1 Tax Devolution: Vertical Quantum and Horizontal Distribution

As mentioned, the THFC has enhanced the vertical share of tax devolution to states from the 30.5% recommended by the Twelfth Finance Commission (TWFC) to 32%. If we look at the horizontal distribution of this transfer, the aggregate share of low-income states2 has remained more or less stagnant at 54% during the award periods of the Eleventh Finance Commission (EFC), the TWFC and the THFC (Table 1). While the share of middle-income states has declined sharply, that of high-income states increased from 9.75% to 11.19% during the award period of the TWFC, but has declined marginally to 10.94% in the THFC award. The aggregate share of special category states has increased from 7.29% to 9.6% during this period. In other words, despite attaching high weightage to the “income distance” or “fiscal capacity index” to achieve fiscal equity, the horizontal distribution formula has failed to increase the aggregate share of devolution to low-income states. In the specific context of some of the low- and middle- income states, their shares in the UFC devolution have continued to decline, imposing a huge fiscal strain on their finances.3 It has been pointed out that one of the major reasons for the low level of per capita development expenditure in low-income states and in many of the middle-income ones is the failure of the t ransfer s ystem to offset the fiscal disabilities of these states (Rao and Singh 2002) despite having apparently progressive principles of transfers.

Table 1: Tax Devolution

Union Finance Commission

Eleventh	Twelfth	Thirteenth
Low-income states	53.762	53.788	53.618
Middle-income states	29.189	26.842	25.839
High-income states	9.750	11.199	10.943
Special category states	7.299	8.171	9.600
Non-special category states	92.701	91.829	90.400
Total	100	100	100

Source: Reports of the Finance Commission (2000, 2004, 2009).

The horizontal distribution formula of the THFC has four d ifferent indicators, each with a different weight assigned to it – area (10%), population (25%), fiscal capacity distance (47.5%) and index of fiscal discipline (17.5%). Fiscal capacity distance is a new indicator, which replaces the income distance used by earlier UFCs, with the rationale that it better reflects fiscal capacity. The fiscal capacity distance in a way benchmarks states according to their tax capacity, down from the state with the highest fiscal c apacity and a prescriptive tax effort. The THFC has worked out the average tax to gross state domestic product (GSDP) ratios s eparately for general and special category states and applied the group-specific averages to obtain the potential tax effort. This has been used to estimate the per capita fiscal capacity at comparable levels of taxation. It has then computed the fiscal distance (weight of 47.5%) of each state by the distance of its estimated per capita revenue from that of Haryana. The distance so computed defines the per capita revenue entitlement of each state based on fiscal distance. But it is worth noting what an editorial in the E conomic & Political Weekly observed:

Although, this is an interesting innovation and the THFC claims that this is a more direct way of estimating fiscal capacity than the income

Economic & Political Weekly

EPW

november 27, 2010 vol xlv no 48

distance method, it is important to remember that the relationship between income and tax is non-linear because of the differences in the taxable consumption basket between high, middle and low income states. Also, as the central sales tax (CST) continues to exist, there is significant tax exportation taking place from the producing highincome states to the consuming low-income states. Thus, the new h orizontal formula creates an inherent bias against the low income states (2010).

Area and population are neutral indicators of need, while fiscal capacity distance as explained above tries to equalise the fiscal capacity differences across states. On the other hand, the index of fiscal discipline tries to capture the efficiency in fiscal management by comparing the own revenue to total revenue expenditure ratio of the states at two different points of time. The index of fiscal discipline is worked out with 2005-06 to 2007-08 as the reference years and 2001-02 to 2003-04 as the base years.

The existence of a fiscal capacity distance and an index of fiscal discipline in the same formula contradict the objective of achieving horizontal equity. The reason being that while fiscal capacity distance tries to enhance the fiscal capacity of states, the index of fiscal discipline tries to limit their expenditure in relation to their own revenue. This, in practice, could conflict with each other. One needs to remember that if the objective of fiscal equalisation is to provide “comparable levels of public services at comparable levels of taxation”, it cannot be achieved by an index of fiscal discipline defined as own revenue to revenue expenditure ratio. It needs some measure of expenditure equalisation taking into account total revenues, including devolution and grants. If the objective is to equalise fiscal capacity, the index of fiscal discipline and fiscal capacity in the same formula may send conflicting signals to the states. Finally, given the large-scale i nequality in government expenditure in per capita terms, it is critical that the principle of devolution primarily be driven by e quity considerations, especially when a large number of specificpurpose transfers is anyway given to enhance the efficiency of government expenditure and also for state-specific needs. To put this issue in perspective, we have tried to examine what the distributional change in devolution across states would be if the index of fiscal discipline criterion is eliminated and the assigned share of the index is assigned to the fiscal capacity distance. The result is in Table 2 (p 58).

As the table shows, under the new formula, the share of devolution to low-income states increases quite significantly while the shares of high and middle-income states decline. Bihar’s share under the new formula would be 12.659% against 10.197% recommended by the THFC. Similarly, the share of low-income states like Chhattisgarh, Jharkhand, Madhya Pradesh, Orissa and Uttar Pradesh would go up significantly while there would be a decline in the shares of high- and middle-income states, particularly those of Maharashtra, Tamil Nadu and Gujarat. It is also important to note that the fiscal capacity distance criterion penalises states with lower than average tax effort for inefficiency by taking the group-specific average tax effort, not their actual tax e ffort, in estimating fiscal capacity distance. In other words, if the fiscal distance is estimated with actual tax effort instead of the average, the distance would be higher for those with a lower

2 Revised Road Map for Fiscal Consolidation

One of the most significant components of the THFC’s recommendations is the revised road map for fiscal consolidation at the c entre and the states. The basic concern of this road map is to

Table 2: Horizontal Distribution Formula: Alternatives and Outcome

Basic data from the THFC Report.

bring down the fiscal deficit to 3% of gross domestic product (GDP), separately at both the centre and the states, by the end of 2014-15. As mentioned earlier, the THFC appears to have been seriously concerned about the fiscal expansion that took place in 2008-09 and 2009-10 to combat the slowdown in India’s economic growth caused by the global financial crisis and decided to emphasise the need for both levels of government to bring down their level of fiscal deficit to 3% of GDP. The centre and all the states, barring West Bengal and Sikkim, had a Fiscal Responsibility and Budget Management (FRBM) Act when the THFC submitted its report. The THFC has recommended that the states incorporate their new target into their existing Acts or introduce it if they do not have one. The THFC’s revised road map for fiscal c onsolidation is not fundamentally different from what was p roposed by the TWFC as far as the level of fiscal deficit is concerned. The only difference is alternative fiscal adjustment paths for states with relatively high fiscal imbalances, with mandated deficit reduction targets for every year to arrive at a fiscal deficit of 3% of GSDP by the end of 2014-15. Now, two fundamental questions arise at this point. One is the feasibility of bringing down the fiscal deficit within the time frame specified by the THFC and the use of deficit reduction as a condition for the release of statespecific grants that the Commission has recommended. The other is the appropriateness of the proposed road map when it is assessed against the backdrop of the fiscal autonomy guaranteed by the Constitution to the states.

To start with the first question, we need to recall that the deficits in 2008-09 and 2009-10 were particularly due to a decline in revenue because of the slowdown in economic growth, coupled with an increase in expenditure. The latter was necessitated by various stimulus packages and the revision of pay scales in accordance with the recommendations of the Sixth Pay Commission (2008). Although these shocks were transitory in nature, the adjustment path could be much longer than what has been s uggested by the THFC. Among the general category states, the THFC has suggested a different fiscal adjustment path for Kerala, Punjab and West Bengal, the states with high levels of fiscal d eficits. Of the 11 special category states, different fiscal adjustment paths have been suggested for six – Jammu and Kashmir, M anipur, M izoram, Nagaland, Sikkim and Uttarakhand. The level of a djustment for all the states starts from 2011-12. In e ffect, there is only one year, 2010-11, to bring down the fiscal deficit to a m anageable level of 3.5% except for Jammu and K ashmir and M izoram where lower fiscal deficit reduction targets have been proposed.

The THFC’s base year for estimating these adjustment paths is 2007-08. As many are aware, 2007-08 was dubbed the best year of fiscal prudence by both the centre and the states with the a ctual fiscal deficit remaining much lower than the targets proposed under their fiscal responsibility legislations. But one cannot deny that the deficit increased significantly in 2008-09 and 2009-10 (Table 3, p 59). So taking 2007-08 as the base year for the fiscal adjustment path, leaving aside two out of the ordinary years of fiscal imbalance, is not justified from the viewpoint of practical management of state finances as well as the implications of the fiscal contraction proposed to be achieved within just a year, especially for states with large fiscal imbalances. For example, according to the THFC’s proposed fiscal adjustment path, Punjab’s fiscal deficit for 2007-08 was 3.5% and this has to be maintained at the same level of GSDP in 2011-12. But if we look at Punjab’s level of fiscal deficit in 2009-10 (budget estimate), it is 5.3% of GSDP. If Punjab has to bring down the fiscal deficit to 3.5% in 2011-12, as proposed by the THFC, the level of deficit reduction will have to be 1.8% in just one year, 2010-11. In the case of West Bengal, the reduction will have to be even higher at 2.3% of GSDP as there has been a sharp increase in the state’s deficit according to the budget estimates for 2009-10. For special category states, the problem is even worse as their levels of fiscal and revenue deficits were much more than those of general category states in relation to their respective GSDPs for 2008-09 and 2009-10. Given

november 27, 2010 vol xlv no 48

EPW

their narrow tax base, they have to contract their level of expenditures much more than the general category states if they have to comply with the fiscal adjustment path proposed by the THFC.

As mentioned, the problem is compounded as reduction in the deficit has been linked to transfers of state-specific grants. This kind of selective approach towards specific states is unfair and subjective. As evident from Table 3, Kerala, Punjab and West

Table 3: Revenue and Fiscal Deficits of States: A Comparison (As a percentage of GSDP)

States Revenue Deficit Fiscal Deficit 2007-08 2008-09 (RE) 2009-10 (BE) 2007-08 2008-09 (RE) 2009-10 (BE)

(-) sign indicates a surplus in deficit indicators; RE: Revised estimates; BE: Budget estimates. Source: State Finances: A Study of Budgets of 2009-10, Reserve Bank of India.

B engal had fiscal deficits in 2007-08 of 3.68%, 3.32% and 3.75% of GSDP respectively, while those of Uttar Pradesh and Jharkhand were much higher. It can be asked why the same fiscal adjustment path has not been recommended for Jharkhand and Uttar Pradesh as well. In short, this type of selective approach is unjust and arbitrary.

Finally, it is mandatory that each state adhere to its fiscal a djustment path if it wants to avail itself of state-specific grants. To quote the THFC, “To facilitate implementation of the above road map, we recommend that the states’ enactment/amendment of their FRLs incorporating the above targets should be a conditionality for release of all state-specific grants”. To put it differently, if the states are not able to follow these road maps despite their best efforts, they will lose out on a large volume of transfers. The total state-specific grants proposed by the THFC add up to Rs 27,945 crore. The biggest beneficiaries of these state-specific

Economic & Political Weekly

EPW

grants would be poorer states such as Bihar, Chhattisgarh, Jharkhand, Madhya Pradesh, Orissa, Rajasthan and Uttar Pradesh. Together, their share accounts for 37.24% of the total state-specific grants, or Rs 10,406 crore. Kerala, Punjab and West Bengal together will lose Rs 4,683 crore if they are not able to adhere to the proposed fiscal adjustment paths specified for each of them by the THFC. It is also unfortunate that the THFC’s fiscal consolidation road map has endorsed the same target of deficit that was proposed by the TWFC instead of allowing states the flexibility of deciding what their sustainable level of fiscal deficit would be, given state-specific economic growth and the interest rate on debt as specified in Domar’s (1944) condition of sustainability and the level of primary deficit. Such a straitjacketed a pproach to fiscal reforms and sustainability not only undermines the fiscal autonomy of the states, but also could result in mindless cuts in development expenditure to achieve the p roposed targets.

3 Implications of Revised Road Map: Comparing Two States

In this section, we have quantified the implications of the revised road map for two states, Bihar and Kerala. The rationale behind the selection of these two states is as follows.

As Table 4 (p 60) shows, if the present fiscal policy stance of the government of Bihar continues, the state will in no way be

14.2 13.5 13.1 12.6 a llowed to continue, by the terminal year of the THFC award,

Medical and public health 0.8 0.8 0.8 0.7 0.7 Other social services 1.8 1.8 1.8 1.7 1.7 has stricter norms than Kerala because, as per the THFC’s assess-Economic services 1.6 1.5 1.4 1.3 1.2 ment, Kerala is a state with higher fiscal imbalance and it requires Compensation and assignment reducing its deficit gradually. to local bodies 1.1 1.1 1.0 1.0 0.9

Table 7: Fiscal Profile and Debt Sustainability: Medium-Term Perspective

Primary deficit 1.1 0.8 0.5 0.2 -0.1

(The Reform Scenario; as a percentage to GSDP) Outstanding liabilities 32.0 29.0 26.0 23.0 20.1 2010-11 BE 2011-12 2012-13 2013-14 2014-15

Revenues 12.7 12.9 13.1 13.2 13.4

i mprovement in revenue receipts and a sharp decline in revenue

Own tax revenues 8.5 8.6 8.7 8.7 8.8 expenditure, primarily due to a decline in general services Sales tax 6.2 6.2 6.2 6.2 6.2 e xpenditure because of a sharp decline in interest payments. Pro-State excise duties 0.8 0.8 0.8 0.8 0.8 jections based on past growth also show a marginal decline in Stamp duty and registration fees 0.9 1.0 1.0 1.1 1.2 social and economic services expenditures to GSDP ratio in the Other taxes 0.7 0.7 0.7 0.7 0.6 Own non-tax revenues 0.9 0.9 0.9 0.9 0.9

Central transfers 3.3 3.4 3.5 3.6 3.7

Tax devolution 2.0 2.0 2.1 2.1 2.1

Grants 1.3 1.3 1.4 1.5 1.5

Revenue expenditure 14.2 13.9 13.5 13.1 12.8

a steady decline in the fiscal deficit to GSDP ratio to 1.6% of GSDP

General services 6.2 6.2 6.0 5.9 5.8

by the end of 2014-15, and a steady decline in the debt to GSDP

Interest payments 2.4 2.3 2.1 2.0 1.8

ratio to 20.1% by the end of 2014-15. Thus, the alarm bell rung by

Pensions 2.2 2.2 2.2 2.2 2.1 the THFC about the deteriorating fiscal situation of the state Other general services 1.6 1.7 1.7 1.8 1.8 a ppears to be incorrect. Disregarding the fact that Kerala has Social services 5.3 5.2 5.1 5.0 4.9 i mproved its fiscal balance significantly in recent years, the THFC Education 2.7 2.6 2.6 2.5 2.4 has imposed a fiscal adjustment path that has little relevance to Medical and public health 0.8 0.8 0.8 0.7 0.7 Other social services 1.8 1.8 1.8 1.7 1.7

the state.

Economic services 1.6 1.5 1.4 1.3 1.2

Kerala’s fiscal adjustment path compliant with the THFC’s

Compensation and assignment

r evised road map for fiscal consolidation is presented in Table 7.

to local bodies 1.1 1.1 1.0 1.0 0.9

Capital expenditure 2.0 2.5 3.0 3.1 3.6

Capital outlay 1.7 2.1 2.6 2.6 3.1 of GSDP by the end of 2014-15, with a revenue surplus emerging in Net lending 0.3 0.4 0.4 0.4 0.5 2013-14 and continuing thereafter. This substantiates our earlier Revenue deficit 1.5 1.0 0.5 -0.1 -0.6 observation that the level of fiscal correction in Kerala in the last Fiscal deficit 3.49 3.5 3.5 3.0 3.0 four years has been significant and a continuation of the same Primary deficit 1.1 1.2 1.4 1.0 1.2 Outstanding liabilities 32.0 29.3 27.2 24.9 23.1

trend will result in a reduction in fiscal deficit much below its

EPW

november 27, 2010 vol xlv no 48

THIRTEENTH FINANCE COMMISSION

c ombination of the growth rate, interest rate and primary deficit.	needs. As these grants are conditional, their actual utilisation
As these are quite different in different states, the estimated	will largely depend on meeting grant-specific conditionalities.
l evels of sustainable deficit would have been different in Bihar	One of the major components is the grant for elementary edu
and Kerala had such an approach been adopted by the THFC.	cation, amounting to Rs 24,068 crore. The conditionality a ttached
Once the sustainable deficit is known, then it is a question of	to the release of this grant is that states have to maintain the
adopting the right fiscal policy options to achieve that sustainable	growth of their own expenditure on elementary education at 8%
deficit in a particular state. This arbitrary 3% target will not only	per annum during the THFC’s award period. The state-wise
	growth of expenditure on elementary education is given in
Table 8: State-wise Growth of Elementary Education Expenditure (Percentage per annum)	T able 8. If we take recent years, the all-state expenditure on ele-
State 2004-05 2005-06 2006-07 2007-08 Trend Growth Rate	mentary education grew at the rate of 14.6% between 2004-05
I Non-special category Andhra Pradesh 4.6 14.7 12.1 9.2 12.0	and 2007-08. This is much higher than the 8% prescribed by the
Bihar 11.2 43.6 17.1 12.6 23.0	THFC. However, the big question at the moment is whether states
Chhattisgarh 19.9 6.5 22.7 30.4 19.7	will be able to maintain this high growth in education expendi-
Goa 11.1 18.0 9.3 16.0 13.8	ture given the fiscal constraints imposed by the revised road map
Gujarat 16.7 2.5 17.0 15.1 11.9	for fiscal consolidation. It may so happen that with THFC-imposed
Haryana 15.5 13.7 17.1 8.6 13.5	fiscal constraints, many states may actually have a lower expend-
Jharkhand 41.7 13.7 11.0 32.1 17.8	iture despite having the grants for elementary education. The
Karnataka 21.0 8.9 14.9 21.0 14.8	d esign of the grant is such that most of the states would still be
Kerala 3.5 5.0 16.9 14.0 12.3	eligible for it if they bring down their own expenditure from the
Madhya Pradesh 8.9 17.4 22.3 -2.7 12.8 Maharashtra 11.8 3.8 16.8 9.2 10.5 Orissa 4.0 11.7 6.7 43.9 18.3	current level. This is contrary to what an equalisation grant is expected to do – augment expenditure for a particular service in
Punjab 0.4 5.0 -3.4 7.7 2.3 Rajasthan 9.3 23.8 4.0 11.7 12.0	a specific jurisdiction where it is low. Coming to the quantum of grants provided, the grant for
Tamil Nadu 10.5 3.5 30.5 10.4 15.8	e lementary education proposed by the THFC is much higher than
Uttar Pradesh 16.3 26.0 22.0 19.9 22.5	what was proposed by the TWFC,5 which was pegged at Rs 10,172
West Bengal 23.1 18.5 12.8 14.2 14.9	crore. The full equalisation requirement as per the TWFC norm
II Special category	worked out to Rs 67,811 crore for its award period (Chakraborty
Arunachal Pradesh 11.0 6.6 21.0 19.9 16.2	2005). Thus, the THFC grant at Rs 24,068 crore is only around
Assam 3.2 -0.2 3.3 10.2 4.2 Himachal Pradesh 5.0 11.5 26.1 15.0 18.2 Jammu and Kashmir 0.6 14.3 17.4 5.2 12.7	36% of the full equalisation requirement as per even the TWFC norm, that too in nominal terms. The TWFC grant was also better
Manipur 1.6 20.7 8.9 4.8 11.0 Meghalaya 11.9 3.8 9.5 36.6 15.1	in terms of its design and helped the states to augment their e xpenditure on education.
Mizoram 14.9 19.2 0.4 12.8 9.5	It is also important to note that the THFC has based the grant
Nagaland 4.2 20.2 16.7 5.0 14.1	for elementary education on Sarva Shiksha Abhiyan (SSA)
Sikkim 15.8 15.6 6.8 18.1 12.7	norms and recommended a grant of 15% of the estimated
Tripura 4.2 -20.8 5.8 -4.2 -5.8	expenditure of each state on the SSA. The rationale given by the
Uttarakhand 8.0 8.5 8.9 13.4 10.1	THFC is that this grant will augment state resources and provide
All states 12.2 13.4 15.7 14.4 14.6	adequate fiscal space to implement the Right to Education (RTE)
	Act, 2009. It will also help the states to provide for the antici
make the states take ad hoc policy options in terms of fiscal sus	pated increase in their share of the SSA to 50% by the terminal
tainability but also seriously undermine the whole idea of growth	year of the Eleventh Five-Year Plan (2007-12). This is ad hoc and
and sustainability if it results in cuts in growth-promoting gov	arbitrary. Instead of depending on the SSA norms and justifying
ernment expenditure, as appears to be what is most likely in	its grant on the grounds that the contribution of states for the
Bihar and probably many other states. This analysis also brings	SSA will go up, the THFC should have revised its own norms for
out that the objective of bringing in fiscal discipline in a multi	complete equalisation and given the grants required by states.
level fiscal system should be based on state-specific fiscal needs,	This kind of partial approach towards equalisation may not
which are intimately linked to growth.	have the desired outcome. It can at best tinker at the margin. As
	there are strict norms set for fiscal consolidation and adherence
4 Sector and State-Specific Grants	to those norms is mandatory for the states to avail themselves
The THFC has recommended a large number of state-specific	of state-specific grants, the scope for states to increase their
grants. Apart from non-plan revenue deficit grants, these include	e xpenditure to bridge whatever gap there is in providing ele
state-specific performance grants; grants for universalising ele	mentary education appears impossible in the short run and the
mentary education; environment-related grants, for forests,	grants as transfers will serve only a very l imited purpose. There
r enewable energy, and water sector management; incentive	is also the danger of states bringing down their expenditure
grants to improve the quality of public expenditure; grants for	growth to 8% per annum to adhere to the fiscal constraint
maintenance of roads and bridges; and grants for state-specific	i mposed by the THFC and avail themselves of this grant.
62	november 27, 2010 vol xlv no 48 Economic & Political Weekly

EPW

5 Conclusions

Notes

1 The other channels of transfers include the Planning Commission and various central government ministries. Planning Commission transfers are in the form of plan grants and ministry-specific transfers are in the form of funds for various centrally sponsored schemes.

2 The group of low-income states is Bihar, Uttar Pradesh, Madhya Pradesh, Orissa, Rajasthan, Jharkhand and Chhattisgarh. The group of m iddle-income states is West Bengal, Andhra Pradesh, Karnataka, Kerala and Tamil Nadu and the group of high-income states is Gujarat, P unjab, Maharashtra, Haryana and Goa. This grouping is done by taking the average comparative per capita gross state domestic product (GSDP) from 2004-05 to 2006-07 in ascending order, which is provided in the Report of the THFC (Finance Commission 2009; subsequently R eport).

References

Editorial (2010): “Whither the States in the Fiscal A rrangement?”, Economic & Political Weekly, 50(13), pp 7-8.

Domar, E D (1944): “The ‘Burden of Debt’ and the N ational Income”, The American Economic Review, 34(4), pp 798-827.

Finance Commission (2000): Report of the Eleventh Finance Commission, 2000, New Delhi.

Rao, Govinda M and Nirvikar Singh (2002): “Fiscal Transfers in a Developing Country: The Case of India”, Paper presented at the University of B irmingham Conference on Comparative Federalism, January.