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Deficit Fundamentalism vs Fiscal Federalism: Implications of 13th Finance Commission's Recommendations

The Thirteenth Finance Commission's recommendation to increase the vertical share of tax devolution to states will help, but its horizontal distribution formula leaves much to be desired. One, its design is such that two of the four key indicators are in conflict with each other. Two, the commission's revised road map for fiscal consolidation at the centre and the states, which recommends state-specific, year-wise, fiscal adjustment paths, not only limits the fiscal manoeuvrability of states but also impinges on their fiscal autonomy. Three, its design of the grant for elementary education has the potential to reduce the expenditure of states rather than augment it. The need to look at intergovernmental transfers from the right perspective of federalism, where the states and the centre are seen as equal partners in development and not from a narrow technocratic viewpoint, cannot be stressed more.

THIRTEENTH FINANCE COMMISSION

Deficit Fundamentalism vs Fiscal Federalism: Implications of 13th Finance Commission’s Recommendations

Pinaki Chakraborty

The Thirteenth Finance Commission’s recommendation to increase the vertical share of tax devolution to states will help, but its horizontal distribution formula leaves much to be desired. One, its design is such that two of the four key indicators are in conflict with each other. Two, the commission’s revised road map for fiscal consolidation at the centre and the states, which recommends state-specific, year-wise, fiscal adjustment paths, not only limits the fiscal manoeuvrability of states but also impinges on their fiscal autonomy. Three, its design of the grant for elementary education has the potential to reduce the expenditure of states rather than augment it. The need to look at intergovernmental transfers from the right perspective of federalism, where the states and the centre are seen as equal partners in development and not from a narrow technocratic viewpoint, cannot be stressed more.

Pinaki Chakraborty (pinaki@nipfp.org.in) is with the National Institute of Public Finance and Policy, New Delhi.

T
he institution of the union finance commission (UFC) as a statutory body to act as an independent arbiter in matters relating to transfer of resources from the centre to the states is a unique feature of Indian federalism. Although there are multiple channels of transfer operating simultaneously in I ndia, the largest share of resources to the states is devolved through the UFC.1 This special issue’s purpose is to discuss and debate the implications of the recommendations of the Thirteenth Finance Commission (THFC). The papers in this issue cover all aspects of the THFC’s terms of reference (ToR), commented on by well-known scholars in their respective fields, to put the body’s recommendations into perspective. My endeavour in this paper is to give a broad overview of the key features of the THFC award (2010-15) and their implications for the states. The important recommendations of the THFC can be categorised u nder the following heads:

  • (1) Enhanced vertical devolution from 30.5% to 32% of the d ivisible pool of taxes.
  • (2) Revised road maps for fiscal consolidation at the centre and the states.
  • (3) Suggested design of the goods and services tax (GST).
  • (4) A large number of sector and state-specific grants.
  • (5) Grants for local bodies amounting to 2.5% of the central pool of taxes.
  • This paper examines what some of these recommendations mean for the states, given their overall operating fiscal constraints and the fiscal inequality across them. The paper also considers whether states will be able to adhere to the fiscal restructuring paths proposed by the THFC for them and what their fiscal implications will be. Towards this, it undertakes a detailed review of the finances of two states and constructs their future fiscal profiles in accordance with the norms p roposed by the THFC for fiscal consolidation from 2010-11 to 2014-15.

    Apart from the introduction, the paper has five sections. S ection 1 evaluates the THFC’s recommendations related to tax devolution and its horizontal distribution principle from the e quity and efficiency perspectives. Sections 2 and 3 analyse the implications of the revised road maps for fiscal consolidation r ecommended for the states. Section 4 analyses one of the major s tate-specific grants – grants for elementary education, its design and implications. Section 5 summarises the findings and draws conclusions.

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    1 Tax Devolution: Vertical Quantum and Horizontal Distribution

    As mentioned, the THFC has enhanced the vertical share of tax devolution to states from the 30.5% recommended by the Twelfth Finance Commission (TWFC) to 32%. If we look at the horizontal distribution of this transfer, the aggregate share of low-income states2 has remained more or less stagnant at 54% during the award periods of the Eleventh Finance Commission (EFC), the TWFC and the THFC (Table 1). While the share of middle-income states has declined sharply, that of high-income states increased from 9.75% to 11.19% during the award period of the TWFC, but has declined marginally to 10.94% in the THFC award. The aggregate share of special category states has increased from 7.29% to 9.6% during this period. In other words, despite attaching high weightage to the “income distance” or “fiscal capacity index” to achieve fiscal equity, the horizontal distribution formula has failed to increase the aggregate share of devolution to low-income states. In the specific context of some of the low- and middle- income states, their shares in the UFC devolution have continued to decline, imposing a huge fiscal strain on their finances.3 It has been pointed out that one of the major reasons for the low level of per capita development expenditure in low-income states and in many of the middle-income ones is the failure of the t ransfer s ystem to offset the fiscal disabilities of these states (Rao and Singh 2002) despite having apparently progressive principles of transfers.

    Table 1: Tax Devolution

    Union Finance Commission

    Eleventh Twelfth Thirteenth
    Low-income states 53.762 53.788 53.618
    Middle-income states 29.189 26.842 25.839
    High-income states 9.750 11.199 10.943
    Special category states 7.299 8.171 9.600
    Non-special category states 92.701 91.829 90.400
    Total 100 100 100

    Source: Reports of the Finance Commission (2000, 2004, 2009).

    The horizontal distribution formula of the THFC has four d ifferent indicators, each with a different weight assigned to it – area (10%), population (25%), fiscal capacity distance (47.5%) and index of fiscal discipline (17.5%). Fiscal capacity distance is a new indicator, which replaces the income distance used by earlier UFCs, with the rationale that it better reflects fiscal capacity. The fiscal capacity distance in a way benchmarks states according to their tax capacity, down from the state with the highest fiscal c apacity and a prescriptive tax effort. The THFC has worked out the average tax to gross state domestic product (GSDP) ratios s eparately for general and special category states and applied the group-specific averages to obtain the potential tax effort. This has been used to estimate the per capita fiscal capacity at comparable levels of taxation. It has then computed the fiscal distance (weight of 47.5%) of each state by the distance of its estimated per capita revenue from that of Haryana. The distance so computed defines the per capita revenue entitlement of each state based on fiscal distance. But it is worth noting what an editorial in the E conomic & Political Weekly observed:

    Although, this is an interesting innovation and the THFC claims that this is a more direct way of estimating fiscal capacity than the income

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    distance method, it is important to remember that the relationship between income and tax is non-linear because of the differences in the taxable consumption basket between high, middle and low income states. Also, as the central sales tax (CST) continues to exist, there is significant tax exportation taking place from the producing highincome states to the consuming low-income states. Thus, the new h orizontal formula creates an inherent bias against the low income states (2010).

    Area and population are neutral indicators of need, while fiscal capacity distance as explained above tries to equalise the fiscal capacity differences across states. On the other hand, the index of fiscal discipline tries to capture the efficiency in fiscal management by comparing the own revenue to total revenue expenditure ratio of the states at two different points of time. The index of fiscal discipline is worked out with 2005-06 to 2007-08 as the reference years and 2001-02 to 2003-04 as the base years.

    The existence of a fiscal capacity distance and an index of fiscal discipline in the same formula contradict the objective of achieving horizontal equity. The reason being that while fiscal capacity distance tries to enhance the fiscal capacity of states, the index of fiscal discipline tries to limit their expenditure in relation to their own revenue. This, in practice, could conflict with each other. One needs to remember that if the objective of fiscal equalisation is to provide “comparable levels of public services at comparable levels of taxation”, it cannot be achieved by an index of fiscal discipline defined as own revenue to revenue expenditure ratio. It needs some measure of expenditure equalisation taking into account total revenues, including devolution and grants. If the objective is to equalise fiscal capacity, the index of fiscal discipline and fiscal capacity in the same formula may send conflicting signals to the states. Finally, given the large-scale i nequality in government expenditure in per capita terms, it is critical that the principle of devolution primarily be driven by e quity considerations, especially when a large number of specificpurpose transfers is anyway given to enhance the efficiency of government expenditure and also for state-specific needs. To put this issue in perspective, we have tried to examine what the distributional change in devolution across states would be if the index of fiscal discipline criterion is eliminated and the assigned share of the index is assigned to the fiscal capacity distance. The result is in Table 2 (p 58).

    As the table shows, under the new formula, the share of devolution to low-income states increases quite significantly while the shares of high and middle-income states decline. Bihar’s share under the new formula would be 12.659% against 10.197% recommended by the THFC. Similarly, the share of low-income states like Chhattisgarh, Jharkhand, Madhya Pradesh, Orissa and Uttar Pradesh would go up significantly while there would be a decline in the shares of high- and middle-income states, particularly those of Maharashtra, Tamil Nadu and Gujarat. It is also important to note that the fiscal capacity distance criterion penalises states with lower than average tax effort for inefficiency by taking the group-specific average tax effort, not their actual tax e ffort, in estimating fiscal capacity distance. In other words, if the fiscal distance is estimated with actual tax effort instead of the average, the distance would be higher for those with a lower

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    tax effort. In turn, these states would benefit from higher transfers. Thus, also having an index of fiscal discipline in the horizontal distribution formula penalises the states twice.

    2 Revised Road Map for Fiscal Consolidation

    One of the most significant components of the THFC’s recommendations is the revised road map for fiscal consolidation at the c entre and the states. The basic concern of this road map is to

    Table 2: Horizontal Distribution Formula: Alternatives and Outcome

    States THFC Share
    With Fiscal Discipline Without Fiscal Discipline Difference
    Criterion (1) Criterion (2) (1-2)
    1 Andhra Pradesh 6.937 6.627 -0.310
    2 Arunachal Pradesh 0.328 0.327 -0.001
    3 Assam 3.628 4.045 0.417
    4 Bihar 10.917 12.659 1.742
    5 Chhattisgarh 2.470 2.512 0.042
    6 Goa 0.266 0.245 -0.021
    7 Gujarat 3.041 2.276 -0.765
    8 Haryana 1.048 0.765 -0.283
    9 Himachal Pradesh 0.781 0.760 -0.021
    10 Jammu and Kashmir 1.551 1.691 0.140
    11 Jharkhand 2.802 3.033 0.231
    12 Karnataka 4.328 3.865 -0.463
    13 Kerala 2.341 1.897 -0.444
    14 Madhya Pradesh 7.120 7.596 0.476
    15 Maharashtra 5.199 3.637 -1.562
    16 Manipur 0.451 0.472 0.021
    17 Meghalaya 0.408 0.435 0.027
    18 Mizoram 0.269 0.272 0.003
    19 Nagaland 0.314 0.325 0.011
    20 Orissa 4.779 4.876 0.097
    21 Punjab 1.389 0.990 -0.399
    22 Rajasthan 5.853 6.045 0.192
    23 Sikkim 0.239 0.244 0.005
    24 Tamil Nadu 4.969 4.130 -0.839
    25 Tripura 0.511 0.553 0.042
    26 Uttar Pradesh 19.677 21.229 1.552
    27 Uttarakhand 1.120 1.222 0.102
    28 West Bengal 7.264 7.272 0.008
    All states 100.000 100.000 0.000
    Special category states 9.600 10.346 0.746
    General category states 90.400 89.654 -0.746

    Basic data from the THFC Report.

    bring down the fiscal deficit to 3% of gross domestic product (GDP), separately at both the centre and the states, by the end of 2014-15. As mentioned earlier, the THFC appears to have been seriously concerned about the fiscal expansion that took place in 2008-09 and 2009-10 to combat the slowdown in India’s economic growth caused by the global financial crisis and decided to emphasise the need for both levels of government to bring down their level of fiscal deficit to 3% of GDP. The centre and all the states, barring West Bengal and Sikkim, had a Fiscal Responsibility and Budget Management (FRBM) Act when the THFC submitted its report. The THFC has recommended that the states incorporate their new target into their existing Acts or introduce it if they do not have one. The THFC’s revised road map for fiscal c onsolidation is not fundamentally different from what was p roposed by the TWFC as far as the level of fiscal deficit is concerned. The only difference is alternative fiscal adjustment paths for states with relatively high fiscal imbalances, with mandated deficit reduction targets for every year to arrive at a fiscal deficit of 3% of GSDP by the end of 2014-15. Now, two fundamental questions arise at this point. One is the feasibility of bringing down the fiscal deficit within the time frame specified by the THFC and the use of deficit reduction as a condition for the release of statespecific grants that the Commission has recommended. The other is the appropriateness of the proposed road map when it is assessed against the backdrop of the fiscal autonomy guaranteed by the Constitution to the states.

    To start with the first question, we need to recall that the deficits in 2008-09 and 2009-10 were particularly due to a decline in revenue because of the slowdown in economic growth, coupled with an increase in expenditure. The latter was necessitated by various stimulus packages and the revision of pay scales in accordance with the recommendations of the Sixth Pay Commission (2008). Although these shocks were transitory in nature, the adjustment path could be much longer than what has been s uggested by the THFC. Among the general category states, the THFC has suggested a different fiscal adjustment path for Kerala, Punjab and West Bengal, the states with high levels of fiscal d eficits. Of the 11 special category states, different fiscal adjustment paths have been suggested for six – Jammu and Kashmir, M anipur, M izoram, Nagaland, Sikkim and Uttarakhand. The level of a djustment for all the states starts from 2011-12. In e ffect, there is only one year, 2010-11, to bring down the fiscal deficit to a m anageable level of 3.5% except for Jammu and K ashmir and M izoram where lower fiscal deficit reduction targets have been proposed.

    The THFC’s base year for estimating these adjustment paths is 2007-08. As many are aware, 2007-08 was dubbed the best year of fiscal prudence by both the centre and the states with the a ctual fiscal deficit remaining much lower than the targets proposed under their fiscal responsibility legislations. But one cannot deny that the deficit increased significantly in 2008-09 and 2009-10 (Table 3, p 59). So taking 2007-08 as the base year for the fiscal adjustment path, leaving aside two out of the ordinary years of fiscal imbalance, is not justified from the viewpoint of practical management of state finances as well as the implications of the fiscal contraction proposed to be achieved within just a year, especially for states with large fiscal imbalances. For example, according to the THFC’s proposed fiscal adjustment path, Punjab’s fiscal deficit for 2007-08 was 3.5% and this has to be maintained at the same level of GSDP in 2011-12. But if we look at Punjab’s level of fiscal deficit in 2009-10 (budget estimate), it is 5.3% of GSDP. If Punjab has to bring down the fiscal deficit to 3.5% in 2011-12, as proposed by the THFC, the level of deficit reduction will have to be 1.8% in just one year, 2010-11. In the case of West Bengal, the reduction will have to be even higher at 2.3% of GSDP as there has been a sharp increase in the state’s deficit according to the budget estimates for 2009-10. For special category states, the problem is even worse as their levels of fiscal and revenue deficits were much more than those of general category states in relation to their respective GSDPs for 2008-09 and 2009-10. Given

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    their narrow tax base, they have to contract their level of expenditures much more than the general category states if they have to comply with the fiscal adjustment path proposed by the THFC.

    As mentioned, the problem is compounded as reduction in the deficit has been linked to transfers of state-specific grants. This kind of selective approach towards specific states is unfair and subjective. As evident from Table 3, Kerala, Punjab and West

    Table 3: Revenue and Fiscal Deficits of States: A Comparison (As a percentage of GSDP)

    States Revenue Deficit Fiscal Deficit 2007-08 2008-09 (RE) 2009-10 (BE) 2007-08 2008-09 (RE) 2009-10 (BE)

    I Non-special category
    1 Andhra Pradesh -0.05 -0.56 -0.57 2.68 2.81 3.85
    2 Bihar -4.05 -2.60 -4.04 1.49 5.68 2.44
    3 Chhattisgarh -3.83 -1.10 -0.71 0.16 2.37 2.25
    4 Goa -0.96 -0.43 1.59 3.14 4.61 6.33
    5 Gujarat -0.70 -0.08 0.94 1.56 2.89 2.90
    6 Haryana -1.45 -0.03 1.59 0.83 2.05 4.02
    7 Jharkhand 2.14 -0.83 0.33 8.98 4.95 5.11
    8 Karnataka -1.58 -0.28 -0.37 2.24 3.44 2.74
    9 Kerala 2.28 1.96 1.38 3.68 3.33 2.61
    10 Madhya Pradesh -3.57 -2.04 -1.00 1.95 3.45 3.79
    11 Maharashtra -2.50 -0.62 0.89 -0.48 2.36 3.33
    12 Orissa -3.99 -0.62 1.69 -1.24 2.10 4.28
    13 Punjab 2.76 2.40 3.42 3.32 4.31 5.29
    14 Rajasthan -0.94 0.14 0.60 1.94 3.22 3.58
    15 Tamil Nadu -1.49 0.00 0.27 1.21 2.73 3.13
    16 Uttar Pradesh -1.00 -1.03 -0.34 4.01 5.16 5.05
    17 West Bengal 2.68 3.66 4.54 3.75 3.67 5.82
    II Special category
    1 Arunachal Pradesh -19.11 -16.97 6.61 -0.41 22.37 21.12
    2 Assam -3.60 -2.38 7.07 -1.10 2.75 12.38
    3 Himachal Pradesh -2.64 -0.91 -0.63 1.71 5.14 3.89
    4 Jammu & Kashmir -6.97 -9.66 -12.16 8.21 6.68 5.78
    5 Manipur -20.79 -17.78 -13.79 -1.74 7.46 5.91
    6 Meghalaya -2.22 -5.43 -2.00 2.53 1.30 5.63
    7 Mizoram -3.96 -6.53 -4.39 11.86 10.16 5.22
    8 Nagaland
    9 Sikkim -15.28 -22.66 -14.21 2.79 13.21 15.39
    10 Tripura -8.35 -6.55 -2.92 0.16 6.66 10.74
    11 Uttarakhand -1.79 -1.49 0.47 4.89 3.88 4.57

    (-) sign indicates a surplus in deficit indicators; RE: Revised estimates; BE: Budget estimates. Source: State Finances: A Study of Budgets of 2009-10, Reserve Bank of India.

    B engal had fiscal deficits in 2007-08 of 3.68%, 3.32% and 3.75% of GSDP respectively, while those of Uttar Pradesh and Jharkhand were much higher. It can be asked why the same fiscal adjustment path has not been recommended for Jharkhand and Uttar Pradesh as well. In short, this type of selective approach is unjust and arbitrary.

    Finally, it is mandatory that each state adhere to its fiscal a djustment path if it wants to avail itself of state-specific grants. To quote the THFC, “To facilitate implementation of the above road map, we recommend that the states’ enactment/amendment of their FRLs incorporating the above targets should be a conditionality for release of all state-specific grants”. To put it differently, if the states are not able to follow these road maps despite their best efforts, they will lose out on a large volume of transfers. The total state-specific grants proposed by the THFC add up to Rs 27,945 crore. The biggest beneficiaries of these state-specific

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    grants would be poorer states such as Bihar, Chhattisgarh, Jharkhand, Madhya Pradesh, Orissa, Rajasthan and Uttar Pradesh. Together, their share accounts for 37.24% of the total state-specific grants, or Rs 10,406 crore. Kerala, Punjab and West Bengal together will lose Rs 4,683 crore if they are not able to adhere to the proposed fiscal adjustment paths specified for each of them by the THFC. It is also unfortunate that the THFC’s fiscal consolidation road map has endorsed the same target of deficit that was proposed by the TWFC instead of allowing states the flexibility of deciding what their sustainable level of fiscal deficit would be, given state-specific economic growth and the interest rate on debt as specified in Domar’s (1944) condition of sustainability and the level of primary deficit. Such a straitjacketed a pproach to fiscal reforms and sustainability not only undermines the fiscal autonomy of the states, but also could result in mindless cuts in development expenditure to achieve the p roposed targets.

    3 Implications of Revised Road Map: Comparing Two States

    In this section, we have quantified the implications of the revised road map for two states, Bihar and Kerala. The rationale behind the selection of these two states is as follows.

  • (1) Bihar is on the bottom rung of per capita income with a low level of development spending and a low fiscal imbalance.
  • (2) Kerala is a fast-growing middle-income state with high per capita development spending and a high fiscal imbalance.
  • (3) Given the differences in initial conditions between these states, it is important to examine and compare the differential implications of the fiscal adjustment paths proposed by the THFC for them.
  • It is worth mentioning that there have been significant i ncreases in development spending in recent years in both the states. In this context, we need to examine if it would be possible for Bihar to follow the proposed path of fiscal adjustment without decreasing much-needed development spending. To address this, we first need to see what the likely fiscal situation will be in Bihar and Kerala during the award period of the THFC if they continue with their present fiscal policy stances. The base year of projection is 2010-11 (budget estimate) and we have made following assumptions.
  • (a) Tax revenues are expected to grow at their present b uoyancy-based growth rates.
  • (b) Non-tax revenues are likely to grow at their observed trend growth rate.
  • (c) Central transfers are assumed to grow according to their observed trend growth rate.
  • (d) Interest payments are assumed to grow at the average e ffective rate of interest for the year 2010-11.
  • (e) Other components of expenditure are assumed to grow at their respective trend growth rates.
  • (f) For the entire projection period, the GSDP of Bihar and K erala are assumed to grow at 14% and 13.7% per annum respectively in nominal terms.4
  • As Table 4 (p 60) shows, if the present fiscal policy stance of the government of Bihar continues, the state will in no way be

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    Figure 1: Development Expenditure Path: Alternative Scenarios

    35.00

    30.00

    25.00

    20.00

    15.00

    10.00

    5.00

    0.00

    2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15

    near the THFC’s proposed fiscal adjustment path. Although the revenue surplus of the state will increase from 3.90% of GSDP to 4.97% of GSDP between 2010-11 and 2014-15, the fiscal deficit will go up from 2.73% to 6.02% and the debt to GSDP ratio will go up to 38.63% by the end of 2014-15. One also needs to find out what

    Table 4: Base Scenario: Business as Usual Fiscal Adjustment Path (As a percentage to GSDP)

    2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15

    Reform scenario Base scenario

    Per cent to GSDP

    Revenue receipts 25.01 25.46 28.07 29.13 30.32 31.65 33.13
    Own tax revenues 4.68 5.47 6.32 6.23 6.14 6.06 5.97
    Own non-tax revenues 0.87 0.65 0.72 0.79 0.88 0.97 1.08
    Central transfers 19.45 19.33 21.02 22.10 23.30 24.62 26.08
    Revenue expenditure 21.62 25.34 24.17 25.09 25.97 27.00 28.17
    General services 7.98 9.46 9.18 9.51 9.76 10.09 10.51
    Interest payments 2.85 2.80 2.68 2.71 2.64 2.64 2.72
    Pension payments 2.64 3.18 3.49 3.69 3.89 4.11 4.34
    Social services of which 9.29 10.68 10.59 10.74 10.89 11.05 11.21
    Education 5.06 5.84 5.61 5.77 5.93 6.10 6.27
    Health 0.78 0.96 0.93 0.93 0.93 0.93 0.93
    Economic services 4.34 5.20 4.40 4.84 5.33 5.86 6.44
    Capital expenditure 5.29 6.68 6.63 7.57 8.69 10.02 11.58
    Total expenditure 26.91 32.02 30.79 32.66 34.66 37.01 39.75
    Revenue deficit -3.39 -0.12 -3.90 -4.04 -4.34 -4.65 -4.97
    Fiscal deficit 1.90 6.57 2.73 3.53 4.35 5.37 6.62
    Outstanding debt 35.63 38.15 36.45 35.50 35.49 36.49 38.63

    the possible reasons are for such a huge increase in the fiscal imbalance. As evident from the table, both social and economic services expenditures as a percentage of GSDP show a sharp increase and the capital expenditure to GSDP ratio also rises sharply from 6.63% in 2010-11 to 11.58% in 2014-15. In other words, the increase in deficits will primarily be due to an increase in the d evelopment expenditure of the state, provided the growth of e xpenditure remains at the observed level used for the projection. Given low development spending (in per capita terms) vis-àvis other states and corresponding physical and social infrastructure deficits, such an increase in government expenditure would not be possible if the THFC’S proposed fiscal consolidation path is stuck to, unless state revenue increases accordingly, which is unlikely given the low resource base of the state.

    We have estimated the alternative fiscal scenario to see the level of contraction in development revenue expenditure required to adhere to the path of fiscal consolidation proposed by the THFC. The latter is shown in Table 5. As can be seen from the t able, if the fiscal deficit has to be at 3% as specified in the fiscal adjustment path of the THFC’s revised road map for fiscal consolidation, development expenditures on social and economic services are expected to fall sharply between 2010-11 and 2014-15. If the entire burden of adjustment falls on capital expenditure, it would increase much less compared to the base scenario. As a percentage of GSDP, the increase would be from 6.63% to 8.26% during this period. The outstanding debt to GSDP ratio will fall from 36.45% to 31.54%. So if the government of Bihar has to a dhere to the fiscal consolidation path proposed by the THFC, it has to happen through a cut in development spending.

    The development spending gap that would emerge due to this can be seen in Figure 1. As evident, if the present fiscal stance continues, the development expenditure to GSDP ratio will increase from 21.61% to 29.24% during the award period of the THFC. If the THFC-compliant path is followed, the increase in development spending will be from 21.61% to 25.92% during the same period – much lower than the base scenario.

    The Kerala story is different. Here too, we estimate what the situation will be if the present fiscal situation continues, how the debt profile will behave and whether that will be sustainable because the state’s large fiscal imbalance has prompted the THFC to suggest a separate and specific fiscal adjustment path for it. A ccording to the proposed fiscal adjustment path, Kerala has to eliminate its revenue deficit to GSDP ratio by 2014-15 and bring down the fiscal deficit to GSDP ratio to 3% by 2013-14. However, in Kerala, there has been substantial fiscal correction in the financial years 2008-09 and 2009-10 (revised estimate) and this is expected to be the case in 2010-11 (budget estimate) as well. Kerala’s medium-term fiscal plan (MTFP) for 2010-11 to 2012-13 proposed a fiscal correction path, which targeted reduction of revenue deficit to 0.88% of GSDP and fiscal deficit to 3.5% of GSDP by the end of 2012-13.

    To get a clear idea about the fiscal correction path in the m edium term, independent of what is proposed in Kerala’s MTFP, we have estimated the movement of key fiscal indicators, based on the assumption that the current fiscal situation will continue in that period as well. Our period of projection is from 2011-12 to 2014-15 and the base year is 2010-11 (budget estimate). The r esulting fiscal path (as a percentage to GSDP) is shown in Table 6 (p 61) and termed the base scenario. As seen from the table, if the present fiscal situation continues, there will be a marginal

    Table 5: Reform Scenario: Fiscal Adjustment Path Compliant with THFC Recommendations (As a percentage to GSDP)

    2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15

    Revenue receipts 25.01 25.46 28.07 29.13 30.32 31.65 33.13

    Own tax revenues 4.68 5.47 6.32 6.23 6.14 6.06 5.97

    Own non-tax revenues 0.87 0.65 0.72 0.79 0.88 0.97 1.08

    Central transfers 19.45 19.33 21.02 22.10 23.30 24.62 26.08

    Revenue expenditure 21.62 25.34 24.17 25.09 25.94 26.86 27.87

    General services 7.98 9.46 9.18 9.51 9.72 9.95 10.21

    Interest payments 2.85 2.80 2.68 2.71 2.60 2.51 2.42

    Pension payments 2.64 3.18 3.49 3.69 3.89 4.11 4.34

    Social services of which 9.29 10.68 10.59 10.74 10.89 11.05 11.21

    Education 5.06 5.84 5.61 5.77 5.93 6.10 6.27

    Health 0.78 0.96 0.93 0.93 0.93 0.93 0.93

    Economic services 4.34 5.20 4.40 4.84 5.33 5.86 6.44

    Capital expenditure 5.29 6.68 6.63 7.04 7.38 7.79 8.26

    Total expenditure 26.91 32.02 30.79 32.13 33.32 34.65 36.13

    Revenue deficit -3.39 -0.12 -3.90 -4.04 -4.38 -4.79 -5.26

    Fiscal deficit 1.90 6.57 2.73 3.00 3.00 3.00 3.00

    Outstanding debt 35.63 38.15 36.45 34.97 33.68 32.54 31.54

    november 27, 2010 vol xlv no 48

    EPW
    Economic & Political Weekly

    Table 6: Fiscal Profile and Debt Sustainability: Medium-Term Perspective (The Base F iscal Responsibility Act (FRA) target. The reform scenario pro-Scenario; as a percentage to GSDP)

    posed should help the state enhance the fiscal space for higher

    2010-11 BE 2011-12 2012-13 2013-14 2014-15

    capital expenditure without violating THFC-proposed norms.

    Revenues 12.7 12.9 13.1 13.2 13.4

    However, this would also mean that Kerala should amend its

    Own tax revenues 8.5 8.6 8.7 8.7 8.8

    FRBM Act to revise the target of fiscal deficit reduction to 3% in-

    Sales tax 6.2 6.2 6.2 6.2 6.2

    stead of the 2% it stands at today.

    State excise duties 0.8 0.8 0.8 0.8 0.8

    These two case studies bring out the unjust, arbitrary and, to a

    Stamp duty and registration fees 0.9 1.0 1.0 1.1 1.2

    great extent, futile nature of the exercise called “revised road

    Other taxes 0.7 0.7 0.7 0.7 0.6 Own non-tax revenues 0.9 0.9 0.9 0.9 0.9 map for fiscal consolidation” proposed by the THFC, which has a Central transfers 3.3 3.4 3.5 3.6 3.7 uniform deficit reduction target of 3% of GSDP for all states by the Tax devolution 2.0 2.0 2.1 2.1 2.1 end of 2014-15, and specifies the path of fiscal adjustment to be Grants 1.3 1.3 1.4 1.5 1.5 followed by individual states. If the current fiscal stance is

    Revenue expenditure 13.9

    14.2 13.5 13.1 12.6 a llowed to continue, by the terminal year of the THFC award,

    General services 6.2 6.2 6.0 5.8 5.6

    B ihar’s fiscal deficit would be more than two times higher than

    Interest payments 2.4 2.3 2.1 1.9 1.7

    what is proposed by the THFC and Kerala’s would be almost half

    Pensions 2.2 2.2 2.2 2.2 2.1

    of what is proposed. This implies that to comply with the norm,

    Other general services 1.6 1.7 1.7 1.8 1.8

    Bihar has to reduce its expenditure by around 3% of GSDP and

    Social services 5.3 5.2 5.1 5.0 4.9

    Kerala can enhance its expenditure if it so decides. But if we com-

    Education 2.7 2.6 2.6 2.5 2.4

    pare the proposed state-specific fiscal adjustment paths, Bihar

    Medical and public health 0.8 0.8 0.8 0.7 0.7 Other social services 1.8 1.8 1.8 1.7 1.7 has stricter norms than Kerala because, as per the THFC’s assess-Economic services 1.6 1.5 1.4 1.3 1.2 ment, Kerala is a state with higher fiscal imbalance and it requires Compensation and assignment reducing its deficit gradually. to local bodies 1.1 1.1 1.0 1.0 0.9

    These kinds of wide differences between norms and actual

    Capital expenditure 2.0 2.1 2.2 2.2 2.3

    performance arise because we do not have state-specific sustain-

    Capital outlay 1.7 1.7 1.8 1.8 1.9

    able levels of deficit. It is obvious that given the debt sustain-

    Net lending 0.3 0.4 0.4 0.4 0.5

    ability condition, the level of sustainable deficit would be a

    Revenue deficit 1.5 1.0 0.4 -0.2 -0.8

    Fiscal deficit 3.5 3.1 2.6 2.1 1.6

    Table 7: Fiscal Profile and Debt Sustainability: Medium-Term Perspective

    Primary deficit 1.1 0.8 0.5 0.2 -0.1

    (The Reform Scenario; as a percentage to GSDP) Outstanding liabilities 32.0 29.0 26.0 23.0 20.1 2010-11 BE 2011-12 2012-13 2013-14 2014-15

    Revenues 12.7 12.9 13.1 13.2 13.4

    i mprovement in revenue receipts and a sharp decline in revenue

    Own tax revenues 8.5 8.6 8.7 8.7 8.8 expenditure, primarily due to a decline in general services Sales tax 6.2 6.2 6.2 6.2 6.2 e xpenditure because of a sharp decline in interest payments. Pro-State excise duties 0.8 0.8 0.8 0.8 0.8 jections based on past growth also show a marginal decline in Stamp duty and registration fees 0.9 1.0 1.0 1.1 1.2 social and economic services expenditures to GSDP ratio in the Other taxes 0.7 0.7 0.7 0.7 0.6 Own non-tax revenues 0.9 0.9 0.9 0.9 0.9

    Central transfers 3.3 3.4 3.5 3.6 3.7

    Tax devolution 2.0 2.0 2.1 2.1 2.1

    Grants 1.3 1.3 1.4 1.5 1.5

    Revenue expenditure 14.2 13.9 13.5 13.1 12.8

    a steady decline in the fiscal deficit to GSDP ratio to 1.6% of GSDP

    General services 6.2 6.2 6.0 5.9 5.8

    by the end of 2014-15, and a steady decline in the debt to GSDP

    Interest payments 2.4 2.3 2.1 2.0 1.8

    ratio to 20.1% by the end of 2014-15. Thus, the alarm bell rung by

    Pensions 2.2 2.2 2.2 2.2 2.1 the THFC about the deteriorating fiscal situation of the state Other general services 1.6 1.7 1.7 1.8 1.8 a ppears to be incorrect. Disregarding the fact that Kerala has Social services 5.3 5.2 5.1 5.0 4.9 i mproved its fiscal balance significantly in recent years, the THFC Education 2.7 2.6 2.6 2.5 2.4 has imposed a fiscal adjustment path that has little relevance to Medical and public health 0.8 0.8 0.8 0.7 0.7 Other social services 1.8 1.8 1.8 1.7 1.7

    the state.

    Economic services 1.6 1.5 1.4 1.3 1.2

    Kerala’s fiscal adjustment path compliant with the THFC’s

    Compensation and assignment

    r evised road map for fiscal consolidation is presented in Table 7.

    to local bodies 1.1 1.1 1.0 1.0 0.9

    Capital expenditure 2.0 2.5 3.0 3.1 3.6

    Capital outlay 1.7 2.1 2.6 2.6 3.1 of GSDP by the end of 2014-15, with a revenue surplus emerging in Net lending 0.3 0.4 0.4 0.4 0.5 2013-14 and continuing thereafter. This substantiates our earlier Revenue deficit 1.5 1.0 0.5 -0.1 -0.6 observation that the level of fiscal correction in Kerala in the last Fiscal deficit 3.49 3.5 3.5 3.0 3.0 four years has been significant and a continuation of the same Primary deficit 1.1 1.2 1.4 1.0 1.2 Outstanding liabilities 32.0 29.3 27.2 24.9 23.1

    trend will result in a reduction in fiscal deficit much below its

    EPW
    november 27, 2010 vol xlv no 48

    THIRTEENTH FINANCE COMMISSION

    c ombination of the growth rate, interest rate and primary deficit. needs. As these grants are conditional, their actual utilisation
    As these are quite different in different states, the estimated will largely depend on meeting grant-specific conditionalities.
    l evels of sustainable deficit would have been different in Bihar One of the major components is the grant for elementary edu
    and Kerala had such an approach been adopted by the THFC. cation, amounting to Rs 24,068 crore. The conditionality a ttached
    Once the sustainable deficit is known, then it is a question of to the release of this grant is that states have to maintain the
    adopting the right fiscal policy options to achieve that sustainable growth of their own expenditure on elementary education at 8%
    deficit in a particular state. This arbitrary 3% target will not only per annum during the THFC’s award period. The state-wise
    growth of expenditure on elementary education is given in
    Table 8: State-wise Growth of Elementary Education Expenditure (Percentage per annum) T able 8. If we take recent years, the all-state expenditure on ele-
    State 2004-05 2005-06 2006-07 2007-08 Trend Growth Rate mentary education grew at the rate of 14.6% between 2004-05
    I Non-special category Andhra Pradesh 4.6 14.7 12.1 9.2 12.0 and 2007-08. This is much higher than the 8% prescribed by the
    Bihar 11.2 43.6 17.1 12.6 23.0 THFC. However, the big question at the moment is whether states
    Chhattisgarh 19.9 6.5 22.7 30.4 19.7 will be able to maintain this high growth in education expendi-
    Goa 11.1 18.0 9.3 16.0 13.8 ture given the fiscal constraints imposed by the revised road map
    Gujarat 16.7 2.5 17.0 15.1 11.9 for fiscal consolidation. It may so happen that with THFC-imposed
    Haryana 15.5 13.7 17.1 8.6 13.5 fiscal constraints, many states may actually have a lower expend-
    Jharkhand 41.7 13.7 11.0 32.1 17.8 iture despite having the grants for elementary education. The
    Karnataka 21.0 8.9 14.9 21.0 14.8 d esign of the grant is such that most of the states would still be
    Kerala 3.5 5.0 16.9 14.0 12.3 eligible for it if they bring down their own expenditure from the
    Madhya Pradesh 8.9 17.4 22.3 -2.7 12.8 Maharashtra 11.8 3.8 16.8 9.2 10.5 Orissa 4.0 11.7 6.7 43.9 18.3 current level. This is contrary to what an equalisation grant is expected to do – augment expenditure for a particular service in
    Punjab 0.4 5.0 -3.4 7.7 2.3 Rajasthan 9.3 23.8 4.0 11.7 12.0 a specific jurisdiction where it is low. Coming to the quantum of grants provided, the grant for
    Tamil Nadu 10.5 3.5 30.5 10.4 15.8 e lementary education proposed by the THFC is much higher than
    Uttar Pradesh 16.3 26.0 22.0 19.9 22.5 what was proposed by the TWFC,5 which was pegged at Rs 10,172
    West Bengal 23.1 18.5 12.8 14.2 14.9 crore. The full equalisation requirement as per the TWFC norm
    II Special category worked out to Rs 67,811 crore for its award period (Chakraborty
    Arunachal Pradesh 11.0 6.6 21.0 19.9 16.2 2005). Thus, the THFC grant at Rs 24,068 crore is only around
    Assam 3.2 -0.2 3.3 10.2 4.2 Himachal Pradesh 5.0 11.5 26.1 15.0 18.2 Jammu and Kashmir 0.6 14.3 17.4 5.2 12.7 36% of the full equalisation requirement as per even the TWFC norm, that too in nominal terms. The TWFC grant was also better
    Manipur 1.6 20.7 8.9 4.8 11.0 Meghalaya 11.9 3.8 9.5 36.6 15.1 in terms of its design and helped the states to augment their e xpenditure on education.
    Mizoram 14.9 19.2 0.4 12.8 9.5 It is also important to note that the THFC has based the grant
    Nagaland 4.2 20.2 16.7 5.0 14.1 for elementary education on Sarva Shiksha Abhiyan (SSA)
    Sikkim 15.8 15.6 6.8 18.1 12.7 norms and recommended a grant of 15% of the estimated
    Tripura 4.2 -20.8 5.8 -4.2 -5.8 expenditure of each state on the SSA. The rationale given by the
    Uttarakhand 8.0 8.5 8.9 13.4 10.1 THFC is that this grant will augment state resources and provide
    All states 12.2 13.4 15.7 14.4 14.6 adequate fiscal space to implement the Right to Education (RTE)
    Act, 2009. It will also help the states to provide for the antici
    make the states take ad hoc policy options in terms of fiscal sus pated increase in their share of the SSA to 50% by the terminal
    tainability but also seriously undermine the whole idea of growth year of the Eleventh Five-Year Plan (2007-12). This is ad hoc and
    and sustainability if it results in cuts in growth-promoting gov arbitrary. Instead of depending on the SSA norms and justifying
    ernment expenditure, as appears to be what is most likely in its grant on the grounds that the contribution of states for the
    Bihar and probably many other states. This analysis also brings SSA will go up, the THFC should have revised its own norms for
    out that the objective of bringing in fiscal discipline in a multi complete equalisation and given the grants required by states.
    level fiscal system should be based on state-specific fiscal needs, This kind of partial approach towards equalisation may not
    which are intimately linked to growth. have the desired outcome. It can at best tinker at the margin. As
    there are strict norms set for fiscal consolidation and adherence
    4 Sector and State-Specific Grants to those norms is mandatory for the states to avail themselves
    The THFC has recommended a large number of state-specific of state-specific grants, the scope for states to increase their
    grants. Apart from non-plan revenue deficit grants, these include e xpenditure to bridge whatever gap there is in providing ele
    state-specific performance grants; grants for universalising ele mentary education appears impossible in the short run and the
    mentary education; environment-related grants, for forests, grants as transfers will serve only a very l imited purpose. There
    r enewable energy, and water sector management; incentive is also the danger of states bringing down their expenditure
    grants to improve the quality of public expenditure; grants for growth to 8% per annum to adhere to the fiscal constraint
    maintenance of roads and bridges; and grants for state-specific i mposed by the THFC and avail themselves of this grant.
    62 november 27, 2010 vol xlv no 48 Economic & Political Weekly
    EPW
    5 Conclusions

    Constitution, is required to protect the fiscal autonomy of states. On the basis of the above analysis, it can be concluded that It is high time that India as a federal country starts seriously a lthough the increase in the vertical share will help the states, thinking about how to get out of this kind of technocratic the horizontal distribution formula does not appear to have made a pproach to a subject that goes beyond the deficit numbers and a any significant departure from the past in terms of greater pro-very narrow idea of fiscal prudence. The prime issue here is nurgressivity of transfers. Also, as explained, the design of the turing federalism in the country by correcting vertical and horih orizontal distribution formula is such that the fiscal capacity zontal imbalances without compromising fiscal autonomy, and distance and the index of fiscal discipline are in conflict with each that cannot be done in a dictatorial way. Even though the Finance other and serve opposite purposes – while the former tries to Commission is an independent arbiter, it should refrain from i ncrease the capacity of states to spend more, the latter tries to making r ecommendations that clamp down heavily on the fiscal limit their expenditure in relation to own revenues. Both the a utonomy of states. Mute acceptance of these recommendations i ndicators together in the same formula penalise states twice by the states and their adherence to them is also surprising. Is over for the same reason. The design of the grant for elementary there a way out from this? The answer probably lies in a deeper education is such that it has the potential to reduce the expendi-understanding of the complex issue of intergovernmental transture of states instead of augmenting it. fers and a corresponding change in the approach of future

    On the revised road map for fiscal consolidation, it needs to be F inance Commissions. It is overdue that the issue of intergovernemphasised that suggesting state-specific, year-wise, fiscal ad-mental transfers be looked at not from a narrow technocratic justment paths not only limits the fiscal manoeuvrability of states perspective or from an implicit view of a benevolent centre giving but also impinges heavily on their fiscal autonomy. This approach funds to begging states, but from the right perspective of federaof the THFC seriously compromises the idea of the Finance lism where the states and the centre are treated as equal partners C ommission itself, which, in accordance with the spirit of the in development.

    Notes

    1 The other channels of transfers include the Planning Commission and various central government ministries. Planning Commission transfers are in the form of plan grants and ministry-specific transfers are in the form of funds for various centrally sponsored schemes.

    2 The group of low-income states is Bihar, Uttar Pradesh, Madhya Pradesh, Orissa, Rajasthan, Jharkhand and Chhattisgarh. The group of m iddle-income states is West Bengal, Andhra Pradesh, Karnataka, Kerala and Tamil Nadu and the group of high-income states is Gujarat, P unjab, Maharashtra, Haryana and Goa. This grouping is done by taking the average comparative per capita gross state domestic product (GSDP) from 2004-05 to 2006-07 in ascending order, which is provided in the Report of the THFC (Finance Commission 2009; subsequently R eport).

    3 This is the case with Bihar. Its share in tax devolution has consistently declined over the award p eriods of the EFC, the TWFC and the THFC. See Chakraborty (2010).

    4 It has to be noted that the annual average nominal rate of growth of GSDP of Bihar from 2004-05 to 2008-09 has been 16.8%.

    5 For partial equalisation of the per capita education and health expenditures of selected states, the TWFC also gave grants.

    References

    Chakraborty, Pinaki (2005): “Financing Sub-National Human Development Expenditure: Is Complete Equalisation Fiscally Unsustainable?”, Mimeo, N ational Institute of Public Finance and Policy, New Delhi.

    – (2010): “Implications of Finance Commission Transfers to Low Income States: A Study of B ihar”, Paper presented at the International Growth Centre – London School of Economics, 20-22 September.

    Editorial (2010): “Whither the States in the Fiscal A rrangement?”, Economic & Political Weekly, 50(13), pp 7-8.

    Domar, E D (1944): “The ‘Burden of Debt’ and the N ational Income”, The American Economic Review, 34(4), pp 798-827.

    Finance Commission (2000): Report of the Eleventh Finance Commission, 2000, New Delhi.

  • (2004): Report of the Twelfth Finance Commission, 2004, New Delhi.
  • (2009): Report of the Thirteenth Finance Commission, 2009, New Delhi.
  • Rao, Govinda M and Nirvikar Singh (2002): “Fiscal Transfers in a Developing Country: The Case of India”, Paper presented at the University of B irmingham Conference on Comparative Federalism, January.

    REVIEW OF WOMEN’S STUDIES
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