The Finance Commission recommendations: The Good, the Bad and the seriously Ugly

The 14th Finance Commission has been in the news for having increased the share of the states in the tax pool of the Government. It also has given some other recommendations that will impact the numbers in the upcoming Union Budget rather sharply. While some of these are really quite robust, the others leave a lot to be desired.

Recommendation: Rather than 32% of the taxes that were devolved on the states till date, let us in the future, share 42% with them

Reasons: The sharing of revenues with the states is only done from the “tax pool”, whereas it is the share of surcharges and cesses (outside the sharable tax pool) that has increased phenomenally over the years. These add-on revenues are not shared with the states and so, the state share remains largely static. The share of these surcharges and cesses has nearly doubled from 7.5% in 2001-02 to 13.1% in 2013-14. Add to it the Swacch Bharat cess that will possibly levied at 0.5% (hopefully additively), and you see how the states remain outside the network of the enhanced central revenues. So, the idea is that we could increase the share in the taxable pool itself so that the states can partake in the growth story at a more de-centralized level.

Pros/ cons of the move: Obvious advantage is that the states get a much better hold over their finances and hence, fiscal consolidation as a philosophy gets going at a de-centralized level. On the minus side (and that’s a pretty big minus here people), we are looking at a jump from 32% sharing to 42% sharing, and that may well put the fiscal consolidation at the Center under severe pressure and that too at a time when the Moody’s and Fitches of the globe have already given us a thumbs down that fiscal health may be around 3 years away. This move makes sure it goes about 5 years away. That current rating of Baa3 on India by Moody’s is lowest investment grading, albeit with “stable” outlook. This huge stride that we are taking puts the Center’s tax resources on the defensive by about Rs.1.78 lakh crore. Now, the Finance Commission also talks about adhering to a fiscal deficit target of 3.6% for FY16 post sharing more with the states. This means that the Center will now be under significant pressure to curtail its expenditure program at a time when the Modi Sarkar really needs to get going on infrastructure development.

My take: The move is too “taxing”, pun intended. Either devolve more, or focus on fiscal consolidation. This “burning the candle at both ends” approach is too severe; kudos to Abhijit Sen’s dissent note that this jump could have been gradual from 32% to 39%.

Recommendation: Let the transfers to the states be more formula driven rather than through grants-in-aid

Reasons: Look at the numbers currently and you see that the total share of all resources given to the states stands at 60%; these include tax transfers as well as grants. If we freeze the total share at about 60% (there seems to be a 63% figure floating about for this year), then it makes more sense to drive it through a formula based transfer rather than through a more discretionary grants route.

Pros/ cons: When the tax pool is to be shared according to the formula, there is no ambiguity in the amount of funds that will be transferred to different states. This is absolutely in keeping with the spirit of fiscal federalism and is an absolute plus. On the minus side, well, there doesn’t seem to be much!

My take: Well done, Finance Commission!

Recommendation: Replace the FRBM with a Debt Ceiling and Fiscal Responsibility legislation

Reasons: Ummmm…can’t really figure out this one

Pros/ cons: Hmmmm….

My take: As you can see, I have chosen to do away with the reason behind the move and thinking about the pros and cons since… there seems to be no rhetoric at all regarding this! Now, I don’t know if this is seriously an Obama influence on us that we want a debt ceiling act for India; to my mind, the FRBM could also work fine, if we chose to respect the targets it sets. So, let me as usual, reflect a bit on the history of the Act. After a lot of debate and discussions, the FRBM Act was put into force in 2004. What did it really do? There are the following few aspects of it which are crucial:

  1. The Government would be required to create reports that gave GDP projections, current account balance forecasts etc. which would give us a picture of the overall macroeconomic framework of India for the medium term.
  2. In keeping with this framework, it asked the Government to set a rolling target for fiscal measures for the next three years, so that we would have a roadmap of fiscal consolidation rather than a snapshot view
  3. It asked the Government to recommend policies that would help fiscal balances in the current year.
  4. The Act spoke about reducing the fiscal deficit of the country to 3% and containing the revenue deficit at zero.

So, why does the FRBM not work? Why is it called as “toothless”? The real Achilles heel of the FRBM is the lack of a penalty structure, should the Government not stick to the targets specified under the budget. All that the Act requires is that a quarterly check on revenues and expenses be done by the FM and presented to the Parliament and deviations from the forecasts be approved by the Parliament. However, there is no structure for levying a penalty for the said deviations.

What is the Debt Ceiling Act? The Debt Ceiling Act (of the US) is an act that limits the Government spending in the current year by quoting a ceiling on the overall debt taken by the Government so far. The gross Government debt to GDP ratio for the USA stands at about 106% whereas the same for India stands at 66%. If we put in a debt ceiling of say 70%, then it would imply that this year, the borrowings would have to be curtailed at 4% of GDP. If the borrowings were to be more than that, then it would take Parliamentary approvals. So, deviation would require a Parliamentary approval. Where have we heard that before? The FRBM, right! So, this debt ceiling business can be done using the present framework of the FRBM too. The FRBM Act could be amended to also require the Government to quote debt ceilings as a part of the rolling targets for the next three years.

So, my final take!: The Commission is not seeing the woods for the trees! There is NO need to change the structure. Let us not waste time in invoking Article 292 and penning down another act. Just pen the penalty and you are done!

Recommendation: Push Fiscal Deficit for FY16 to 3.6% of GDP

Reason: Now that the economy has stabilized a bit, its time to get back to fiscal consolidation. The Commission believes that a 3.6% fiscal deficit target for this year will pave way for a 3% target for FY17, which is the original vision of the FRBM.

Pros/ cons: On the pro side, what this means is that India becomes fiscally conscious, in keeping with the global expectation. Hopefully, this will put pressure on the Government to curb the revenue expenditure more and the quality of the deficit will stand bettered. Also, if at all the oil correction pushes the oil prices to a $65 zone in FY16, there is a possibility that the inflation figures will also stand corrected upwards. Ensuring the deficit at 3.6% makes sure that at least there will be no add-on to the inflation issue from a monetization perspective.

But let me talk about the cons. Frankly, I am a bit stumped at the Commission suggesting such a controlled fiscal environment in the face of a 0% WPI-led inflation. Even if oil corrects through the year, it is largely expected that it will stay in the $65 range, which is still a 45% reduction over the prices that were prevailing last year. Given the high weights in the WPI that oil would carries, I really am of the opinion that the inflation could move maximally in the 3-4% zone but no more than that. What happens to CPI? Well, since the current reduction in the prices has anyway not been passed over to the consumer, she more or less enjoys status quo or a very small increase in her bills, if the prices were to correct. So, clearly, I think inflation as indicated by any of the indicators will continue to be soft in the next year. Isn’t that ideal recipe for carrying out big bang expenditures on infrastructure and social infrastructure? 3.6% seems to be overly cautious at a time when growth is essential. Come on, the 7.4% growth under the new series is a smoke screen and that talk of we having already overtaken China fools no one. This recommendation carries a hint that we are growing rather robustly and so let us get everything back on track using cautious procedures. But, it ignores the fact that capacities have to be created and higher capital expenses are crucial.

My take: Scaredy cat behaviour, this. Let us focus on getting the revenue deficit to zero in the next three years. Let us look at the quality of the fiscal deficit, not its size. If 4.5% fiscal deficit is what it takes to grow robustly and create infrastructure to end all future supply shocks, I am all for it.

I am compelled (do forgive me for ending a fiscal commission discussion on such a literary and poetic note, but its too perfect not to be quoted!) to visit David Baird from Fiesta of Happiness…

“Yes no yes no yes no?
Red blue?
Yes red, no blue?
No red, yes no?
In out, up down?
Do don’t, can can’t?
Choices sit on the shelf life
New shoes in a shoe shop.

If the in crowd are squeezing into a must-have shoe
And the one pair left are too tiny for you
Don’t feel compelled into choosing them
If you’re really a size 9, buy that size.

While everyone else
Hobbles round with sore feet
Your choices should feel comfortable
Or they aren’t your choices at all.
Why limp when you can sprint?”


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