Fiscal Devolution in the Era of Globalisation

Because India has a federal system of government - and indeed, because the very survival of our polity probably requires a more open and pronounced acceptance of such federalism - it is important that this also be reflected in economic decision making. Indeed, the Constitution of India recognises this, which is why there is a such a detailed listing of the powers and responsibilities of the Central and State governments respectively, with separate and concurrent lists.
 
But this in turn creates further areas of decision, because of the issue of revenue sharing between Centre and States which must necessarily evolve as the economic context itself changes. This is why there are periodic Finance Commissions which are empowered to suggest guidelines for such revenue sharing.
 
The Eleventh Finance Commission, which submitted its report recently, was widely expected to increase the devolution of Central revenues to the State governments. This is not only because the impetus to economic decentralisation at various levels has become increasingly significant, but because the need for such devolution has become even more obvious and urgent in the recent past.
 
Most starkly, there is a glaring gap between the responsibilities of State governments, especially in providing physical and social infrastructure, and their own revenue mobilisation capacity. This is not simply a matter of being unfair to State governments : it is, more crucially, a major factor in determining the provision of such infrastructure and a range of public goods to the citizenry at large. When the States do not find the resources to undertake much needed infrastructure investment, or expenditure on health and education, or even the provision of public goods and basic needs, it not only affects current welfare but also the possibility of future development.
 
This is why the Report of the Eleventh Finance Commission (EFC) was awaited with such anticipation, since it comes in a context in which the need for a major reorganisation of the structure of fiscal devolution is apparent. In addition, the Constitutional (Eightieth Amendment) Act passed in March 2000 changed the earlier terms of devolution, requiring all Central taxes and duties (except surcharges and certain sales taxes) to be shared between Centre and States.
 
Finance Commissions in the past have typically made recommendations on the distribution of net proceeds of taxes between Centre and States and the allocation of this shared amount between States. However, the terms of reference of the EFC extended far beyond that, to cover almost all aspects of fiscal strategy, in what appears to be an astonishingly large brief.
 
Thus, the EFC was asked, among other things, to "review the state of the finances of the Union and the States and suggest ways and means by which the governments, collectively and severally, may bring about a restructuring of the public finances so as to restore budgetary balance and maintain macroeconomic stability." It was also asked to "make an assessment of the debt position of the States ... and suggest such corrective measures as are deemed necessary, keeping in view the long term sustainability for both the Centre and the States."
 
These are major issues, on which there need not be only one "technocratic" opinion. Thus, the idea that there can be an "independent" Commission which can pronounce on matters of fiscal strategy which have major redistributive implications and are therefore reflections of certain political and social configurations, is itself problematic.
 
However, the EFC has indeed addressed these issues, informed by what is essentially a monetarist perspective on macroeconomics, in which budget deficits are inflationary and government borrowing crowds out private investment. Some of the problems it identifies are extremely valid - such as the decline in the tax-GDP ratio over the 1980s and 1990s and the virtual stagnation in non-tax revenues. However, in terms of the expenditure, certain items which have contributed to the deteriorating fiscal situation are taken for granted as inevitable, while others are questioned.
 
Thus, the EFC identifies three reasons for unsustainable expenditure expansion : periodic upward revision of government wage bills because of "Pay Commissions"; increasing interest burden because of greater reliance on market borrowings by government; and growing explicit and implicit subsidies. It is interesting that the EFC questions - and even attacks - only the first and third factors, condemning them as populist and unnecessary, while accepting the inevitability of the second.
 
But in fact, the financial liberalisation measures which have led to the Government reducing its access to cheaper borrowing from the Reserve Bank of India and relying more on expensive market borrowing, were by no means inevitable. Rather, they have reflected the interests of rentier groups in the economy, who have benefited at the expense of both taxpayers and all those who have suffered the effects of cuts in other government expenditure. It is important to remember that this has been a political choice, not the outcome of some implacable economic law.
 
By contrast, while Pay Commission awards are often presented as purely political in nature, there is an important economic consideration to their recommendations. In an economy which is integrating with the global economy especially at the level of the organised formal sector, and where therefore salaries of certain professionals in the private sector grow sharply even as other wages stagnate in real terms, it is unrealistic to expect the public sector to attract professionals without offering at least comparable salaries. The explosive growth of public sector salaries is therefore a reflection of the economic liberalisation process, along with the political factors that influence the outcome.
 
This point is not mentioned at all in the Report, which instead castigates both increased wage bills and increased spending on overt and covert subsidies as undesirable, but does not see the rise in interest rates as another way of subsidising rentiers. This underlying acceptance of the basic economic strategy of the 1990s, which characterises the EFC's whole approach, is problematic because it also informs the attitude to how to resolve the problem of fiscal imbalance, and leads to some suggestions which are actually contradictory with others.
 
The fiscal context that the EFC describes is indeed one marked by large imbalances. Chart 1 shows the fiscal deficits of the Centre and States over the 1990s as per cent of GDP (Old Series). It should be noted that the figure for the Central fiscal deficit for 1999-2000 appears lower only because it excludes the States' share of small savings, which were earlier included. The problem is not with the size of these deficits so much as that they have been increasingly composed of revenue deficit rather than capital expenditure, as evident from Chart 2.

Here the deterioration of State finances appears to have been faster than that of the Centre in the 1990s, but this is not due to any worse performance in terms of raising tax revenues. In fact, as shown in Chart 3, while tax buoyancy (per cent changes in tax receipts divided by per cent changes in GDP) has declined for both Centre and States over the decades, the decline in the 1990s has been sharper for the Centre. This has gone to the point where tax buoyancy for the Centre has fallen below 1 in the 1990s. This is clearly the result of falling tax rates, which despite the grandiose claims of successive Finance Ministers, have not yielded better compliance at all.

The EFC is clearly correct to argue that there should be a much more systematic attempt to increase the tax-GDP ratio, and it includes such an increase in its proposed fiscal adjustment scenario which is detailed in Chart 4. Overall, the fiscal adjustment that the EFC asks for over the next five years is quite substantial. As Chart 5 illustrates, tax revenues of Centre and States are to go up by nearly 3 percentage points of GDP, and total revenue receipts by more than 3 percentage points.

Meanwhile, revenue expenditure is also to be cut by nearly 3 percentage points, bringing the revenue deficit down from nearly 7 per cent of GDP at present to a highly respectable 1 per cent. This would be associated with an aggregate fiscal deficit of 6.5 per cent of GDP, implying 5.5 per cent of GDP for capital expenditure by both Centre and States. This is not particularly ambitious but still substantially more than at present.
 
How is such a dramatic turnaround to be achieved ? One mechanism is increasing tax revenues, of course. What is interesting, however, is the EFC's expectation that a very large part of this increased tax revenue (around 45 per cent of it) will come from enhanced tax effort by the States. This is intriguing, given that the States' ability to impose taxes is far more constrained than that of the Central government, and that the Centre has shown much poorer performance in the recent past in this regard and therefore has much more scope for improvement.
 
There is of course a more basic question. Raising tax-GDP ratios requires more than just political will, which is obviously a necessary condition. It also, in today's world, implies a willingness to engage in macroeconomic strategies which may not please potentially mobile capital. It is not an accident that all finance capital dislikes taxation; and recent experience suggests that the competitive pressure to attract other forms of capital also typically generates policies like tax incentives. Indeed, more taxation is probably greater anathema to large capital than the much-maligned large fiscal deficits.
 
The EFC's intentions in this regard are wholly laudable, but there must be an explicit recognition of the implications, which involve a redirection of the basic macroeconomic strategy. Thus, the anticipated increases in income tax and corporation tax, while entirely feasible at one level, are not really compatible with a macroeconomic approach that puts primacy on the need to attract inflows of capital.
 
That the EFC is basically operating in that kind of world is evident from the suggestions on expenditure restraint. The largest element of Central revenue expenditure today is interest payments, which the Report actually describes as one of the items which is "inflexible downwards". The EFC appears to suggest that the only way out of this in future is to reduce public debt by cutting deficits at present. But even changing the pattern of financing the existing deficits can have a major effect on reducing the interest burden of the government.
 
The EFC uncritically accepts the position that the government has to rely only on expensive market borrowing and rules out the possibility of deficit financing altogether, even though this would sharply reduce interest payments at the margin. Similarly it appears to accept that the Statutory Liquidity Ratio cannot possibly be raised, even though this would increase access to slightly cheaper borrowing by the government. All this because the EFC seems to subscribe to the position that public borrowing "crowds out" private investment, even though empirical studies in India and elsewhere suggest that there is if anything a positive correlation between public and private investment.
 
The constraints imposed by this approach mean that the EFC is forced to rely on cuts in other expenditure to move towards fiscal balance. Thus, as shown in Chart 7a, the Centre must makes cuts in the already pitifully small proportions of GDP that are spent on social and economic services, not to mention the declines in expenditure (as share of GDP) slated for pensions and general services.

For the States - as described in Chart 7b - there are to be small increases in the per cent of GDP expended on social and general services, especially in some sub-categories, but, alarmingly, a further cut in the proportion spent on economic services. It is hard to imagine the justification for such a cut by both Centre and States, especially now that the myth that the private sector will enter to fill such spending gaps has been well and truly exposed by the Indian experience of the 1990s.
 
Of course, all these considerations, interesting as they are, are of little immediate relevance since these are no more than general policy suggestions which may or may not be taken seriously by the Government, and by the Finance Ministry in particular. But they are important for our purposes because they inform the real bread and butter issues of the EFC, that is the questions of sharing tax revenues between Centre and States and allocating across States. Thus, the EFC appears to be so concerned with its own prescription of fiscal health of the Centre that it has tailored the need for revenue sharing with the States accordingly, despite the requirements of greater fiscal federalism.
 
This is where the real disappointment with the Report comes. Despite the crying need to devolve more resources to the State level, which many would argue to be self-evident, the EFC has actually set the clock backwards and moved away from greater devolution, notwithstanding its statements to the contrary.
 
At first sight, it appears that the EFC has actually provided more resources from the Central pool. Thus it has made provision for about 37.5 per cent of all Union taxes and duties to be shared with State governments. However, some of this relates to direct grants and support by the Centre rather than the amounts which must be statutorily shared, and therefore depends upon the discretion of the Central government.
 
In terms of the statutory requirement, the EFC has been much more restrained, and has ended up providing to the States even less (as a proportion of total tax revenues) than they have received at several points over the past twenty years. This is clarified below.
 
One important respect in which a major demand of the States has been neglected (again, because of the wording of the Eightieth Amendment Act) has been in terms of the sharing of net proceeds versus the gross tax revenues of the Central government. The difference is not large, and many would argue it to be inconsequential were it not for the fact that the discrepancy has grown substantially in the past few years, as plotted in Chart 9. Not only does it mean that there is no incentive for the Centre to be more efficient in terms of collecting its taxes, but it effectively reduces the pool of resources for the States.

The EFC has proposed that 28 per cent of the net tax revenues of the Centre must be shared with the States. As would be clear from an examination of Chart 8, this is lower than the previous year and even lower than the average for the entire decade. Of course, in addition the EFC has also recommended that another 1.5 per cent of the net proceeds be shared in lieu of the additional excise duties which were effectively foregone after the Eightieth Amendment Act.
 
Even this amount is just close to the levels of the recent past, and below that of several years earlier. But the extra 1.5 per cent of tax revenues on offer relates to sales taxes on sugar, tobacco and textiles, and the EFC has made it clear that those States which choose to levy any tax on these items will not be allowed to get any share of this. Since these are among those taxes which do provide high revenues for several States, it is quite likely that they may opt to continue to levy such taxes, in which case they would no longer be eligible for this additional amount.
 
In any case, it was hoped that the EFC would actually increase the allocation of shared taxes to the States, rather than simply continue along the lines of recent experience which has clearly revealed the inadequacy of the current devolution. Instead it has chosen what for it was the softer option, of expecting the States to raise a substantial amount of additional taxation, on the implicit argument that the Central finances need to be protected from further erosion. This leaves unsolved, the critical problem of inadequate resources for the wide range of development and infrastructure expenditure which remains in the domain of State governments.
 
A further issue relates to the inter se distribution of these resources among States. This is the area that has received the most publicity in recent days, with a number of State governments voicing their opposition to the formula that has been presented by the EFC. It is wrong to present the issue as a simple one of more developed versus less developed States, or in regional terms as South versus North.
 
It is true that a number of more developed southern States are negatively affected in terms of a reduced share of even the relatively small pool that is provided to all the States. And some large northern States may get more in proportionate terms, such as Uttar Pradesh and Bihar. But there are various other States that also appear to be "losers" in this respect, despite their lack of development and relative poverty. These include northeastern States like Assam, Manipur, Meghalaya and Tripura. Interestingly, Jammu and Kashmir also comes out as a relatively large loser.
 
The relevant point is not to consider which specific states are gainers or losers but more generally to consider the validity of the principles applied. And this is where the EFC's recommendations certainly do appear to be problematic. The pie diagrams in Chart 10 elaborate on how the EFC's formula differs from the one used by the Tenth Finance Commission.

There are several important differences. Firstly, the weightage for population has been very sharply reduced, from 20 per cent to only 10 per cent, which does seem to contradict one basic principle of democracy. It is true that the income criterion (which in this case is the distance of the per capita income of a State from the weighted average of the top three States) has been increased, but only marginally from 60 per cent to 62.5 per cent. The weight for area has been increased from 5 per cent to 7.5 per cent, the reasons for which are not entirely obvious. Similarly the weight for infrastructure has also been increased.
 
But the most unjustified change of all comes in the form of the introduction of a new element - that of fiscal discipline. This has been given a weight of as much as 7.5 per cent, and the weight of tax effort has been halved from 10 per cent to 5 per cent accordingly. This is both arbitrary and unfair, because it imposes on all the state governments a certain conception of fiscal viability which is part of the Central Government's current approach, and reduces the reward for tax effort which is a much more transparent and equitable consideration.
 
In any case, the idea of rewarding fiscal discipline is extremely peculiar in the current context, because such discipline can come about even as a result of mismanagement whereby important expenditures necessary for welfare and development are simply not made. The specific way in which fiscal discipline is sought to be measured is in terms of "the improvement in the ratio of own revenue receipts of a State to its total revenue expenditure related to a similar ratio for all States as a criterion for measurement." The base year has been taken as the average of 1990-91 to 1992-93, and the reference period as the average of 1996-97 to 1998-99.
 
Note that the criterion is that of change rather than absolute levels : thus if a state begins with better fiscal balances but deteriorates slightly over this period, it will come off worse than a state with much worse overall balances which has experienced a slight improvement. The average of all States which is taken as reference for comparison also relates to rates of change, so even in terms of applying some notion of fiscal discipline this particular measure appears to be flawed.
 
Note also that higher revenue receipts and lower revenue expenditures are treated on par, which is a poor way of dealing with situations in which States should ideally be given incentives to increase those types of revenue expenditure with clear positive welfare and growth effects. In effect, the EFC seems to be subscribing to the idea, commonplace among those less schooled in the economics of public policy, that the smaller the economic role of government, the better.
 
But the basic critique of using this - or indeed, any notion of fiscal discipline - as a weight in determining allocations to States is more fundamental. This is that it uses an exogenous criterion which reflects only one particular view of economic management, and does not relate to the considerations which should normally work in a democracy. The idea that this approach is "economic" and not political in nature is completely wrong - once again, as in the attitude to expenditure restraint, it reflects a political choice whereby certain groups in society are favoured over others.
 
Quite apart from the fact that it is ironic to observe a Central government showing little or no "fiscal discipline" itself, being given the power to allocate to States according to this criterion, it is wrong to allow factors like this to determine what is really a constitutionally required need to devolve resources to different levels of government. In fact, the very application of the criterion of fiscal discipline goes against the basic tenets of decentralisation, and is therefore in opposition to greater fiscal federalism in itself.
 
It was pointed out at the beginning of this article that greater federalism, and especially economic devolution, is necessary in India today not only because it allows for more democracy and greater accountability to citizens than a more centralised system. It is also urgently required because it may be a necessary condition for the survival of our Union as stable polity able to provide development to the people. That is really why the recommendations of the EFC, which have failed to see the critical need for much more devolution at this juncture, can be a source of discontent.