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Monday, Apr 25, 2005

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Sharing the federal pie fairly

The generally accepted criteria for fixing individual shares are equity and a State's efficiency

While the States are united in asking for a greater percentage of devolution, they are not so over their respective shares, says K. Venkataraman.

AN EXERCISE IN PARTNERSHIP: The Chairman of the 12th Finance Commission, C. Rangarajan, along with the Member, T. R. Prasad (left), presenting the Commission's report to the President, A. P. J. Abdul Kalam.

THE CENTRAL Government passes on some 40 per cent of its tax revenues to the States in one form or the other. For their part, States as a class depend on the Centre for about 40 per cant of their revenues, besides loans. States' expenditure amounts to 14 per cent of the country's GDP with a fiscal deficit of about 4 per cent. Their finances have macro-economic implications and have a bearing on governance. Nevertheless State finances have not received much attention except when a quinquennial Finance Commission submits its report.

The main questions before all Finance Commissions have been: how much of Central revenues should be passed on to the States; how much through devolution and how much in the form of grants; and what are the criteria for their distribution among different States (Plan grants depend on the size of a State plan as agreed with the Planning Commission and amount to 30 per cent thereof).

Devolution quantum

Ideally, the extent of devolution depends on what the States need and what they can raise by themselves and what the Centre can raise and what it needs - issues that involve complex calculations and judgments. The Finance Commission cannot be a Santa Claus. The total amount in absolute terms available through devolution will depend on the elasticity of Central revenues which in turn will depend on the Centre's tax policies, collection efficiency and the growth of GDP. A higher GDP growth and/or a higher Central tax to GDP ratio will benefit both the Centre and the States.

The Eleventh Commission had fixed an overall figure of 37.5 per cent of the gross Central revenues for transfer to the States, of which 29.5 per cent of the net revenues were to be passed on through devolution, including 1.5 per cent for additional excise duties. Now the TFC has taken 38 per cent of gross revenues as the indicative aggregate with 30.5 per cent of the net revenues for devolution (including an additional 1 per cent as long as the Centre levied and collected additional excise duties).

What count more for the States are a higher GDP growth and a higher Central tax to GDP ratio in future — factors that can raise the absolute amounts available for devolution. The substantial increase in the actual devolution by the TFC has thus to be related to the recent and prospective GDP growth and not to any dramatic hike in the devolution percentage. Incidentally, in referring to the increase over the Eleventh Commission's award by one percentage point, the TFC makes the significant remark that "this increase can be accommodated by the Central Government by pruning their activities that fall in the domain of the States."

Criteria for distribution

While the States are united in asking for a greater percentage of devolution, they are not so when it comes to their respective shares. Horizontal distribution of Central devolution has always been a subject of debate and sometimes of controversy. The generally accepted criteria for fixing individual shares are equity and at the same time a State's efficiency, that is, how to help the financially weaker States to improve their services to the average level, without placing a premium on inefficiency on their part or even on the part of States that are relatively efficient.

There is a third unstated criterion, namely, broad political acceptability. Fifty years ago, the criteria for Central devolution were population (as an index of needs) and revenue realisation from each State. The latter criterion was soon given up as working against the objective of equality. In its place a distance criterion was accepted, that is, the distance in per capita income between a particular State and the State (or group of States) with the highest per capita income. At the same time, the weight for population was reduced gradually, to 20 per cent now.

Before the TFC, distance and population together had an 80 per cent weightage and the balance was distributed on criteria such as backwardness and lack of infrastructure, with 10 to 12.5 per cent for fiscal discipline and tax effort. Thus, on a rough basis, till recently equalisation claimed some 87.5 per cent of the total weight and fiscal performance the balance, where the better performing States could score. Budgetary gaps as a ground for equalisation were taken as a criterion but were soon given up as not being conducive to efficiency. The TFC has increased the `efficiency share' to 15 per cent (7.5 per cent for fiscal discipline and 7.5 per cent for tax effort) and the weightage for population from 10 per cent to 25 per cent, while reducing the share of distance criterion to 50 per cent. This is some consolation to better performing States n though they are not easily consoled.

Political exercise

Horizontal distribution has been essentially a politically acceptable calibratory exercise within a limited range. The question remains whether the equalisation efforts have yielded results and whether the financially weaker States have improved their services. There is still a wide disparity in the fiscal performance of State governments, regardless of whether they are high income, middle income or low income States (This is in spite of successive Finance Commission awards. If those awards had borne fruit, the disparity ought to have been nearly eliminated. ) Outside the Finance Commissions' recommendations, there are the grants for Plan schemes and for Centrally sponsored schemes, where the financially stronger States may generally get an advantage. The question of balanced regional development has thus a canvas larger than the Finance Commission awards — a canvas that also encompasses the ability of the various States to attract and retain investments.

Even in regard to what a Finance Commission can do, the TFC has admitted that in endeavouring to strike a balance between equity and efficiency, it has not been possible to implement the "equalisation approach" fully as the disparities in per capita fiscal capacities of States were too large and some of the better-off States were also in serious fiscal imbalance.

Devolution and grants have to be taken together for assessing their impact on the States. Devolution is untied while grants are generally for specific purposes. In absolute terms, the TFC's award of grants is 2.4 times that of its predecessor. The percentage of grants to devolutions is now roughly 23.3 as against 15.6 in the Eleventh Commission's recommendations. However, one has to look at how much of the grants are for filling budgetary gaps (mostly but not wholly for the ten special category States such as J&K and northeastern States) and how much for other purposes. In the Eleventh Commission's recommendations, the ratio of non-gap filling grants to devolution was about 6 per cent; in the TFC recommendations it is a little over 9 per cent. The areas for which the grants are to be given are only partly similar to those covered by the previous commission. A significant item covered by the TFC is the maintenance of roads, bridges and buildings.

Ex post verification of the utilisation of Finance Commissions' awards has been weak and not very much in public knowledge. The TFC has recommended a permanent Finance Commission Secretariat in the Finance Ministry. This apart, considering that State finances are not receiving adequate attention now and the States need to have consultation and coordination among themselves, the time is ripe for setting up an independent Centre for the Study of State Finances, in which all States and the Centre can participate.

(K. Venkataraman is Chairman, Public Expenditure Round Table)

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