THIRTEENTH FINANCE COMMISSION

Economic & Political Weekly EPW november 27, 2010 vol xlv no 48 35

Report of the 13th Finance Commission: Introduction and Overview

Pinaki Chakraborty

This special issue on the Report of the Thirteenth Finance

Commission has eight experts evaluating its

recommendations from different perspectives. While

acknowledging the many plus points of the report,

the writers also draw attention to its numerous

drawbacks, ranging from a lack of proper attention

and omissions to faulty logic. There is little doubt that

some of the recommendations, if implemented in the

right spirit, will benefit the management of public

finances in the country. However, an awareness of the

report’s limitations could serve as an antidote to not

slipping up again.

The union finance commission (UFC) appointed every five years by the president of India for the purpose of resource sharing between the centre and the states is unique to the

Indian federal structure. The UFC’s task is defined by its terms of reference (ToR), which have been expanding in recent times. Although the primary function of the UFC as envisaged in the Constitution of India is to correct vertical and horizontal imbal-ances, ever-broadening ToR have required it to look into, among other things, the critical issues of macroeconomic stability and fiscal restructuring by both the centre and the states. The Thirteenth Finance Commission (THFC), 2010 to 2015, had larger than usual ToR, which required it, apart from carrying out its primary task of resource sharing, to suggest measures for improving the output and outcome of government expenditure; to look into means of tackling climate change and environmental sustainability; and to assess the implications of the proposed goods and services tax (GST) on the finances of the centre and the states.

Given these ToR covering a wide range of issues, one must ac-knowledge that the THFC tried to address them all in a definitive manner in a short period of two years, besides carrying out its core task of making its recommendations on resource sharing in an objective way. The noticeable features of the THFC recommen-dations are as follows.(1) Enhancing the vertical share of tax devolution from 30.5% to 32%.(2) A design for the GST and a compensation package linked to adherence to the proposed design.(3) A revised road map for fiscal consolidation and ensuring com-pliance to it by linking it to transfers.(4) Devolution of a specified share of central taxes to local bodies as grants.(5) A large number of specific-purpose grants to address the issues defined in the ToR such as climate change, sustainable de-velopment, and improving the output and outcome of govern-ment expenditure.

This special issue brings together a set of eight papers criti-cally evaluating various aspects of the THFC’s recommendations. The symposium starts with an essay by Mihir Rakshit that discusses the fiscal restructuring plan of the THFC and its implications for inclusive growth. Following it is a paper by M Govinda Rao, which gives a broad overview of the changing role of UFCs and focuses on the THFC’s approach to intergovern-mental fiscal relations in the country. Pinaki Chakraborty analy-ses the recommendations of the THFC on three specific issues –

Pinaki Chakraborty (pinaki@nipfp.org.in) is at the National Institute of Public Finance and Policy, New Delhi.

THIRTEENTH FINANCE COMMISSION

november 27, 2010 vol xlv no 48 EPW Economic & Political Weekly36

tax devolution, grants for elementary education, and the pro-posed road map for fiscal consolidation at the centre and the states.

D K Srivastava’s paper discusses the equity and efficiency trade-off in the awards recommended of the THFC. R Kavita Rao analyses the design of the GST proposed by the THFC. Arindam Das-Gupta makes an assessment of the THFC’s recommendations on improving the fiscal outcomes of government expenditure. The paper by Narayan Valluri discusses specific-purpose grants recommended by the THFC and their fallout for the states. Lastly, M A Oommen weighs the recommendations to do with decentralisation and their implications for future progress of the process.

Mihir Rakshit’s paper argues that “lack of a macro-theoretic framework and the THFC’s uncritical acceptance of the current fashionable orthodoxy” of fiscal conservatism have made the rec-ommendations relating to fiscal adjustment less than satisfac-tory. For example, he points out that though the THFC emphasises the need for harnessing “the one-time demographic dividend through appropriate investment in human capital”, there is no mention of this in the recommended road map for fiscal consolidation proposed by it. Rakshit highlights that “given the overarching requirement of a non-negative revenue balance, clubbing HRD expenditures with current ones not only leaves little scope for enlarging investment in human capital, but also the stipulated FRBM targets might in all probability be met through a slowdown in HRD spending.” According to him, the most serious deficiency of the THFC’s revised road map for fiscal consolidation is the lack of any optimality considerations related to output gap, public investment and growth. He observes that given the economy’s structural imbalance by way of huge human resource development (HRD) and infrastruc-tural gaps, under an optimal fiscal adjustment programme, fiscal deficit, debt stock and public investment will first have a rising and then a declining phase. This has not been con-sidered by the THFC while drawing up the revised road map for fiscal consolidation.

Govinda Rao draws attention to the horizontal distribution formula, which has “fiscal capacity distance” as a new indicator in place of “distance of per capita income”, and emphasises that it does not really make any significant difference in terms of distri-bution of resources among the states. He explains that fiscal capacity distance, as estimated by the THFC, “does not recognise that taxable capacity increases more than proportionately as per capita income increases” and this, in turn, could be regressive. The paper also contends that a large number of specific-purpose transfers loaded with conditionalities have further fragmented the transfer system. On the GST design, it observes that “all-or-nothing” types of conditions do not leave much room for conclud-ing a “grand bargain”, and this has led to both the centre and the states rejecting the proposed design.

The paper by Chakraborty reviews the THFC’s recommenda-tions related to tax devolution, grants and the revised road map for fiscal consolidation. He maintains that the existence of “fiscal capacity distance” and “index of fiscal discipline” in the formula for horizontal distribution contradict the objective of

achieving horizontal equity. The reason being that while the fiscal capacity distance tries to enhance the fiscal capacity of states, the index of fiscal discipline tries to limit their expendi-tures in relation to their own revenue. By working out an alter-native assigning the weight of the index of fiscal discipline to the fiscal capacity distance, Chakraborty shows that the transfer system would have been more progressive and helpful to the poorer states if this had been done. The likely impact of the revised road map for fiscal consolidation on two states worked out in this paper also brings out that the one-size-fits-all approach, where all the states will have to bring down their fiscal deficit to 3% of gross domestic product (GDP) by 2014-15, is not appropriate and may have little relation to fiscal sustain-ability because state-specific sustainable levels of deficit vary. This kind of straitjacketed approach to fiscal reforms has the potential to reduce much-needed development spending in many states.

Srivastava’s paper holds that though both the vertical and hori-zontal transfers recommended by the THFC have some desirable features, the design could have been better “if it had not intro-duced an unnecessary modification in the application of the dis-tance formula”, which may result in discouraging tax effort, an effect that could be further compounded because the tax effort criterion has been removed from the tax devolution formula. He also emphasises that there are constraints on designing a suitable fiscal transfer methodology in the Indian context because of the time lag in information – the use of dated data on per capita gross state domestic product (GSDP) and 1971 population figures being two basic limitations. The paper stresses the need to develop a better indicator of fiscal capacity at the macro level than the per capita GSDP of states and points out that it becomes even more important as state tax systems move closer to destination-based taxation such as a comprehensive GST.

Commenting on the design of the GST proposed by the THFC, Kavita Rao underlines that though it has many desirable features of an ideal GST, the direction of discussions on the tax in the Empowered Committee of State Finance Ministers has been very different. The paper also points to three fundamental problems with the approach adopted by the THFC to the GST. The first is that it was required to look into the revenue impact of the GST rather than proposing a design. Second, the revenue-neutral rates proposed by it are abysmally low at 12% when the current rate of tax on manufactured goods is more than 20%. Third, it recommends a uniform rate across all states, which

available at

Akshara-The Executive Partner8/3/1089, Plot No 46,

Srinagar Colony Hyderabad 500 034

Andhra Pradesh Ph: 23736262

THIRTEENTH FINANCE COMMISSION

Economic & Political Weekly EPW november 27, 2010 vol xlv no 48 37

does not look very practical. The paper also questions the usefulness of estimates based on income tax returns filed by more than 28 lakh business entities in the financial year 2007-08 for the calculation of revenue-neutral rates. It argues that the THFC’s estimate of the size of the informal sector that will come under the GST is highly questionable. To quote the author, “The Report on average assumes that over 20% of total purchases are from the informal sector. While this number is as good or as bad as any other number, the derived tax base is quite sensitive to where the level is pegged. For instance, if the purchases from the informal sector are assumed to be 10%, not 20%, of total purchases, the total tax base would decrease from Rs 30 lakh crore to about Rs 20 lakh crore, and the reve-nue-neutral rate of tax for the country would increase to more than 16%.”

Das-Gupta looks at the design of six specific-purpose grants to the states for improving outcomes. While appreciating the effort of the THFC in handling the complex issue of efficiency of public expenditure and its outcome in a short period of time in a com-prehensive manner, he focuses on some of the key deficiencies of the proposed design of these grants. According to him, “No safe-guards are provided to prevent states from diverting funds away from areas covered by the THFC grants. To put it differently, it is not ensured that the grants will truly provide additional funds for the purposes they are intended.” Although the grant for infant mortality rate is tied to outcome, no indications are given on how states should go about achieving the result. Also, with such a grant design, states may divert expenditures from other equally important indicators that have not been incentivised, leading to lopsided spending priorities. Das-Gupta suggests that the THFC could have designed a better system of grants targeted at out-comes by adopting the precepts of new public management (NPM), suitably tailored to Indian reality. As he puts it, “Reforms in line with NPM would seek to overhaul public expenditure and budgeting institutions to enable better identification and target-ing of outputs; to facilitate assessment of the real economic cost of these outputs, which, in turn, would improve allocation of public expenditure as well as cost efficiency; and promote ac- ac-ac-countability via both improved internal controls and more effec-tive external audit.” The two major problems the author discov-ers in the THFC’s approach to grants for improvements in outcome are not taking into account the significance of unit costs of public outputs and an inadequate treatment of the distinction between outputs and outcomes.

Examining the THFC’s recommendations related to grants-in-aid, Valluri points out that despite an unusually large number of specific-purpose grants being proposed, their share in total transfers is still not very large. The paper underscores that the effective use of grants-in-aid as a tool by a constitutional body such as the UFC could really help in directing spending to the most desirable areas rather than using centrally-sponsored schemes to promote certain specific expenditure. On the question of a large number of specific-purpose grants vis-à-vis fiscal autonomy, the author is of the view that “autonomy rooted in the principle of subsidiarity is overshadowed by the larger national interest of ensuring incremental expenditure on desirable, and

in the long-run, growth enhancing social sector expenditures, which otherwise might be starved of adequate funding.”

Finally, Oommen’s paper observes that the THFC has made significant departures from its predecessors and its recommen-dations, provided they are properly implemented, could hasten the process of decentralisation in the country. The author af-firms that one of the most significant recommendations is that on the sharing of resources from the divisible pool of taxes so that local bodies also benefit from the buoyancy of central reve-nues. He also holds that the nine-point conditionality package proposed by the THFC for the release of performance grants is the best way to ensure result-based accountability, which, in turn, will lead to vibrant local self-governments.

Concluding Remarks

To conclude, it must be emphasised that the papers in this special issue bring out the strengths and weaknesses of various recommendations made by the THFC. There is no doubt that the THFC’s approach has been different from that of earlier UFCs, be it with regard to horizontal distribution, the revised road map for fiscal consolidation, the design of grants to local bodies, or various other specific-purpose transfers. Despite various short-comings, many of the recommendations, if implemented in the right spirit, will benefit the management of public finances in the country. Drawbacks aside, a major strength is the effort that has been made by the THFC to move towards a more direct measure of fiscal capacity than per capita income and its use in the hori-zontal distribution formula. It is critically important that efforts are made to have proper estimates of fiscal capacity at the state level so that fiscal capacity equalisation, a core task of the UFC, becomes more objective and free of the many limitations pointed out in the use of the fiscal capacity distance. Another important recommendation is granting a predictable share of resources from the central pool of taxes to local bodies, unlike the ad hoc grants of an absolute amount awarded by earlier UFCs.

However, the large number of specific-purpose transfers teth-ered to conditionalities recommended by the THFC seriously un-dermines the very idea of fiscally autonomous lower levels of gov-ernment in a multi-level fiscal system. While it is true that there is no limit on the quantum of grants in total transfers, it is impor-tant that they should not unnecessarily impinge on the fiscal autonomy of states. Some of the grants, as the papers show, have serious design problems and may not actually augment expendi-ture, especially that for elementary education. Finally, though the revised road map for fiscal consolidation provides different fiscal adjustment paths to different states to reach the target of a fiscal deficit of 3% of GDP by 2014-15, it reinforces the view of the Twelfth Finance Commission that 3% of GDP is the optimal sustainable fiscal deficit target for states. In reality, this is not so because state-specific levels of sustainable deficit differ depend-ing on state-specific growth, the interest rate on debt and the level of primary deficit.

EPW is grateful to Pinaki Chakraborty for guest editing this special issue on the Thirteenth Finance Commission.