If the Planning Commission were to give up stipulating the size of state plans, and (as suggested in the previous column) be content with deciding the size of Central plan assistance to the state plan, a new model of responsible fiscal federalism would have been initiated.

Two things follow from a focus on assisting state plans: First, the size of the state plan gets linked to the state’s own resource position and the absorptive capacity of its economy. Second, the Planning Commission no longer has to balance the plan resources of individual states with their approved plan expenditures. It will be the responsibility of the state governments themselves.

Given its overall budgetary constraints in the form of a gross budgetary support from the finance ministry, the Planning Commission more often than not achieves this balance by virtually fudging it from the current revenues of state governments and overestimating their additional resource mobilization. This invariably results in gaps in the financing of the plans. These would hopefully be covered through a better-than-estimated revenue buoyancy. That, as is well known, has never happened in any state at any time.

A look at the state budgets reveals that the fiscal balance of states would improve substantially with lower levels of Central assistance, but on more favourable terms. The high proportion of loans in plan transfers is the single biggest source of not only rising indebtedness but also of fiscal imbalance in the state budgets. As such, it is not the magnitude, but the composition of the plan transfers that needs to be changed.

At present, the loan-to-grant ratio of Central assistance is fixed at 70:30 for all non-special category states. This ratio is invariant to the proposed plan investment, its sectoral composition and resources available with the states. Indeed, it is now a number that seems to have acquired a certain ideological, if not mythological sanctity.

There is a history to the 70:30 ratio. In the 1960s, when the Five-year Plans were an aggregation of capital projects, an estimated 30% of any capital expenditure was the recurring revenue expenditure. Hence, a 30% grant was given to cover the revenue expenditure part in line with the highest standards of conservative fiscal ethics. The number has remained, but the logic has been forgotten.

Fifty years and 10 plans later, the Five-year Plans have moved away from a being an aggregation of capital projects. With social sectors such as health and education gaining in prominence, the revenue component per unit of plan expenditure is now almost 50%. Indeed, even in absolute terms, the revenue component of the state plan is now invariably higher than the capital expenditure. This justifies a higher grant component of 50% in the central assistance to the state plan.

It may be worthwhile to make the assistance flexible depending on the composition of the state plan. If the state plan is biased towards, say, non-revenue-yielding social sectors, then the grant component could be increased. Alternatively, if the plan is geared towards capacity-creating capital sectors, a higher proportion of loans can be justified. Ideally, this loan-grant mix should be used as an incentive to the state governments for spending more on creating capacities in the desired social services sectors. This will pave the way for state governments investing in creating social infrastructure and will catalyse the public-private partnership model being advocated by the Planning Commission.

With a favourable financing mix, a long-standing methodological problem of plan financing will be resolved. At present, the Planning Commission matches the overall plan outlay—revenue and capital—with the overall resources available for the plan. This seems perfectly in order as there are no visible gaps in plan financing. In practice, as any state planner will testify, this is a sleight of hand. The problem with this aggregative approach is that even as the overall balance is achieved, the resources on the revenue account are not separately matched with the revenue component of the plan.

When this is done in practice, it is found that the plan resources on the revenue account are far short of the plan revenue expenditure. Therefore, a diversion of the borrowed funds, from capital to revenue account, is built into the plan. It is for this simple reason that state governments have moved from a position of having non-plan surpluses in 1986-87 to a position where the non-plan account for all states starts with a deficit and has to be financed through borrowings.

If the Planning Commission continues to finance state plans the way it has been doing, a time will soon come when the growth of a state’s debt crosses its revenue growth, resulting in a fiscal crisis. From there, the new debt dynamics guided by structure of debt and interest rates can play havoc with state finances. Haseeb A. Drabu is chairman and chief executive of Jammu and Kashmir Bank. He writes on monetary and macroeconomic matters from the perspective of policy and practice. The views are his own and don’t necessarily reflect the views of the organization he works for. Comment at haseeb@livemint.com

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