolution (including an additional 1 per cent as long as the Centre levied and collected additional excise duties).

What count are a higher GDP growth and a higher Central tax-to-GDP ratio in future - factors that can raise the absolute amounts available for devolution. The substantial increase in the actual figures of devolution by the TFC has thus to be related to recent and prospective GDP growth and not to any dramatic increase in the devolution percentage. Incidentally, in referring to the increase over the Eleventh Commission's award by 1 per cent, the TFC makes a significant remark that `this increase can be accommodated by the Centre by pruning the activities that fall in the domain of the States'.

While the States are united in asking for a greater percentage of devolution, they are not so when it comes to their inter-se share. Horizontal distribution has been the subject of debate and sometimes of controversy. The generally accepted criteria are equity and efficiency, that is, how to help the financially weaker States improve their services to a level common to all the States, without placing a premium on inefficiency on their part or even on the part of those that are relatively efficient. There is a third, unstated, criterion: Broad political acceptability. Before the TFC, distance and population accounted for some 80 per cent of the weight; the balance was distributed on such criteria as backwardness, lack of infrastructure, and so on leaving 10-12.5 per cent for fiscal discipline and tax effort. Thus, roughly speaking, till recently equalisation has accounted for some 87.5 per cent of the weight and some 12.5 per cent for fiscal performance, where the better performing States can score.

Budgetary gaps as a ground for equalisation were taken up as a criterion and soon given up as not being conducive to efficiency. The TFC has increased the `efficiency share' to 15 per cent (7.5 per cent for fiscal discipline and 7.5 per cent for tax effort) and the weightage for population from 10 per cent to 25 per cent, while reducing the distance criterion to 50 per cent. This is some consolation to better performing States — though they are not easily consoled.

Even in regard to what a Finance Commission can do, the TFC has admitted that in endeavouring to strike a balance between equity and efficiency, it has not been possible to implement the "equalisation approach" fully as the disparities in the per capita fiscal capacities of the States were too large and some of the better-off States were also in serious fiscal imbalance.

Devolution and grants have to be taken together for their impact on the States. Devolution is free, while grants are generally for specific purposes. In absolute terms, the TFC's award of grants is some 2.4 times that of its predecessor. The percentage of grants to devolutions is now roughly 23.3 against 15.6 in the Eleventh Commission's recommendations.

However, one has to look at how much of the grants are for filling budgetary gaps (mostly but not wholly for the ten special category states such as Jammu & Kashmir and the North-Eastern States) and how much for other purposes. It is noteworthy that the Commission has recommended the discontinuance of the Medium Term Fiscal Reforms Facility, which incorporated a scheme of incentives for reduction of revenue deficits by the States. The TFC found the facility too small; its implementation marked by `arbitrary flexibility' dictated by the crisis level in different States; and at any rate its objective not being achieved.

The TFC has broken new ground on debt relief by combining it with an incentive to reduce revenue deficits. It had been asked to look into the sustainability of the debt of the States. It has recommended a three-fold approach: (i) each State should adopt a fiscal responsibility legislation if it has not; (ii) once a State does it, past loans to it from the Centre will be consolidated as a 20-year loan (the total for all States comes to Rs 1,28,795 crore) with a uniform interest of 7.5 per cent; (iii) thereafter, for each year up to 2009-10, the annual repayments for that loan will be written off, linked to the absolute amount by which the revenue deficit is reduced in each successive year (a detailed formula has been suggested depending on the conditions of the States). If all States achieve revenue balance by 2008-09, some Rs 32,200 crore will be written off in five years. This is a contingent obligation for the Centre, which is in addition to an interest of Rs 21,276 crore foregone in its revenue Budget. One hopes, with fingers crossed, that this package (and the formula) works smoothly. The TFC has, thus, tried to blend the objectives of fiscal prudence of the States, of incentive for revenue deficit reduction on a State-specific basis, and of debt sustainability. But it has also sprung, what some States may regard as, a surprise. It has said that the Centre may not give loans to the States for Plan or non-Plan purposes; States have the option of going directly to the market. The limits of borrowing may be fixed by them through their respective Fiscal Responsibility legislation and by a new Loan Council which will supervise the overall limit of annual borrowing for each State.

There are several implications of the proposed new regime. Past loans can be repaid over 20 years and this will ease the States' positions somewhat. However, no specific measure has been proposed for reduction in borrowings; the States can still pile on loans, except for the limits imposed by their own Fiscal Responsibility legislation. States, spoon-fed with Central loans, will now have to basically rely on the market; the annual limits to borrowing may be fixed by a new Loan Council. To ask the States to take charge of their own affairs and to be self-reliant and not be over-dependent on the Centre and to lead them to adopt fiscal responsibility legislation is certainly welcome. But what happens to States that do not yet have a standing to borrow all their requirements from the market? Sensitive to this problem, the TFC has said that in such cases the Centre could resort to lending.

Moreover, in the past States went for a large Plan hoping to get 70 per cent of it as loan. Now, if they have to go to the market, they may have to go in for less ambitious Plans and slippages could also occur during the Plan period. In addition, there will be some change in the role of the Planning Commission as the arbiter of the Plan size, and its complexion.

A grant component of 30 per cent of the Plan size has also been historically low as State Plan activities in education, health, etc., are staff-intensive. The percentage can now be increased to, say, 50 so that the revenue deficit reduction envisaged is not handicapped, particularly in the context of rising social sector expenditure.

Such issues will require investigation and elucidation. Ex-post verification of the utilisation of Finance Commissions' awards has been weak and not very much in public knowledge. The TFC has recommended a permanent Finance Commission Secretariat in the Finance Ministry.

This apart, considering that State finances are not receiving adequate attention now and the States need to have consultation and coordination among themselves, the time is ripe for setting up an independent Centre for the Study of State Finances, in which all States and the Centre can participate.

(The author is Chairman, Public Expenditure Round Table.)

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