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IT is curious that the polity sometimes fails to react to far-reaching changes in the offing. The report of the latest Finance Commission - the Twelfth Finance Commission (TFC) - recently tabled in Parliament by the government is a case in point.
Generally, the reports of the Finance Commission are awaited eagerly and commented upon by the States because the Commission is considered as the arbiter between the Union Government and the States with regard to the sharing of financial resources. In recent years, particularly after the onset of economic liberalisation, the States, whose finances have gone awry largely as a result of the policies unleashed by the Centre, have placed much hope on the Finance Commission mechanism to set right the financial imbalances in the system.
Despite the TFC, headed by former Reserve Bank of India (RBI) Governor C. Rangarajan, recommending far-reaching changes in the way State finances are to be managed in the next five years, the reactions, especially of the main political parties, have been muted. Surprisingly, the regional parties, which are the first to react as champions of the rights of the States, have responded tamely responded to the report. The media have, in keeping with their tradition of supporting the liberalisation process uncritically, characterised the report as providing a "road map" for the "restructuring" of State finances in the next five years.
THE creation of the Finance Commission is a result of the recognition that the ability to raise resources, particularly through taxation, is skewed in favour of the Centre vis-a-vis the States. Soon after Independence, it was recognised that a mechanism was needed to correct this bias. The Finance Commission emerged as a device for correcting this imbalance. Politically, it is not insignificant that the First Finance Commission was constituted in 1951 in response to the growing demand for regional autonomy. It was then that the political mobilisation for the reorganisation of States was beginning to gather momentum.
There are several reasons why so much hope was placed in Finance Commission-mandated transfer of funds from the Centre to the States. First, the powers of taxation are loaded heavily in favour of the Centre. For instance, the main taxes - Customs, Excise, Income tax, Corporation tax - are all levied by the Centre. The only substantial tax instrument in the hands of the States is sales tax. However, there are limits to how far the States can rely on this tax to earn revenues; in particular, the rates are dependent on what rates other States choose to impose.
Secondly, although the States' powers to tax are limited, the responsibilities of the States, particularly in addressing serious developmental issues, are substantial. For instance, the Constitution mandates responsibilities relating to education, health, agriculture, irrigation and many others to the States because they are better suited to perform these functions. However, since these responsibilities are not balanced by adequate powers, it was hoped that the Finance Commission mechanism would enable the States to discharge these basic developmental responsibilities adequately.
Thirdly, the Constitution also envisaged that the transfer of resources from the Centre would even out inter-regional disparities. Thus, it was hoped that Finance Commission-mandated transfers would enable achieving the ideal of every citizen of the country being entitled to a certain basic standard of living.
Traditionally, the Commission has concerned itself mainly with two matters. The first relates to determining the criteria governing the sharing of the Centre's funds with the States. This is referred to as "vertical transfers". The second, based on the recognition that all States are not similarly placed in terms of their social and economic conditions, relates to the Commission working out criteria that determine how the pool of funds in the hands of the Centre will be distributed among individual States.
Soon after the TFC was constituted in 2002, observers pointed out that its terms of reference were "overloaded". Although the Constitution prescribes that the main task of the Finance Commission is to perform its role as an agency for setting the modalities for the transfer of resources from the Centre to the States, the terms of reference of the TFC were expanded by asking it to suggest "a plan by which the (State) governments, collectively and severally, may bring about a restructuring of the public finances, restoring budgetary balance, achieving macro-economic stability and debt reduction along with equitable growth". In specific terms, there were fears that this was, apart from being a violation of the principles of federalism, an attempt by the Centre to straitjacket the States in the liberal reform mode with all its harsh implications for the already financially beleaguered States.
These fears were backed by the empirical observation that there was a serious deterioration in the tax collections by the Centre since the 1990s. Liberal policies, which mandated lower rates for all the major taxes, resulted in substantial lowering of the ability to generate revenues relative to national income. Between 1990-91 and 2003-04 the gross tax revenue of the Centre as a proportion of national income fell from 10.12 per cent to 9.20 per cent. Although during this period revenue generation from corporation tax and income tax rose as a proportion of the national income, they were more than offset by the collapse in collections from excise and customs duties relative to the national income. As can be seen from Table 2, the general failure to mobilise resources resulted in a substantial expansion of the revenue deficit of the Centre - from about 49 per cent of the fiscal deficit in 1990-91 to almost 76 per cent in 2003-04.
Meanwhile, the government's commitment to continue on this path of fiscal reforms implies that this trend will continue. The point, however, is that this failure of the Centre to mobilise resources means that its shareable pie has shrunk. This means that the liberal path has had adverse consequences on the fiscal transfers from the Union to the States and for Centre-State relations.
Professor K.K. George, Chairman of the Centre for Socio-economic and Environmental Studies in Kochi and an expert on Centre-State financial relations, points out that during the 1990s the buoyancy in taxes mobilised by the State was higher than that of the Centre. He says that the States are the "aggrieved party" because they have lost because of the Centre's deliberate failure to raise resources, which has deprived them of their share. The Centre's tax buoyancy, which measures the increase in revenue relative to income, declined from 1.14 in the 1980s to 0.89 in the 1990s. In fact, the States' tax buoyancy (1.02) was higher than that of the Centre (0.89) during the 1990s.
It is striking that although the media have encouraged the Centre to continue relentlessly on the path of forgoing taxes, particularly those on the rich and the well-heeled, they continue to blame the States for "fiscal profligacy". Table 3 shows the growing indebtedness of the States, which is largely a creation of the Centre's fiscal policies. Table 4 shows that the mechanism of the Finance Commission has failed to address the imbalance in State finances caused by liberal policies. Finance Commission-mandated transfers to the States have declined from 3.05 per cent of national income to 2.80 per cent between 1993-94 and 2002-03. It was hoped that the TFC headed by a reputed economist would provide succour to the States by reversing this trend.
Instead, the TFC report is characterised by the enthusiastic pursuit of "reform", and the Commission has failed to perform its constitutionally mandated role as the arbiter between the Centre and the States. The TFC has increased the share of the States in the Centre's tax revenue by a mere 1 per cent - from 29.5 per cent set by the Eleventh Finance Commission (EFC) to 30.5 per cent. The TFC prescribes that the States' share of statutory transfers, which includes the share of the States in taxes mobilised by the Centre as well as grants, increase to 38 per cent, an increase of 0.5 per cent in relation to the EFC's recommendations. George points out that the Seventh and Eighth Finance Commissions awarded the 38 per cent level in the 1980s. In fact, the share of the States in gross revenues under the award of the Ninth Finance Commission covering the first half of the 1990s, was two percentage points more than what has been prescribed by the TFC. In short, increased fiscal transfers, which is what every State expects from a Finance Commission, are unlikely to be buoyant.
The TFC, contrary to popular impression, has not addressed the "equalisation" principle, which aims to redress regional imbalances by transferring more resources to poorer States. George points out that the recommendations of the TFC mandate that the share of the Special Category States other than the three newly created ones - Uttaranchal, Jharkhand and Chhattisgarh - is lower than those prescribed by the EFC. In fact, the share of six of the 10 Special Category States has fallen. The share of low-income States (with per capita State Domestic Product less than the all States' average) after adjusting for the shares of the newly created States, has increased only marginally - from 49.3 per cent to 51.0 per cent.
George points out that the TFC has made a "radical departure" from previous Finance Commissions with reference to grants-in-aid, prescribed by Article 275 of the Constitution. It has raised the share of grants in total transfers to 19 per cent, from 13.5 per cent under the EFC and 9 per cent as prescribed by the Tenth Finance Commission. Normatively determined grants, meant to cover the deficits of the States, account for only 40 per cent of all grants. The remaining 60 per cent are special-purpose grants, aimed at meeting the needs of specific projects in the States.
George says that allocations for special-purpose grants are arbitrary and made without applying any transparent criteria. Thus, funds for a zoological park and botanical garden in Meghalaya have been approved by the TFC. So has an e-governance project for Bihar. It is not that these projects are not worthy of funding. The point is that the Commission is simply not empowered to determine the priorities of the States. In some cases, as in the case of grants for meeting State-specific needs, the determination of grants is quite arbitrary. George points out that the spirit of Article 275 of the Constitution, captured by the First and the Second Finance Commissions, was that statutory grants through the Finance Commissions should be "residuary and should be mostly automatic and unconditional". Of course, it was envisaged that in exceptional cases the grants could be directed to broad but well-defined purposes.
George says: "But, the TFC has distorted the spirit of this constitutional scheme and allotted more than half of the grants on a conditional basis. The TFC has imposed its own priorities on the States. In places it appears to have gone overboard, prescribing minor details regarding how the schemes financed by the grants should be utilised." For instance, the TFC prescribes that urban local bodies should enter into "public-private partnership to enhance the service delivery in respect of solid waste management". The TFC urges municipalities to "concentrate on collection, segregation and transportation of solid waste... ."
THE more disturbing aspect of the TFC report, however, is the overbearing influence of the agenda that is not normally a part of the task of the Finance Commission. In short, while the TFC focusses on restructuring State finances, it recognises that the period between 1997-98 and 2002-03 was "the worst in the history of State finances". It also observes that the salary bill of State governments had increased sharply during this time, largely on account of the Centre's acceptance of the Fifth Pay Commission report.
Significantly, the TFC points out that this was also a time when fiscal transfers from the Centre to the States declined and the States "were engaged in exemption-proliferating tax competition leading to a fall in the level of own tax revenue relative to GDP". The TFC also notes that the debt crisis of the States escalated during this period, because they had to increase their borrowings. They were also using an increasing proportion of such borrowings to finance interest payments on borrowings, apart from revenue expenditures, mainly salaries and other recurring expenses.
Outstanding debts of the States expressed as a proportion of combined Gross State Domestic Product (GSDP) of all the States constituted about 25 per cent of the States' income in 1993-96. According to the TFC this proportion increased to almost 37 in 2000-03. This summary all-India figure hides the true picture of State finances; in Bihar, Rajasthan, Uttar Pradesh, Punjab and West Bengal debt constituted more than 40 per cent of the State's income in 2000-03. Needless to say, interest payments of the States increased sharply between the time periods 2000-03 and 1993-96. The total debt of the Centre as well as the States as a proportion of the national income increased from 56 per cent in 1995-96 to 76 per cent in 2002-03.
After portraying starkly, through a series of tables, the substantial worsening of the fiscal situation in the States, the TFC proceeds to the heart of its report, Chapter 4, which deals with the restructuring of public finances. After an analysis of the macroeconomic parameters, the TFC observes that the States, just like the Centre, ought to have "targets" and timetables for restructuring their finances. It points out that the States ought to set fiscal limits similar to those prescribed in the Fiscal Responsibility and Budgetary Management Act (FRBMA), which sets limits to the deficits run up by the Centre.
The fiscal tightening is one aspect of the restructuring of State finances prescribed by the TFC; the other aspect of restructuring requires the States to depend increasingly on the market, instead of depending on the Centre. One of the most important prescriptions of the TFC relates to its recommendation that the Centre "should progressively reduce its intermediation in State borrowing".
This is likely to have disastrous consequences for State finances because the States, particularly the weaker ones, would be unable to raise funds at competitive rates. As any borrower knows, the larger borrowers in the loan market can negotiate harder with banks when compared with the small borrower; this analogy would apply just as well to the Centre and the weaker States. Chapter 12 of the TFC report prescribes detailed time-bound targets for a fiscal correction for the States.
The TFC uses a carrot-and-stick policy for the financially beleaguered States. It recommends that the debts of the States be consolidated at the end of 2004-05 and be repaid by the States in 20 years; States will pay interest at the rate of 7.5 per cent on these loans. It also proposes a "debt relief" scheme for States. However, this will be only available to the States if they "enact fiscal responsibility legislation".
The TFC observes that the legislation would result in "eliminating the revenue deficit in the respective States no later than 2008-09, incorporate annual targets for reduction in fiscal and revenue deficits, and present to the respective legislatures a consolidated growth and fiscal strategy statement along with their budgets". The TFC reasons that increasing transparency and the lack of opportunities to borrow from the Centre would result in the States seeking to borrow from the market. It notes that the States would also be "increasingly assessed by markets".
The risks are not unknown to the TFC. It observes: "They [the States] may be forced to pay higher than average interest rates to cover additional risk if the public finances are not evaluated to be robust by the assessment of the market." To add insult to injury, it observes that the twin pillars of its prescriptions - the fiscal responsibility legislation and greater recourse to the market for funds - "may prove to be effective instruments of fiscal discipline without compromising the autonomy of the States".
In effect, the TFC prescribes that the FRBMA, which is widely regarded as being antithetical to the Common Minimum Programme of the United Progressive Alliance government, be replicated throughout the country. It does not take great hindsight to guess that the poor and marginalised are likely to be the first victims of a full-blown fiscal squeeze; the hullabaloo over the efforts to provide a minimal employment guarantee has just shown this. But the silence of political parties and the polity at large is what is most scary.
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