By Amol Agrawal
I came across this very interesting lecture by late Raja Chelliah, one of the architects of Indian public finances. The lecture was given in 2005 but the overall context still remains.
He says despite numerous attempts and promises problems of fiscal deficit remain.
Government of India’s avowed objective is to restore overall fiscal balance by reducing the fiscal deficit of the government sector to a reasonably low percentage of GDP and eliminating the revenue deficit by the year 2008-2009. Also, the state governments are being urged to radically improve their finances such that they would, collectively and severally, soon reach a sustainable fiscal situation in which their debt will be stabilized at reasonable levels with the fiscal deficit being brought down as percentage of their respective GSDPs.
These are laudable objectives and undoubtedly several steps have been taken in recent years to moderate the financial crisis, such as the debt swap scheme for the benefit of the states, attempts to raise the tax/GDP ratio of the central government and reducing the interest on small savings loans given to the states. However, there is no sign of visible improvement in the overall fiscal situation or in the fiscal situation of most states.
He says main reason for this apathy is the impossible quadrangle in Indian public finances.
Macroeconomists speak of the “Impossible Trinity” in the area of monetary-external sector policy. They argue convincingly that the policy of fixed exchange rate, full capital account convertibility and freedom to follow monetary and fiscal policies required by domestic circumstances cannot all be pursued simultaneously. They are incompatible and one of them will have to give way.
In India, under the auspices of the central government, four major policies affecting the government finances are being pursued which are incompatible. These are:
a) adoption of the “gap-filling approach”by the Finance Commissions,
b) the policy of the Planning Commission of extending loan “assistance” to the states according to a set of entitlement formulae with no reference to borrowing or repayment capacity or the existing level of public debt – the same criteria are used for the distribution of loans as for the distribution of grants,
c) the policy of pay revision of government servants through the appointment of pay commissions periodically and the adoption of the same recommended revisions by the central government and by all the state governments, regardless of the size of the government labour force in different states, the capacity to pay of the governments of the different states, their per capita incomes and the general level of salaries in those states, and
d) the pursuit of the objective of achieving fiscal health through getting the governments to maintain reasonably low levels of fiscal deficit, through responsible fiscal policies, that is, each government assuming responsibility for balancing its budget.
Together these four objectives keep the fiscal problem as it is
The last-mentioned is a basic objective of the central government’s macroeconomic policy. However, the other three policies generate trends that make it impossible to achieve, in the medium or long-term, a state of fiscal balance. This incompatibility may be christened “the Impossible Quadrangle”.
The incompatibility basically arises from the fact that the policies relating to central transfers and loans to the states generate wrong incentives and violate economic considerations while the policies relating to the recruitment of government servants and their pay revisions do not take into account incentives, economic considerations or capacity to bear higher tax burden.
The planning mode applied to public financial activities proceeds on the basis that finances can be managed without reference to incentives, financial capacity of sub-national governments or fiscal discipline (essentially meaning that the governmental authority undertaking an increase in public expenditure on its own volition must pay for it). Fiscal responsibility cannot be planned from above; rather such conditions and rules must be created that fiscal responsibility will have to be practised by the sub-national governments / states which have a good deal of autonomy.
The author then looks at the evolution of state and government finances (tables need to be updated now) with continued surges in revenue expenditure. He then looks at federal finance in India, and explains the role of finance and planning commissions in not helping solve the problem.
His suggestions:
It will not be easy to bring about changes in the existing policies. Short-term compulsions will encourage adoption of remedies (like the debt swap scheme and debt relief) that will give only short-term relief.
Certain basic policy decisions will have to be taken.
First, the states should be treated as autonomous units and they should be allowed to determine for themselves levels of revenues and expenditure. They will have the primary responsibility to maintain fiscal balance in their respective jurisdictions.
Second, the percentage share of central taxes going to the states must remain constant for at least 15 years.
Third, block grants should be aimed at making up deficiency in fiscal capacity. “Need” must be defined as deficiency in fiscal capacity. Cost disadvantages could also be compensated. The proportion of block grants to devolution should rise.
Fourth, the distinction between plan and non-plan expenditure should be done away with, at least as far as revenue expenditure is concerned. The Planning Commission should deal with only capital expenditure.
Fifth, while loans could be extended to states by the centre to a limited extent, states should be required to borrow from the market within the limits set by the centre
The centre could subside a small part of the interest (to differing extent) in respect of states that have less than average taxable capacity. Concurrently, in the place of plan loans, some capital grant assistance should be given with higher per capita amounts for the states with lower capacity. Collections of small savings should go into a fund as of now, and the states should negotiate loans (within the cap) with the fund, the lending rate of interest being determined by the borrowing rate and the credit worthiness of the states concerned.
When this new approach is adopted, it may be necessary to write-off 50 per cent of the debt which the states are now holding in order to enable the states to cope with the new situation (only that part of the debt which consists of central loans and market borrowing). But this will be on the understanding that there will be no more debt relief. With this new approach, our federal fiscal policy would become more rational, equitable and efficient and fiscal balance will be gradually restored.
Amazing stuff. Didn’t know of this impossible quadrangle. What an insight.
Though am wondering have things changed with 13th Finance Commission. One of the suggestions of states managing their debts by market borrowing is being implemented. In recent meet of State secretaries, talks of presenting state government borrowing projections and auction calendar was also discussed. So some reforms have happened there.
Need to do more research. Need to read RBI’s report on State finances carefully. I think this report is not read as well as it should be
(courtesy : www.mostlyeconomics.wordpress.com)
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