Devolution dilemmas

Print edition : August 19, 2000

A critique of the Eleventh Finance Commission's recommendations.


ONE must, to begin with, sympathise with the Eleventh Finance Commission (EFC). Consider the following facts. The Presidential Order appointing the Finance Commission was issued on July 3, 1998, with the mandate to submit its report by December 31, 1999, that is, in less than 18 months. Second, paragraphs 3 to 8 of the Presidential Order - which set out the terms of reference and lay down guidelines - are awe-inspiring. The Government of India obviously expects 'miracles' to be performed by strictly tem porary (expert) bodies set up by it, even as the Ministry of Finance and the Planning Commission continue in their merry old ways. Finally, after the EFC had submitted its interim recommendations early in 2000 comes the Constitution 80th Amendment Act, 2 000, which materially changes the very basis of financial devolution from the Centre to the States. As a result, the EFC's interim recommendations become null and void, and an additional term of reference was issued to the EFC on April 28.

Not unnaturally, there are two notes appended by two members. One of them is by the legal expert on the EFC, suggesting a permanent Finance Commission, with the members changing every five years and with a permanent staff.

There is further complexity. It is common knowledge that since the mid-1980s, the fiscal situation has been steadily deteriorating. Indeed, the really worrying aspect of the problem is that after two years of 'stabilisation effort' - under International Monetary Fund (IMF) 'conditionalities' - over 1991-92 and 1992-93, the Government of India (adhering to the World Bank guidance on 'Structural Adjustment', which is really a misnomer) has reverted to fiscal 'irresponsibility', and has been imitated merri ly by the States. In part, of course, the Fifth Pay Commission is responsible for the present disarray in government finances; but why did the government yield so completely and supinely? Let us summarise some telling data contained in the EFC report - c onverting the new Gross Domestic Product series to the 'Old' series to enable comparability over time - regarding some important parameters of the fiscal situation. Table 1 gives the gross tax revenue, revenue deficit, fiscal deficit, and capital expendi ture, as a percentage of the GDP, of both the Centre and the States combined.

Coming from an official document, no further critique of the policies adopted by the Government of India - pursued since the 1990s - is necessary. In the present instance, if these facts are highlighted, it is only to emphasise the extremely difficult ta sk faced by the EFC, in the face of the steady deterioration in the overall fiscal situation, despite the enormous and sudden burdens placed on the economy following the Kargil War, when the Finance Minister refused not only to impose a temporary 'tax' to meet the emergency, but also announced later absurd concessions to 'speculative capital'. This, despite the 'guideline' (No. 3) in paragraph 5 of the terms of reference, which states that "the Commission shall have regard, among other considerat ions, to ... (iii) the requirement of the States for meeting the Plan and non-Plan revenue expenditure, keeping in view the need for generating surplus for capital investment and reducing fiscal deficit."

This essay is not concerned with the Government of India's policies (or the lack thereof), but with the recommendations of the EFC. One must add herein that essentially the matter becomes highly subjective, especially when there is no permanent ex pert body to analyse past trends and the patterns of revenue and expenditure which have evolved over time. Changes in such patterns need time; one simply cannot reverse gears all of a sudden.

Let us focus on the main elements of the principles adopted by the EFC for the devolution of Central resources to States.

To begin with, one must compliment the EFC for the 'target' set for 2003-05, wherein it has assumed (a) a GDP growth of 7.0-7.5 per cent per annum over the period; (b) inflation at 5.5-5.0 per cent; (c) current account balance of payment at (-) 1.5 per c ent of GDP; (d) revenue deficit (overall) at 1.0 per cent of GDP; (e) fiscal deficit at 6.5 per cent of GDP; and, more important (f) tax revenue at 16.7 per cent of GDP; (g) non-tax revenue at 3.2 per cent of GDP; and capital expenditure (by government) at 6.6 per cent of GDP.

Just compare the above parameters with those given for 1999-2000 in Table 1, and one must admire and compliment the EFC for the 'vision' (and the 'targets') it has in mind.

Some of the basic criteria adopted by the EFC need to be 'appraised' and 'questioned'. There are two different sets of criteria involved: one for overall devolution of Central finances to the States; and the other, the inter se distr ibution of Central finances to different States.

One can have no quarrel with the proposition that in the final analysis the EFC has to rely on normative judgments in coming to certain crucial parameters. If a corrective to the past is necessary, one cannot merely go by history or routine statistical p rojections. The latter are necessary as a backdrop; but where change is of the essence, certain positive prescriptions are necessary.

First, then, as regards overall devolution from the Centre to the States. One cannot help feeling that the concept of transfer of "gross collections" is far better than that of "net collections"; the Centre should have some incentive in keeping do wn the 'cost of collections', and, in a scheme of transfer of 'net tax proceeds', the Centre has no such incentive. However, this is essentially a minor point: the more important point is, with devolution to a third tier of governance becoming necessary now whether a larger percentage of Central tax proceeds should not devolve below.

The more important - and problematic - issue arises with the inter se allocation of resources between the States. The EFC has adopted the following criteria for the inter se allocation of resources among the States. Table 2 gives the detail s.

Admittedly, all such criteria must remain subjective and heavily influenced by the approach and attitudes of the members of the Commission. Let us give but one example. One member (Prof. A. Bagchi) has added a separate note to the EFC Report. Titl ed 'On the Need to Strengthen the Equalising Role of Fiscal Transfers', it is an excellent piece of analysis to which there can be no objection in principle. And yet, many practical problems remain. The only data - and these are quite bad - availa ble relate to per capita State Domestic Product; there are no estimates available as to per capita income. It is known that there could be - and indeed do exist - wide discrepancies between the two. How does one get over the difficulty? In the absence of other data, could the EFC not use data on per capita consumer expenditure available from the National Sample Survey? Here is a mental block. The officials in the statistical hierarchy attach great sanctity to their estimates of output, not to sam ple surveys relating to consumer expenditure. Never mind that 'cross validation' attempts reveal very serious deficiencies in output data.

Briefly, the income criterion (distance method), for which a weightage of 62.5 per cent has been given by the EFC, is based on data which are little more than figments of the imagination. This and the population criterion - still based on the 1971 popula tion data - account for 72.5 per cent of the total weightage for the inter se allocation of Central resources among the States. The allocations are not only highly arbitrary, but make nonsense of Bagchi's note. Indeed, the reduction in the weighta ge for population (from 20 in the Tenth Finance Commission to 10 by the EFC) despite the reliance on 1971 population data goes against the so-called 'Bimaru States' - Bihar, Madhya Pradesh, Rajasthan and Uttar Pradesh - which are highly populous and impo verished. So much for the 'equalising role' of the EFC's recommendations. Incidentally, the combined weightage given by the Eighth Finance Commission to the criteria of per capita income and 'distance' (or, 'inverse income') was 75 per cent.

There is more to the problem, and that sleight of hand is not easily discernible. The 'distance' formula has been changed, and while the average of the top three States (rather than the State with the highest per capita SDP) has been taken, there are some other changes in the procedure adopted which are not clearly or explicitly indicated. Considering that the past record in fiscal management, where the performance of the southern States - especially Tamil Nadu, Karnataka and Kerala - has been go od, these States have been especially 'done in' by the recommendations of the EFC; they have lost in comparison with their earlier percentage allocations. Let us briefly compare the percentage allocations between the States as per the TFC and EFC calculations. Admittedly, these percentages - in respect of the EFC - exclude the devolution in respect of expenditure tax and service tax, which cannot be devolved to certain States, but the EFC does not bother to give the total 'effect' of all these de volutions in terms of the percentage share of different States. It would be seen from Table 3 that other than Karnataka, the southern States have lost out (in comparison with earlier allocations), despite the so-called incentives given by the EFC for 'tax effort' and 'fiscal discipline'. Obviously Bagchi's 'equalising effort' and the 'incentives' allowed by the other members more or less cancel out each other, and the difference between the TFC and the EFC is really between Tweedle Dum and Tweedl e Dee, no matter how much credit for 'inventiveness' and 'courage' is given to the EFC.

The EFC report raises many other issues; indeed, far too many to be discussed here. While no one would object to the special treatment of Special Category States (or, now, Jammu and Kashmir and Punjab), they raise issues that go beyond the scope of a dis cussion on the Finance Commission's recommendations. For instance, is internal social unrest not a result of the lack of development and employment opportunities? One must praise the EFC for assuming (or recommending) an increase in the government 's capital expenditure for infrastructure build-up. But, is the present government likely to take such recommendations seriously? Second, why on earth does the EFC accept Central resources from the sale of profitable central Public Sector Enterprises (PS Es) equity at Rs.10,000 crores annually when it is known that only the most profitable PSEs' equity is to be divested, at a cost much, much lower than the return from the PSEs forgone annually? Is it not the responsibility of the Finance Commission to ex pose the unwisdom of such a policy?

Penultimately, as in the past, there are some specific allocations made for (a) 'upgradation' of administration, for 'equipment and weapons for the police', for fire services, for certain specified health services, for 'computer training for school child ren', all of which sound too much like the voice of a tired, old schoolteacher who must impose his world-view on all his pupils.

Finally, as far as the local bodies are concerned, the intentions appear to be good; yet, knowledge of the functioning of local bodies appears to be wholly absent. Did any member of the EFC study the working of the panchayat system in Kerala? And, does any member of the EFC know the precise rules, regulations and procedures of the Indian audit and accounts system devised by the British? The recommendation that "The C&AG (Comptroller and Auditor General) should be entrusted with the responsibility of exercising control and supervision over the proper maintenance of accounts and their audit for all the tiers/levels..." could mean the death sentence to the 73rd Amendment to the Constitution.

Again, in the above context, the States that have done well unfortunately get discriminated against. We are once again up against the conflicting objectives of the 'equalising effect' of devolution and the 'incentives' for good performance. In this insta nce, the latter appears to be a casualty. Does that augur well for the future?

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