Goodbye to Gadgil’s formula on state funding?

add_main_imageThe Raghuram Rajan committee report on the Composite Development Index of states is more than a mere index. As a development index, it is yet another addition to the plethora of existing ones.

It is not the construction of the index but the probability of it being used to devolve funds to state governments that makes it very important.NextMAds

If it is going to replace the good old Gadgil formula—named after the economic historian D.R. Gadgil who devised it for providing plan assistance to states—as it appears, then it needs to be far more rigorous. The index also needs to have a deeper connection with the history and politics of the fiscal federal system and the transfers that emanate from it.

There are five problems with the report. First, its recommendations don’t address the basic issue of the aggregate pool of plan transfers available for distribution among the states. Prior to addressing the issue of inter se distribution of central assistance, attention ought to have been paid to the total kitty available for distribution.

The real problem of plan transfers is not the “formula” of distribution but how and to what this formula will be applied.

It is well-documented and intensely debated that the Union government preempts resources from the Gadgil pool. The Gadgil pool has been shrinking. It reached a peak in the late 1990s with almost half of the non-statutory transfers being made from outside its ambit. As such, no formula, howsoever good it may be, will be effective if a large part of the funds bypass it. The transfers that bypass the formula, by design, are the central plan schemes and/or centrally-sponsored schemes. Even after being trimmed and restructured, flagship schemes for employment generation or guarantee, account for one-third of the central assistance to the state plans.

Second, the report has nothing to say about the composition of the plan transfers. More than changing the indices, what will equalize development across states is changing the composition of the central assistance to the state plan.

Under the existing Gadgil formula, the loan-to-grant ratio is 70:30. The 30% grant was supposed to finance in a non-debt creating manner the revenue component of capital expenditure.sixthMAds

While this was true 30 years ago, with greater emphasis on health and education, this has changed. Indeed, in the plan expenditure of states, the revenue component is now higher than capital expenditure; revenue expenditure accounts for 55% and capital expenditure for 45%.

Any new thinking on the plan transfers must address this issue. Is it possible to make the composition flexible depending on the composition of the state plan?

Third, is the issue of using monthly per capita consumption expenditure (MPCE) instead of the gross state domestic product (GSDP). This has been correctly pointed out in the dissenting note by one member of the committee. Apart from the rankings being extremely sensitive to this change, MPCE numbers are far less reliable than GSDP.

In fact, underlying the chaos in poverty estimates is the infirmity of the MPCE numbers. This number may work well for academic and policy purposes, but to use this as a devolution criteria can cause havoc.

Fourth, even as the index is made to look analytical and statistically sophisticated, most of the key weightages seem arbitrary and qualitative. For instance, on what basis has 80% weightage been given to the population and 20% to area? Why not 75% and 25% that the Finance Commissions use, is hardly a justification. The basis and logic of their transfers is different.

At the very least, the report must indicate the sensitivity of the ranking to a change in the weights or multiples.

These numbers must be justified either on analytical or on statistical grounds. For example, will the states go into a surplus on the plan revenue account after the fixed transfers? Will the aggregate plan account be in balance, after the proposed need-based transfers? With the performance transfers, will the revenue account of a state turn into a surplus? There has to be a clearly stated fiscal result and/or principle associated to these transfers. It cannot be open-ended.

This leads to the fifth inadequacy in the report. It doesn’t build the criteria or the index as a part of an integrated fiscal federal system. It seems to treat the plan transfers in isolation and independent of the other transfers.

A lot of the fiscal imbalance in states, especially in less and least developed ones, is due to fiscal mismanagement of the Union government. Plan expenditure in a state is based on the shared tax revenue from the Union government. Often, the latter doesn’t meet its budgeted revenues and state plans, and through that development efforts, bear the brunt.

In such a scenario, should the fixed part be linked to a minimum guaranteed devolution by the Union government, so that the states are assured of a certain development spending?

Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice.

To read Haseeb A. Drabu’s earlier columns, go to www.livemint.com/methodandmanner-