Targeting the States

Print edition : December 06, 2002

The terms of reference of the Twelfth Finance Commission presages a process in which State governments are forced to go along with the neo-liberal reform agenda of the Central government.

AT the end of October, the government announced the terms of reference of the Twelfth Finance Commission (TFC), which is to be headed by the Andhra Pradesh Governor and former Governor of the Reserve Bank of India, Dr. C. Rangarajan. The Commission is supposed to submit its final report by July 2004 so that the government can incorporate the recommendations in the Budget for 2005-06. While Dr. Rangarajan is the chairman, the members include Planning Commission member Som Pal, former Cabinet Secretary T.R. Prasad and D.K. Srivastava of the National Institute of Public Finance and Policy.

As has been the case with most economic announcements in recent times, the terms of reference of the newly constituted TFC have not invited much comment, even though they reflect a further widening of the conventional mandate of a Finance Commission and presage a process in which State governments are forced to go along with the neo-liberal reform agenda of the Central government. Speaking to the press soon after the Union Cabinet cleared the terms of reference, Finance Secretary S. Narayan said: "As compared to the terms of reference of the Eleventh Finance Commission, the terms of the twelfth Commission lay emphasis on certain efficiency factors such as adjustment of user charges, relinquishing non-priority enterprises through privatisation or disinvestment and resource mobilisation to improve the tax-GDP ratio." This can only be taken to mean that a State's access to resources would be linked to its willingness to raise user charges for the public services it provides, disinvest the enterprises it owns and impose new taxes to raise revenues and cover more of its expenditures.

Conventionally, the Finance Commission is concerned with the criteria that should govern distribution of taxes between the Centre and the States and among the States themselves. The evolving mandate of Commissions constituted in the past has sought to address essentially two issues. First, it recognised the fact that in a federal system, the ability of the government at different levels to raise revenues through taxation is unlikely to match the responsibilities shouldered and therefore the expenditures undertaken at those levels. Hence the Finance Commissions were mandated with determining the vertical sharing of Union taxes between the Centre and the States.

Second, in order to reduce the large inter-State disparities, which would widen if a State's access to resources was determined purely by its gross domestic product (GDP), it provided for the construction of a formula that would prevent poorer States from being trapped in their underdevelopment by providing a weight for backwardness in the determination of revenue shares.

Despite these safeguards, neither have the States been able to obtain adequate resources to finance their expenditures, nor has inter-State disparity been reduced substantially. While inadequate resources mobilisation and unnecessary expenditures at the state level have contributed to the financial difficulties confronted by the State, Central policies have played a major role in generating a fiscal crisis at the State level. For example, it has been observed that over time the Centre has sought to increase the share of non-sharable revenue sources (such as surcharges) in its total revenues, adversely affecting the States. Further, neo-liberal reform has affected the States in two ways. Stabilisation policies adopted in the early 1990s raised domestic interest rates substantially. The larger outgo on account of interest payments meant that the States had to increase the volume of debt incurred by them. Today, the restructuring of State-level debt, by replacing high-cost debt with low-cost debt, is seen as an important means to resolve the fiscal crisis at the State level. In addition, direct and indirect tax concessions provided by the Centre as part of neo-liberal reform in order to spur private initiative, have led to a significant decline in the Central tax-GDP ratio, which affects the States adversely as well. Not surprisingly, States that were recording revenue surpluses until the late 1980s, witnessed their transformation into deficits, which have increased sharply through the 1990s.

More recently, the erosion of resources available to the States because of the implementation of the Fifth Pay Commission's recommendations has led to a crisis. The impact of those recommendations, which the States were forced to adopt once they were implemented at the Central level, was that the ratio of salaries and wages to the revenue receipts of the States, which had been going down till 1996-97, rose dramatically and almost doubled after 1997-98. Consequently, the gross fiscal deficit of the States, which was below 3 per cent of the GDP during much of the 1990s, shot up to 5 per cent by 1999-2000.

With this growing role of debt in financing expenditures, the outstanding debt of all State governments, more than doubled from Rs.243,000 crores in March 1997 to about Rs.500,000 crores in March 2001. This massive increase in debt had as its corollary a more than sixfold increase in the interest liability of all States over the 1990s, from less than Rs.9,000 crores to more than Rs.54,000 crores.

Overall, the States' debt-to-GDP ratio, which was over 19 per cent in the early 1990s, but came down to under 18 per cent by 1996-97, rose to about 23 per cent in the four years ending 2000-01. We must also note that the revenue deficit, or the excess of current expenditures over revenues, which accounted for less than 30 per cent of the gross fiscal deficit of the States in the early 1990s, rose to 60 per cent by the end of the decade. This implies that nearly two-thirds of the debt incurred by the States is being used to finance current expenditure.

As mentioned earlier, in an ostensibly cooperative effort between the Centre and the States to resolve this problem, the high-power committee on State finances, chaired by Finance Minister Jaswant Singh, has mooted a debt-swap mechanism, involving the replacement of high-cost debt with low-cost debt, as a solution. This, together with the move to replace sales tax with VAT at the State level has been viewed with suspicion by the States.

The grounds for suspicion are strong, given the evidence that the Centre is seeking to use the fiscal problems of the States, which have been partly created by the former, to force the latter to adopt controversial neo-liberal policies. In the past, this was done through means other than conditions attached to what are constitutionally warranted statutory transfers of resources to the States. One such means was to use the mechanism of non-statutory transfers to the States, principally through the Planning Commission, in order to force unpopular policies on the States. The other was to encourage State governments to approach agencies such as the Asian Development Bank and the World Bank for project funding, in return for which they would demand a restructuring of finances by the States. This is what happened in States such as Orissa and Andhra Pradesh and is currently under way in Kerala. It was also a reason for the controversy in the state of West Bengal.

But starting with the Eleventh Finance Commission, the effort to force the States into accepting neo-liberal reform policies has involved making suitable additions to the original mandate laid down in the constitution for such Commissions. Thus, the Presidential Order of April 28, 2000, had asked the Eleventh Finance Commission "to draw a monitorable fiscal reforms programme aimed at reduction of revenue deficit of the States and recommend the manner in which the grants to States to cover the assessed deficit on their non-Plan revenue account may be linked to progress in implementing the programme." Thus the Eleventh Commission was asked to include the formulation of a fiscal reform programme in its terms of reference. By doing so the Centre was not merely seeking to give constitutional validity to a particular kind of "fiscal reform", but asking the Commission to give the Centre the right to use the provision of assistance to cover non-Plan revenue deficits as an instrument to enforce compliance with such a reform programme. Not surprisingly, many States, led by the Government of Kerala, had expressed strong reservations about the additional terms of reference.

Now the Centre has gone even further. To start with, the TFC has been asked once again to suggest a plan to restructure public finances to restore budgetary balance and macro-economic stability and reduce the debt burden.

In addition, it has been required to provide weightage to a State's willingness to implement "reform" policies such as raising user charges, privatise and reduce the tax-GDP ratio when determining its access to a constitutionally guaranteed share in resources. Further, in order to ensure that the effort at strapping the States onto the reform process would be successful, the government has decided to give the Planning Commission a role in influencing the devolution formula and the conditionalities to be associated with the provision of a share to the States in Central resources. Clearly, Planning Commission member Sompal is an "ex-officio" nominee to the Finance Commission, and is likely to ensure this role for the body which hitherto could use only non-statutory transfers as a means of pushing the Central agenda at the State level.

This attempt to use the Finance Commission to push through what is the real thrust of the so-called "second-generation" of reforms, namely, the enforced adoption of reform polices in a host of areas which fall within the jurisdiction of the States and not the Centre, is clearly a violation of the constitutional mandate in this regard. Article 280 Clause (1) of the Constitution provides for a statutory Finance Commission being set up every five years, to recommend the rules that should govern the devolution of funds from the Centre to the States and their distribution among the States. The choice of a five-year life-span for the recommendations of any single Commission implies that those who framed the Constitution wanted changes in the economic structure, which occur with development, to be taken account of when formulating devolution rules. However, using the Finance Commission, which is a constitutional instrument, as an agency to push through a highly controversial change in the economic policy regime is clearly a breach of its constitutional obligation by the Centre. Using the Planning Commission, which is an administrative body, to implement this subversion of the work of a constitutional institution such as the Finance Commission is an even greater violation. It is imperative that the States challenge the Centre's manoeuvres in this regard, so as to protect the freedom provided by the Constitution to frame their own policies in areas identified as within their jurisdiction.

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