A macro-economy deep dive
The chairman of the 15th Finance Commission, NK Singh, spoke to Zia Haq about the final report of the Commission for 2021-26 which has now been made public. Edited excerpts.
The Constitution, through Article 280 to 281, provides for finance commissions every five years as a mechanism for sharing of taxes and revenues vertically between the Centre and states; and horizontally among all states, based on levels of development, demographic outcomes, prosperity and regional needs. The final report of the 15th Finance Commission for 2021-26 has now been made public. The Union government, in its action taken report on the commission’s report tabled in Parliament, has accepted most of the recommendations, and overtly rejected none. The 15th FC had the onerous task of devolving resources at a time when the pandemic has devastated the economy, shrinking the resource pie. The chairman of the 15th FC, NK Singh, spoke to Zia Haq about the report. Edited excerpts:
What were the philosophical underpinnings and approach of the 15th FC? Your report states that “stability and predictability of resources is an essential component of good long-term budgeting for both Union and States”.
The history of the Finance Commission is embedded in the legacy of unalloyed confidence and trust. When the Constituent Assembly in its debates was unable to come to a conclusion of how the resources were to be divided between the Union and states, various mechanisms were considered at that time. Earlier it was said that nothing was shareable, except income tax, and you know the finance commission in a sense is older than our Constitution, because the Independence was in 1947, whereas the Constitution came into play only in 1950. So, there was a period they had appointed an interim chairman of the finance commission under CD Deshmukh because the Constituent Assembly had asked him to do it. He had given a certain framework on the division of resources. Then the Constitution got adopted and the 1st FC under KC Neogi was constituted. Since then it has had an unbroken legacy, an unbroken record embedded in bipartisanship, fair play and has been totally ideologically neutral.
In terms of receiving the requests, each of the states and the Union government… and then looking at what would be their expenditure, looking at their likely revenue, what would be a fair distribution of these resources between the entities of the Union and the states, and thereafter what would be a reasonable basis for allocation. And if there were obvious gaps after the revenue expenditure of the state had been calibrated in an optimum way and the revenues had been projected in a somewhat optimistic way. Now, if there were inescapable gaps, what amount of it was reasonable to fill up by taking recourse to Article 275 of the Constitution, by way of revenue-deficit grants.
Thereafter, two big changes took place. One was that the third tier (urban local bodies and panchayats) was brought into play by the two constitutional amendments (73rd and 74th), which assigned responsibilities to the FCs and second, the Disaster Management Act 2005 was enacted and it became customary for assignment of resources for disaster management. Also, it gave greater latitude to the President in asking the FC’s views on any other matter which the president may choose in the interest of sound finance. Over these 72 years or so, the dynamics of the Indian economy have changed enormously. From an economy originally depended on imported foodgrains and scrambling for shortage of foreign exchange to an economy, given the liberalisation and successive crisis, that has matured and evolved, we see that the needs and obligations from the states have increased.
There are two important points. One is the recognition that the Union government had obligations that went beyond the strict interpretation of the 7th Schedule of the Constitution (which specifies allocation of subjects between Union and states, containing three lists: Union list, state list and concurrent list), namely what went beyond what was assigned to the Union government in terms of taking care of national priorities of the states. The birth of centrally sponsored schemes and the central outlays… these were important changes. Second was that the number of states increased rather significantly, many states required special treatment particularly, those who have a small population, hilly terrain etc. So these transformative changes have led to the evolution of the role, responsibility and obligation of the FCs.
When the 15th FC was constituted, there were great worries. In the terms of reference, the President asked the commission to use the data of the 2011 Census in respect of the population criteria if population was to be used as a criterion for purposes of the assignment of the horizontal distribution. Then, there were strong protests by some states, particularly the southern states, because they would be big losers because they had controlled population well.
What states look forward to most in every report is the devolution formula, which you have maintained. It’s 41%, with a 1% downward adjustment (from 42% earlier) because of two new Union territories. You assigned a weight of 12.5% for demographic performance, which is the inverse of the fertility rate. You have said the 2011 Census better represents the needs of states. Was the biggest challenge for you was to not penalise efficient states, demographically speaking, at the cost of the inefficient?
When the 15th FC was constituted, there were great worries. In the terms of reference, the President asked the commission to use the data of the 2011 Census in respect of the population criteria if population was to be used as a criterion for purposes of the assignment of the horizontal distribution. Then, there were strong protests by some states, particularly the southern states, because they would be big losers because they had controlled population well. It was argued that it would result in rewarding the inefficient and penalising the efficient. It was a challenge to therefore deal with this conundrum. We had no option because use of the 2011 data was a given fact by the president. It is the president’s right to assign a particular way in which we look at the criteria. Now, what are the options we had?
One option, which was a hypothetical option, was... in total neglect of any past practice to ignore population completely as a criterion and to do it on the basis of some other criterion. The Constitution doesn’t bind me to use any particular criterion. But then we came to the conclusion that let us see what else could we have used.
Some suggestions were made that maybe we could do it on the basis of per capita income. The result would have been that again the states that have the lowest per capita income would have the highest population density. In effect it would have meant that those states where rates of growth had been poor would get rewarded unduly and states with higher growth rates would get penalised. So the income distance criteria would begin to also mirror this phenomenon.
So we went back to the drawing board and said, why not take the bull by the horn? Why not face the problem squarely and say, yes, there’s an X amount which used to be historically given on the basis of weightage to population in the horizontal formula and now we have to use the 2011 (population data) and break that into two parts. One part you give it on the basis of population, whatever weight you assign, and two, you actively reward states that have managed their demography better; which reflects what? Namely, greater investments they have made in girl-child education, managed their health parameters better, and have got a better governance matrix. So, in many ways assigning a positive weight in demographic management embedded the investments those states had made in the social sector particularly health and education. We found that in this way we would be able to mitigate any adverse consequences to some extent of what would be the outcome.
Broadly speaking, in this horizontal distribution, there are three important factors which we have pointed out in the report. We have sought to balance need, efficiency and equity. The population reflects the need; the weight given to geographical area represents the need; the income distance criterion, namely the per capita income, represents the equity part. In what way are we rewarding efficiency? By giving weightage to the demographic criteria and also giving some weightage to the fiscal achievements to the state. So in some ways therefore if you look at these, each of these criteria...the forest area also represents the need... are evenly divided in some ways.
We subjected each of the states to very careful scrutiny, then we worked out what would be the minimum inescapable revenue expenditure, we compressed that and calculated the maximum amount of resources that they were likely to generate on a normative basis and concluded that this is the inescapable gap between the inescapable minimum expenditure and what is likely to be the optimum revenue. We have therefore assigned revenue-deficit grants.
Many of the southern states were extremely nervous about what would happen to them. They feared that they would be penalised for getting their population under control. Do you think you have adequately addressed those concerns now?
Adequacy is a subjective norm. The best way this would have been addressed is a situation where we hadn’t used population as a criteria at all. But then I explained you would have had other kind of choices. Instead of saying ‘adequately addressed’, let me say ‘reasonably mitigated’, or ‘responsibly mitigated’. The concern of the southern states was not only the award of the 15th FC, but they looked a bit ahead -- that if, for the purpose of the delimitation of the constituencies, this was going to be the pattern of using the most contemporary population census data, what would happen in terms of the nature their representation in Parliament and the size of their Assemblies, and therefore the number of the seats they would elect to Rajya Sabha. That was fortunately not a concern with us but I know that embedded in their minds was also this particular concern.
You could say that we have tried to in some ways redressed this in a manner we considered appropriate. In spite of what we did as we had done, to mitigate this , it turned out to be that many of the states would have had a huge yawning resource deficit. That is why, ₹2.95 lakh crore given by way of revenue-deficit grants... if you look at the states who are beneficiaries of this, huge amount has gone to Andhra Pradesh, huge amount has gone to Kerala.
Kerala was one of the states where the demographic management was one of the best. Some has gone to Telangana. The way we have calibrated these revenue-deficit grants, we looked at this... as you can see there’s one full volume in the report devoted to the states. We subjected each of the states to very careful scrutiny, then we worked out what would be the minimum inescapable revenue expenditure, we compressed that and calculated the maximum amount of resources that they were likely to generate on a normative basis and concluded that this is the inescapable gap between the inescapable minimum expenditure and what is likely to be the optimum revenue. We have therefore assigned revenue-deficit grants. A fair amount of that has gone to states who would have been the unaddressed factor in spite of the mitigation on account of the use of the 2011 data. Have we succeeded totally? One classic example to be honest is that we have not been able to take care of, for instance, Karnataka because it has managed its finances in a reasonable way and their expenditures have very low and their revenues have been reasonable. So I have no answer to this question. A state like Karnataka I was not able to give revenue-deficit grant. I couldn’t reinvent a formula to overcome this handicap. I did try to address the concerns of Karnataka by giving them some state-specific grants for the rejuvenation of lakes and water bodies and some important places, particularly rejuvenation of Bangalore and Mysore.
Do you think some states would still have reasonable grounds to complain?
Sure, I think that is quite legitimate. We must also recognise that for many FCs, the weightage given to per capita income was much more than what we have given. If we had stuck to those weightages, their injury would have been far more significant. The issue of equity would have got greatly compromised. The lowest per capita income is of Bihar. Bihar, UP and Rajasthan, these are known as the really backward states. You would recall that in the earlier government, they appointed a committee under Raghuram Rajan to come up with the multiple index on the backwardness of states. In that multiple index Raghu had done at that time, Bihar and Odisha were at the rock bottom. In this case, Odisha has also done better subsequent to Raghu’s report; Odisha has managed its demography also well; so Odisha is not too happy. Maybe this will get mitigated when some of their special projects, such as the cyclone, get addressed.
You have recommended a fiscal glide path whose imprint is more or less clear in the Budget. You have also recommended a committee to review the Fiscal Responsibility and Budget Management Act (FRBM). What prompted this?
In the FRMB committee, which I chaired, what we were aiming at then and also during the terminal period of the 15th FC, was to look at the debt-to-GDP (ratio) to be 60% -- 40 for the Central government, and 20 for the states. We had done a calibrated fiscal-deficit trajectory which would enable this level of debt to be reached. So that’s now embedded in history, and overtaken by events in a very dramatic way. We are no more in that world.
The world has changed in some important respects: The pandemic permanently changed the structure of the global economy. When I chaired the FRBM committee, the focus was the central government and as far as the states were concerned the committee said this would be left to a subsequent FC. I didn’t know then I was going to head that FC. But investors look at the general government debt. FDI looks to general government. So that FRBM which had reference to the central government, where states were not in the picture, has changed. That’s why I proposed that we need to have a fundamental re-look at this overall framework, the changed global context and the changed national context in which we make the states and the central government equal partners. That is why I have not given a point (for fiscal deficit) both for the central government and the states, but a range (of fiscal deficit).
When I visited all the states, the giant and the gorilla in the room is power. Look at any state’s finances, it is the power sector and unbridged financial gaps in the power sector that is critical. The 0.5% headroom for borrowing by states was quite in line with what we had experienced during our visit to states.
Why had I suggested a fixed point in the FRBM committee? The reason is in parliamentary democracies, the tendency is to adhere to the upper end of the range given the populist pressures for public outlays.That logic doesn’t hold good anymore. Giving fixed number is to build in inflexibility and I am increasingly coming around to the view that this framework needs not to be pro-cyclical, it needs to work in accordance with the tandem of the cycle; and therefore a cyclically adjusted fiscal deficit and debt norm would be more appropriate. I have given the states a leeway to go up to 4% and taper down to 3% (fiscal deficit) much later. I have given a 0.5% leeway for purposes of reform in the power sector. Why did I select [the] power [sector]? When I visited all the states, the giant and the gorilla in the room is power. Look at any state’s finances, it is the power sector and unbridged financial gaps in the power sector that is critical. The 0.5% headroom for borrowing by states was quite in line with what we had experienced during our visit to states. If there is a shortfall in Goods and Services Tax compensation, and states have to borrow, that should not be debited against what we have proposed i.e. 4% and 0.5. The important thing I realised is that there no point in any debt framework which doesn’t involve the partnership of the states.
Stan (Fischer) has been writing and saying that the entire literature in relation to the fiscal issue by eminent economists has undergone a rethink in terms of the importance of the role of public outlays, particularly on the need for them to play a proactive role on rejuvenating of infrastructure and more importantly employment, given in terms of what (labour-saving) technologies have done and also in terms of health and education. So I agree with you that the literature on fiscal policy has undergone a change.
Given the events of the last year, do you think our thinking of fiscal mathematics not just in India but the world has undergone a change?
I would say yes. Who else, if you think among the global economists, write and have written continuously on this? I am not going to an extreme version like Larry Summers (former chief economist of the World Bank)... no Larry is not one who may be regarded as a fiscal fetishist, but there were others like Stanley Fischer (former vice chair of US Federal Reserve). Stan (Fischer) has been writing and saying that the entire literature in relation to the fiscal issue by eminent economists has undergone a rethink in terms of the importance of the role of public outlays, particularly on the need for them to play a proactive role on rejuvenating of infrastructure and more importantly employment, given in terms of what (labour-saving) technologies have done and also in terms of health and education. So I agree with you that the literature on fiscal policy has undergone a change.
If I were to ask you a hypothetical question, that if there was no implicit guarantee upon the charge of the consolidated fund of each individual state government, don’t you think that the market would have displayed their hesitation. For instance, if we looked anecdotally at the debt today of Punjab, it’s so high, and yet Punjab successfully borrows market development loans because there is an implicit state guarantee and unlike the US constitution, there is no such thing as federal bankruptcy. California can get bankrupt, I cannot imgaine any state becoming bankrupt.
To give you an anecdote, I was invited to give a lecture to the finance ministers of all Commonwealth countries. The title of my lecture was fiscal forbearance. People talk of monetary forbearance. But I talked of fiscal forbearance in times of this kind, which represents in some ways the changing ethos. Similarly, in the last OECD fiscal networking conference, the thinking on this fiscal issue has been an evolving one. OECD has been one of the flag carriers with regard to adherence to fiscal policies. The Germans have had a very strong influence if you recall. So all that... I agree entirely has undergone and is undergoing a change. In our federation, it’s much more important for the states to become increasingly involved in all of this. If I were to ask you a hypothetical question, that if there was no implicit guarantee upon the charge of the consolidated fund of each individual state government, don’t you think that the market would have displayed their hesitation. For instance, if we looked anecdotally at the debt today of Punjab, it’s so high, and yet Punjab successfully borrows market development loans because there is an implicit state guarantee and unlike the US constitution, there is no such thing as federal bankruptcy. California can get bankrupt, I cannot imgaine any state becoming bankrupt. The issue of the sovereign guarantee -- that’s why I think we need to consider the states and the Centre in a holistic way.
The hobbling implementation of GST has been a structural problem and the 15th FC has made key recommendations to reform it, including simplifying the inverted duty structure. Your comments.
I have a feeling that there is deep realisation on the part of the finance minister, reflected in the statement I have seen by the revenue secretary on this issue of GST, and he was asked this pointed question maybe by your paper, about the 15th FC recommendation in our fairly robust chapter on resources (Chapter 5, Volume I), and what he intended to do. He said ‘these are all work in progress’ and because of the pandemic, the GST Council has not been able to deliberate on them. I think clearly on this whole story of invoice matching, you could see the budget talking on this, on invoice manipulation, and in terms of much better compliance... you see there are fundamental issues of the inverted duty structure, there are issues of moving towards a more standardised set of rates. I am not wanting to take the extreme view of one rate only but you can have one standard rate, one merit (goods) rate and one which may be called the penal rate but no more than three (rates) and we have said so. It is our expectation and sanguine belief that our key suggestions would be considered by the GST Council. It is of vital concern. I’m happy to say the finance minister and finance secretary are acutely aware of all of this and will take it as soon as things return to normalcy.
You have looked at the whole idea of defence in somewhat innovative way and recommended creation of a non-lapsable defence and security fund.
On defence, we got special terms of reference. It was not, so to say, spontaneous. I had the experience of working in the ministry of home also looking after paramilitary forces. In that sense I have a little bit of hangover. I realised having been expenditure secretary that there was a huge mismatch between the expenditure cycle and financial cycle of the defence ministry. The procurements are so complicated and the need to be clear of any controversy that by the time they are ready, the finances are not there. There is this inherent mismatch with regards to capital expenditure. Also, I realised the need for predictability and stability for the capital expenditure on the defence side. Keeping pace with technology often meant that they need a resource. So I played with many ideas. The other thing was how to make states partners in this process.
The issue of defence really transcends any list. I obtained many legal opinions on this. I obtained the opinion of (Kesava) Parasaran. When I had gone to the late Mr Jaitley, for whom I had great affection, I asked him that there is this complex issue which is troubling me; he said there is only one person who will know but will not give you the opinion. I said why, because he is 93 years old. Yet, I rang up Parasaran, who gave important opinions. One, he said I cannot play around what is in the divisible pool and there’s nothing I can to do to impose any condition on the resources from the divisible pool and that will have a constitutional infirmity. Second, he said there’s no question that the defence of India is of paramount responsibility.
So then we were hard put to fund resources. I visited some of the defence establishments. I visited Pangong, Leh, I saw some of the stuff. We said we must create a non-lapsable defence fund and to bridge this asymmetric cycle. I had done so for the road cess. That’s how I came up with the non-lapsable fund and the funding of it. In defence funding what I have done, before the fund becomes a part of the divisible pool, you understand the gross revenue reciepts (GRR) and gross tax revenue (GTR), I calibrated the GRR by 1% and got the amount which I wanted, and added it to the monetisation of the surplus defence land, added it to the proceeds of the disinventment of defence units, and added it to the liabilities of different entities which owed to defence establishments. So four sources of income outlined towards the creation of a non-lapsable fund.
Do you think if I had asked you the hypopthetical question that the Seventh Schedule of the Constitution (the part which divides domains into central, states and joint Centre-states jurisdiction) has outlived its purpose, what would be the answer? In my view, yes.
Can you talk about any discomfort that states have right now with the new kind of fiscal federalist architecture that’s come in where it’s becoming increasingly difficult to sort of segregate matters of financial management of states?
I think that area also needs a rethink. Do you think if I had asked you the hypopthetical question that the Seventh Schedule of the Constitution (the part which divides domains into central, states and joint Centre-states jurisdiction) has outlived its purpose, what would be the answer? In my view, yes. The Seventh Schedule decided to classify between the three categories... what would be in the exclusive category of the Union, exclusive domain of the states, and what would be in the concurrent list. There was a degree of clarity in that. Over a period of time, you have really transgressed from one end to the other. Most of the centrally sponsored schemes are subjects which are classic subjects in the domain of the states, such as employment, food, education. You have now standalone parliamentary legislation, which are justiciable, in areas such as employment like MNREGA, you have given a major boost to resources for right to education. Take for example a function number one for states, which is law and order. They have taken up a whole new centrally sponsored scheme under health. So the Seventh Schedule requires a revisit. So does the entry under Article 282 of the Constitution which has been used and misused for having all the centrally sponsored schemes.