If I ran the finance commission

If I ran the finance commission
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First Published: Mon, Mar 24 2008. 01 21 AM IST
Updated: Tue, Mar 25 2008. 11 30 AM IST
Vijay Kelkar, who heads India’s 13th Finance Commission (FC), is known for his optimism and innovative thinking, as well as wide experience of government. Besides serving as finance secretary, he masterminded three important and influential reports on tax reform and fiscal management.
India’s reforms in public finance over the last 15 years— guided by economists such as Kelkar, Raja Chelliah, Govinda Rao, and Amaresh Bagchi (who recently died, depriving India of a significant thinker)—have been an important factor in the country’s strong growth performance. The scope of successive FCs has grown in this period, to include far more than recommendations on Centre-state tax sharing and grants to states to boost their fiscal capacity. FCs have advised on local government finances, state-level fiscal consolidation, other channels for transfers (such as the Planning Commission), and the overall fiscal health of India’s multi-layered government.
The latest FC has the broadest charge yet. It is supposed to consider the impact of indirect tax reform on foreign trade; the quality of public expenditure; public investment needs, productivity and viability; and even “the need to manage ecology, environment and climate change consistent with sustainable development.”
This is a remarkable scope, especially for a body that is reconstituted every five years and has no permanent staff. A body, whose main mission is just to divide government revenues among the Centre and states, is being asked to consider the thorniest problems of development, ones that have eluded solution by all the powers of government.
If I were heading the FC, I wouldn’t dare to tackle all these knotty issues, but would defer them to the branches of government that are supposed to know better. My goals would be far less ambitious. The doctors’ maxim, “first, do no harm”, would be my initial principle.
In the context of Centre-state transfers, that means not worsening the incentives of states for taxing and spending at the margin. But I would not presume to decide what the states should spend on— they are perfectly capable of circumventing conditionalities anyway. Central ministries and the Planning Commission ought to have the expertise and staff resources to make targeted transfers to states, and to monitor spending quality. My goal would simply be to ensure that each state, especially the poorest, has the resources to provide some minimum level of public services to its population. This was articulated by the very first FC, more than 50 years ago.
How is that test of desired fiscal capacity, or minimum spending norms, to be conducted, though? Unfortunately, the current methodology, using a mix of historical data, a complex formula, and essentially discretionary grants, provides no guidance. Govinda Rao, advising the ninth FC, made some recommendations that were not implemented. The 11th FC took another stab at estimating expenditure norms—that effort was abandoned in making the actual recommendations.
A few years ago, Prof. Bagchi, together with Pinaki Chakraborty, undertook a similar exercise along simpler lines. Using aggregate performance data for the set of major states, and basic across-state averages to determine achievable norms for revenue effort and desirable levels for expenditure, they constructed an alternative set of Centre-state transfers. In other words, these transfers were designed so that states would achieve minimum per capita expenditure levels, if they also made reasonable revenue efforts.
There were two results of that exercise. First, poorer states would receive larger transfers, and richer ones would get less than under current practice. Second, the states in aggregate would get substantially more than is currently the case. Both would be insurmountable political obstacles to implementation.
But the second problem can be dealt with by modifying the norms—in particular, raising the bar for states’ own revenue raising. Both can be dealt with by giving the states more capacity to tax, for example, by assigning services taxes to the states rather than grabbing them, as the Centre has done.
Recommending changes in the assignment of taxes across levels of government, along with a conceptual reworking of the methodology of determining Centre-state transfers, would be a bold move, and one probably outside the terms of reference of the new FC.
If such changes were made, however, one would get greater simplicity in the transfer system, a clearer alignment of implementation with the avowed objectives of transfers, and less distortion of incentives away from efficiency of taxing and spending.
So, if I were running the FC, I would tell the Planning Commission, the ministries of finance, commerce and environment, the state governments, and the rest, to do their jobs with respect to monitoring the quality of public expenditure, analysing the structure of the economy, and developing policies for sustainable development. I would tell voters to hold their representatives accountable for doing all this, and taxing and spending efficiently. I would focus just on creating a simpler, more focused, less distortionary transfer system. I would probably get fired immediately.
Nirvikar Singh is professor of economics at the University of California, Santa Cruz. Your comments are welcome at eyeonindia@livemint.com
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First Published: Mon, Mar 24 2008. 01 21 AM IST