A fine balance between equity and efficiency

By NR Bhanumurthy, Director, Madras School of Economics The much-awaited 16th Finance Commission (FC) report was tabled in Parliament on Sunday. The report retained the 41% vertical devolution while making some minor, but important, changes in the horizontal devolution. The first impression is that, unlike the previous Commission, this FC has tried for a balance between equity and efficiency. There are two major changes that this FC has brought. One is on the criteria for horizontal devolution and another is discontinuation of revenue deficit grants. In the horizontal devolution, by including a new criterion of ‘contribution to GDP’, which the report says is ‘introducing in recognition of India’s growth ambition’, the FC tried to partially address the concerns of the fast-growing states. With a weightage of 10% to this criteria, the report suggests that it captures all forms of efficiency both on spending and fiscal rectitude. On revenue deficit grants, in chapter-9, the report makes an assessment on how this has been assessed as well as its outcome in the past. The report strongly argues that such grants have only encouraged states to be fiscally profligate and it has created a time inconsistency problem whereby fiscal policies that are found to be optimal in the pre-award period becoming sub-optimal in post-award period. Rather the report strongly pitches for improving efficiency both in spending as well as in revenue mobilisation. With respect to other criteria, while the report broadly follows the previous FC, it has made minor tweaks—bringing more categories for forest cover and also higher weightage in increase in forecast cover; replacing total fertility rate with population growth. On the local bodies, the report highlighted two focus areas that aid growth of local bodies—revamping of drainage systems in urban areas and speedy conversion of eligible rural local bodies to urban local bodies. With regard to the issue of ‘sound finance’, the report has three separate chapters on important aspects such as power sector reforms, subsidy management and reforms of public sector enterprises. On subsidies, the report only advises both the Union and states to rationalise and that all schemes should have an exit clause and continue only if the scheme is assisting the poor. On the issue of cesses and surcharges and states’ representation regarding declining devolution as a percentage of gross tax revenue (GTR), there are two interesting paragraphs— 7.35 and 7.51. The report argues that despite increase in cesses and surcharges, the devolution is higher than during the 13th FC period. Further, the report questions the recent proliferation of cash transfers and other schemes at the states suggesting existence of sufficient funds. Hence, there is no case for recommending higher share for states’ in divisible pool due to increased cesses and surcharges. This conclusion could be a major point of discussion going forward. However, the argument that states spend over two-thirds of revenues with only 32.9% available for Union is a valid one. On the macro-fiscal framework, the report suggests that the fiscal deficit of Union and states be brought down to 3.5 and 3% by FY31. Following this, it suggests the general government debt at 73.1%, though it does not separate the debt between Union and states. Overall, the report tries for a fine balance between equity and efficiency. Disclaimer: The views expressed are the author’s own and do not reflect the official policy or position of Financial Express.