Gist of Important Articles from IIPA Journal: Indian Finance Commission G. Thimmaiah
Gist of Important Articles from IIPA Journal
Indian Finance Commission G. Thimmaiah
Promoting National Welfare
Complementing Planning Commission
The methodology is intended to minimize vertical as well as horizontal federal fiscal imbalances and to enable the future Finance Commissions to function smoothly side by side with the Planning Commission. In India, this is necessary to make the functioning of Planning Commission effective. A major objective of my suggested methodology is, therefore, to make the Finance Commission complement the role of the Planning Commission in the task of promoting national welfare. The Planning Commission should continue to recommend the distribution of plan grants under Article 282 in accordance with its responsibility for formulating the national economic plans which embrace all the states’ plans. The responsibility of distributing plan grants provides the Planning Commission with an effective control over the states’ plans and priorities as they have to be coordinated with those of the national plan. Further, as the Fifth Finance Commission recognised, the Planning Commission also recommends additional Central assistance to states in case of severe financial difficulties during the interval between the two Finance Commissions. Therefore, the Finance Commissions should recommend tax shares either under Article 270 or 272, and unconditional grants under Article 275 or under an Alternative Devolution Scheme recommended by the Tenth Finance Commission and accepted by the Government of India under which 29 per cent of the gross yield from all Central taxes will be shared with the states in addition to providing unconditional grants under Article 275, if necessary.
Federal Transfers to Minimise Vertical Fiscal Imbalance
All the past ten Finance Commissions have no doubt recommended gradually increasing amounts of federal financial transfers from the Centre to the states mainly to reduce the vertical federal fiscal imbalance. But they have not given adequate attention to the task of minimising horizontal federal fiscal imbalance. It is not sufficient if the imbalance between the revenues and expenditures of all the states is reduced at the aggregate level by transferring some revenues from the Centre to the states. For such transfers will not enable every state to provide the benefits of essential public services to its people comparable to those of other states owing to the existence of inequalities of revenue raising capacity. It has been accepted in all civilised societies that certain essential government services of the nature of ‘pure public goods’-such as general administration, police and justice-should be provided equally to every citizen whether he demands them voluntarily or not, and whether he is prepared and able to pay for them or not. Besides, a minimum level of certain social services of the nature of ‘merit goods’-such as primary education, primary health facilities and road communications-have to be provided to every citizen whether he asks for them voluntarily or not, and weather he is prepared and able to pay for them or not. Since some of these essential public and social services involve wide-spread externalities, they have come to be accepted as the responsibility of the government. ‘Merit goods’ can be allowed to be provided by the market mechanism. But in that case, not all people, particularly in a poor country like India, can afford them in socially desirable quantities. So they have to be provided, at least partially, by the governments of the democratic countries. Provision for such public and social services has been one of the objectives of federal financial transfers in Australia, Canada and, in recent years, in the USA.
In India, this social responsibility has been accepted by the public authorities. However, the responsibility has been mostly assigned to the states which lack sufficient funds to ensure a uniform level of essential public and social services to their people. Although the Finance Commissions have been recommending increasing amounts of federal financial transfers from the Centre to the states, yet no serious attempt has been made by them to promote equalisation of these services across the states through their scheme of federal financial transfers.
Equalising Standard of Essential Public and Social Services
In India, the number of states has been increasing and these states vary very widely in their area as well as population. Further, they differ in their levels of economic development (as indicated by their per capita incomes), levels of revenue raising capacity, and even in the standards of administration. Consequently, the extent of horizontal federal financial imbalance is wide in India. Under these circumstances, there exists a wide disparity between the levels of public and social services provided by the richest and the poorest states. So it is necessary to reduce such disparity by lifting the level of the poorest states. This policy has been recognised by the previous Finance Commissions.
But they have failed to recommend federal financial transfers with a view to reducing such disparity. No doubt, the First Finance Commission tried to achieve it partially. But the Second Finance Commission disapproved of such an approach on the ground that “since the total resources are limited, this can be achieved only by stages. We have taken the view that it is the function of the Planning Commission and the National Development Council to ensure the equalisation of the standard of essential social services in the various states of Union.
To the extent the plan expenditure incurred on raising the level of social services has become committed expenditure, we have taken it into account. For our scheme of devolution, we have accepted the plan as ensuring an equitable development in the field of social services". This escapist view has been endorsed by the successive Finance Commissions and as a result the Finance Commissions have failed to make a dent in the field of equalising certain essential public and social services in the Indian federation.
It is true that the Planning Commission has been formulating national plans with a view to developing certain social services in every state. But there has never been an attempt to equalise them. Further, the Planning Commission has never been concerned with the development of essential government services as many of them fall under non-plan programmes. So the justification of the Second Finance Commission, which was accepted by the Central government until recently, has not been borne out by past experience. But what is relevant now is that even if the Planning Commission tries to develop these social services, in actual practice they may develop disproportionately in different states. Hence, the Finance Commission should be allowed to examine such inevitable disparities once in five years and equalise the levels of certain essential public and social services among the states. This will also coincide with the completion of a Five Year Plan and hence the Finance Commission’s evaluative role will logically fit into the scheme of ‘development with social justice’. This function of the Finance Commission becomes complementary to that of the Planning Commission and not overlapping as the Fifth Finance Commission observed.
Method of Achieving Such Equalisation
There is another issue relating to the equalisation of essential public and social services by the Finance Commission. The Finance Commission can achieve it only through financial inducements. Besides, the Commission is supposed to recommend only unconditional grants under Article 275. But it is argued that equalisation of essential public and social services could be achieved only through conditional grants for specific purposes, and there must be an evaluation body to ensure the use of such grants for the intended purposes. The Second Finance Commission felt that in the absence of such a body, they could not recommend special grants. The Third Finance Commission, however, felt that it was enough to attach the condition to use the special grants for achieving equalisation and leave the states free for reallocation if necessary. But the later Commission did not agree with this view and instead followed the reasoning advanced by the Second Finance Commission.
However, all the past Finance Commissions have failed to realise that they were recommending only grants for some specific purposes and the Planning Commission would act as an assessing agency while determining the outlay on social services. Further, as the Finance Commissions never recommended unconditional grants on the basis of net fiscal needs of the states, their apprehension of the purposes not being achieved was not quite warranted. And in the context of the suggested alternative approach, which treats the net fiscal needs of the states as an essential basis of unconditional grants, any apprehension of the future Finance Commission is unwarranted. For, under the suggested alternative approach, no special unconditional grant is required to be made for equalising certain essential public and social services. Instead, the difference between the level of expenditure on such services in the richest states and the level of expenditure in other states will be adjusted while working out net fiscal needs. Further, the Planning Commission should realise that the Finance Commission will be doing a job which has long been neglected by it, perhaps rightly. The Central government should also realise that the Planning Commission should give more emphasis to growth while making plan grants though regional development has become an integral part of the plans. And the Finance Commission should attempt to reduce wide disparities in certain public and social services over and above reducing vertical federal fiscal imbalance. This can be done by estimating gross and net fiscal needs of the states and recommending the transfer of revenue from the Central government in the form of tax shares and grants-in-aid under Article 275. Such a method will also encourage prudent financial management by the states and ensure a certain level of public and social services to the citizens of all the states.
Estimating Fiscal Needs of the States
The Finance Commission may adopt the following method of estimating the fiscal needs of the states for recommending financial transfers.
Asking for Central Government Memo on Revenue Surplus
First, it should review the past financial position of the Central government on the current account and examine the future position for about five years-the period covered by its recommendations. Instead of accepting whatever is reported by the Union Ministry of Finance, the Finance Commission should ask the Central government to submit formally its own memorandum outlining the revenue surplus it might spare for the non-plan current expenditures of the states over the period of the next five years. In fact, one of the terms of reference of the recent Finance Commissions suggests that they should take into account the expenditure obligations of the Central government while recommending financial transfers. But there has never been any mention of taking into account its revenue surpluses. The Finance Commission is not debarred from asking for a memorandum from the Central government by the provisions of Article 280, or by the provisions of the Finance Commission (Miscellaneous Provisions), Act 1951, as amended in 1955. The Central government may use such a memorandum to comment on the demands of the states, the principles adopted by the past Finance Commissions and suggest justifiable modifications in them. However, the Finance Commissions are not bound by such suggestions whether they come from the Centre or states. Such a memorandum and its examination by the Finance Commission need not weaken the position of the Central government. For, the Central government need not accept all the recommendations of the Finance Commission if they are not sound, compelling, or practicable enough. Further, the memorandum gives the Central government an opportunity to make its points of view known to the Finance Commission publicly. In fact, this has been done by the Australian Commonwealth Government through a memorandum to the Commonwealth Grants Commission. Furthermore, in the past, there were many confusions about the scope of recommendations of the Finance Commission and whenever the Central government did not agree with the Finance Commission, it used to make its views known to the Commission through the Member-Secretary. Such confusions and irregular methods may be avoided by asking the Central government to submit a formal memorandum.
Seeking State’s Realistic Expenditure Forecasts
In the second stage, the Finance Commission should ask all the states to submit realistic forecasts of their expected expenditures over the next five years. These forecast should be scrutinised and adjusted so as to make them comparable. Such adjustments have by now been standardised by the previous Finance Commissions and so there is no need to stress this point any further. However, it deserves to be stressed here that after making these adjustments, the Finance Commission should use, as far as possible, uniform rates of growth of non-plan expenditure. In the past, the Finance Commissions assumed varying rates of growth of not only different items of non-plan current expenditure but also varying rates of growth of the same item for different states.
This procedure violates the principle of uniformity expounded by the First Finance Commission. Therefore, the future Finance Commission should use a uniform rate of growth for individual items of non-plan current expenditure for all states, though such growth rates may differ for different items.
Then, the Finance Commission should project the rate of growth of different items of own revenues of the states at the prevailing rates of tax by using buoyancy method. The difference between the projected non-plan current expenditure and the projected own revenues of the states will give unadjusted gross current account deficits of the state governments.
Reducing Vertical Federal Fiscal Imbalance
In the third stage, the Finance Commission should try to reduce the extent of vertical federal fiscal imbalance by recommending the tax shares to all the states. The criteria used at present for distributing states’ shares in the yield from sharable taxes, assigned taxes and rented taxes are fairly objective. The gross current deficits of the states after distributing the tax shares may be termed as gross fiscal needs of sates, which indicate both vertical and horizontal federal fiscal imbalances in the Indian federation over the period covered by the recommendations of the future Finance Commission.
Estimating States Needs with Their Revenue Efforts
In the fourth stage of estimating the net fiscal needs of the states, the future Finance Commission should assess the revenue efforts (tax as well as non-tax efforts), made by the states during the period of the preceding Five-Year Plan. This is necessary to ensure that the states have exploited their sources of revenue fully in relation to their fiscal capacity.
The past Finance Commissions have not used penalties and rewards to discipline or encourage the states in the field of tax efforts. Probably, they could not do it within the framework of their outmoded approach. However, the previous Commissions took into consideration non-tax revenue efforts of the state governments in the field of earnings from state government’s departmental and commercial undertakings, such as State Electricity Boards and Road Transport Undertakings, by making unfavourable adjustments of their losses. Other than this, the Finance Commission, have paid scant attention to the overall revenue efforts of the states in the past while assessing the net fiscal needs of the state governments. And if at all they have tried to assess them, they have done it in a piecemeal way without making it an integral part of their overall approach. The future Finance Commission, therefore, should assess the revenue efforts made by each state during the period of the immediately preceding Five Year Plan in relation to its revenue raising capacity. For this, it is necessary to take the additional revenue efforts promised by each state and approved by the Planning Commission during the period of the preceding Five Year Plan as a standard required effort.
For a number of reasons, this method is better for the Indian situation than the method followed by the Australian Commonwealth Grants Commission. First, the future Finance Commission has no time to estimate the revenue raising capacity of each state in terms of the tax base of each source of its revenue, work out a normative standard rate for each source of state revenue and find out the difference between the maximum possible and the actual revenue efforts of each state. Second, with its limited research staff (in the absence of a separate and permanent research cell), it cannot adopt the Australian method and estimate the relative revenue efforts of the states in India for the purpose of its recommendations. Third, even if it is able to do it, it is unsuitable for the Indian situation owing to the need to use state taxes for achieving other objectives, such as attracting and encouraging economic activities through lower rates, in addition to the objective of raising more revenue. The additional revenue efforts involve policy issues which have to be settled by the Planning Commission. Finally, the additional revenue efforts promised by the states during the plan period also become a common test for both the Planning Commission and the Finance Commission for recommending plan and non-plan grants respectively to the states.
Thus, if a state has fulfilled its additional revenue efforts promised during the preceding Five Year Plan period, it should be deemed to have done its job. If, on the other hand, a state has failed to achieve the promised targets, the extent of the shortfall should be added on an annual average basis to the annual gross revenue of that state. In other words, the gross annual deficit of a state should be reduced by the amount of shortfall in the additional revenue efforts promised by the state. However, if a state has over fulfilled its additional revenue efforts, no bonus need be given to an already surplus state. If any bonus is provided on the ground of giving incentive, it will result in unequal distribution of federal financial transfers. But a penalty for the states which do not fulfil their additional revenue efforts is justified to make them financially responsible.
Adjusting Gross Revenue Deficits with Expenditure on Standard Public and Social Services
In the fifth stage, the future Finance Commission should make adjustments to the gross revenue deficits of the states from the expenditure side also. First, the Finance Commission should estimate, as far as possible accurately, the wastage of revenue expenditure as well as economy achieved in the non-plan revenue expenditure. For this purpose, it is better to depend upon the reports of the CAG of India for each state for the last five years. If necessary, the future Finance Commission should even ask the CAG to give necessary information on the wastage and economy in revenue expenditure of the states during the period covered by the recommendations of the preceding Finance Commission. Then the Commission should deduct such amount of wastage incurred by each state from the estimated gross non-plan revenue deficit. But, there is no need and justification for giving bonus for the states which achieve savings in the allocated non-plan expenditure as it will involve inequitable distribution of federal financial transfers.
The Commission should also make adjustments to the gross revenue deficits of the states for the additional expenditure required to raise the level of essential public and social services in each state to a standard level. In the past, the Finance Commissions either recommended special grants for achieving this purpose or increased the level and rate of growth of such expenditure on current account of the states’ budgets while working out adjusted current deficits of the states. The previous Commissions did not try to equalise the levels of revenue expenditure of the states on certain essential public and social services but only allowed the probable growth of such expenditure of all the states. And, hence, the Central government was compelled to ask the Sixth and the Seventh Finance Commissions to take into account the special needs of the states for only a part of essential public services. But even so, such special grants fell outside the main scheme of devolution and hence they are not an integral part of estimating the fiscal needs of the state governments. Therefore, the future Finance Commission should try to integrate such grants into the scheme and equalise the expenditures on certain other items also. For this purpose, it should determine a standard level of such expenditure to which it should bring the levels of such expenditure of other states. A possible standard level would be the national average level of expenditure on such services. However, the national average level is very low and not many states will benefit if that standard is adopted for equalising the essential public and social services among the states. Therefore, it is better to adopt the method of the Australian Commonwealth Grants Commission and use the average levels of certain essential public and social services of three or four richest states (in terms of per capita income). The Finance Commission may conveniently use the average of Maharashtra and Kerala to whose standard it should raise certain essential public and social services of other states. Though it would be desirable to equalise physical units of such services rendered indirectly by estimating the unit-cost of such services in different states, in view of the fact that this is not done by the Finance Commission effectively, it is better to try to equalise at least per capita revenue expenditures on general administration, police justice, education, medical care and public health and road communications in terms of unit-cost requirements. Though this is not as effective as the method of the Planning Commission, it is within the purview of the Finance Commission and will not come into conflict with the function of the Planning Commission which may be responsible for equalising these social services in terms of physical units.
Adjustment as per Difference in Actual and Standard Per Capita Expenditures on These Items
Thus, after estimating the standard level of per capita expenditure on the above-mentioned services, the Commission should find out the difference between the actual per capita expenditure and the standard per capita expenditure on each of these items in each state. If the standard per capita expenditure is equal to the actual per capita expenditure, no adjustment need be made to the gross non-plan current deficit of the concerned state. If it is greater than the actual per capita expenditure, the difference may be converted into an absolute amount by multiplying it by the respective state’s population and deducted from the average annual gross current deficit of that state. If it is less than the actual per capita expenditure, the difference should be converted into an absolute amount and added to the average annual gross current deficit of the concerned state.
After making all these adjustments to the gross current deficits of the states at the fourth and the fifth stages, the Commission should arrive at the final net current deficit of each state for each of the five years covered by its recommendations. This is the true net fiscal need of each state. And it will have to be filled up by recommending unconditional grants under Article 275.
Advantages of Suggested Approach
This suggested approach takes into account past revenue efforts, economy measures, and future special needs of each state to bring the level of essential public and social services to the level of the better-off states. It penalises inefficient management of state finances and hence discourages financial irresponsibility. And this net fiscal needs approach will enable the future Finance Commission to minimise both vertical and horizontal federal fiscal imbalances in the Indian federation.
A final word on earmarking of financial transfers for Upgradation/equalising essential public services. Past experience shows that the state governments divert funds received in the form of unconditional grants and tax shares for other non-essential purpose. Therefore, it would be better to estimate the additional expenditure on account of equalisation scheme for each state and earmark that portion of he funds transferred as the first charge on the developed funds. This will ensure proper utilization of funds for the purpose of equalisation of essential public services.