Equity and Consistency Properties of TFC Recommendations

This paper examines three aspects of the Twelfth Finance Commission recommendations. First, it looks at the most urgent issue for states, the FRBM legislation which they must enact if they are to qualify for the interest rate reduction on debt owed to the centre. The required revenue deficit target of zero by 2008-09 is unambiguously clear but the fiscal deficit requirement is not. The parameter values underlying the fiscal deficit correction path could be valued by states very differently from those assigned in the TFC report. The second issue addressed in the paper is the complex and ambiguous set of conditionalities relating the debt write-offs in year t to the reduction in the revenue deficit in year (t-1) relative to (t-2). These conditionalities also carry a fiscal deficit cap which could be sharply inconsistent with a fiscal deficit correction path fully in conformity with that prescribed by the TFC. These issues are illustrated with simulations for a sample state. Finally, the paper examines the equity attributes of the tax devolution and non-tax grants prescribed by the TFC. The formula adopted for determining tax shares of states assigns a greater weightage to distribution-neutral factors, and so reverses the trend since the Sixth Finance Commission towards increasing weightage for redistributional factors. The non-tax grants do not show an inverse relationship with per capita GSDP. Together, these suggest that the TFC has chosen to move away from equity as a guiding principle for its statutory flows, but the report does not make plain why it has chosen to do so.