Subir Gokarn: Carrots and sticks

The Report of the Twelfth Finance Commission was placed before Parliament yesterday. Its recommendations will shape the course of state finances over the next five years.

Its bread-and-butter objectives are to determine the share of the central government's tax collections that go to the states as a whole and to distribute this amount across states.

On the first, it has not deviated significantly from the course set by the previous Finance Commission. It has raised the aggregate share of states marginally from 29.5 per cent to 30.5 per cent.

On the second, while it has stayed with the same list of factors used to determine individual states' shares, the weightings assigned to each have changed.

Population, which was given a 10 per cent weighting by the previous Commission, now gets 25 per cent. Backwardness, measured by the difference between a state's per capita income and that of the most prosperous state, has seen its weighting shrink from 62.5 per cent to 50 per cent.

The weighting for area goes up from 7.5 per cent to 10 per cent. Tax effort, measured by the ratio of taxes collected per capita to an adjusted measure of per capita income, sees its weighting go up from 5 to 7.5 per cent.

And, fiscal discipline, measured by the changing ratio of current revenues to current expenditures, remains at a 7.5 per cent weighting.

The first three factors are, in effect, a state's "legacy". Their combined weighting has declined marginally, but still dominates the allocation.

This time, however, it has gone relatively in favour of large and densely populated states, as opposed to small, very poor ones. The rationale presumably is that, even if the state isn't all that poor, delivering adequate public services to large numbers of people, requires additional resources.

The two fiscal variables provide incentives to prudence and management. In the context of the overall priority on fiscal consolidation, an argument could perhaps be made for increasing their weightings, but what is done is done.

It is on the issue of debt that this Commission takes a long step forward. The previous Commission had initiated the Fiscal Reform Facility, which made some flows to the states conditional on implementing reforms.

This arrangement has now been replaced by a much broader debt relief programme, offers states the opportunity to significantly reduce their debt burden if they commit legislatively to the elimination of their revenue deficits over a five-year time frame, just as the central government has done.

In return, their existing debt to the Centre will be rescheduled to repayment over a twenty-year period at a fixed interest rate of 7.5 per cent.

This recommendation substantially reinforces the benefits of the debt-swap scheme, which the Centre had introduced last year to enable states to garner some benefits from the dramatic decline in interest rates.

It also ensures that borrowing to finance current expenditures by any level of government will come to an end.

As of now, the simple enactment of a fiscal responsibility legislation will make states eligible for this scheme. However, the Commission has also provided an incentive to states to live up to their commitment by offering to write off debt in proportion to the actual reduction in revenue deficits.

This combination of carrot and stick should significantly increase the likelihood of the country as a whole achieving a zero revenue deficit status by 2010.

Going beyond the treatment of existing debt, the Commission recommends that the Centre should stop lending to states completely. As the revenue deficit is eliminated, states will in any case be borrowing only for capital expenditures.

This can be done directly from the market, which would then impose all its disciplines on the projects being financed. This should significantly increase the probability of both good projects being selected and their being efficiently implemented.

The recommendations leave a small window for financially weaker states by suggesting that the Centre can borrow on their behalf and pass on the full interest cost to them.

This may weaken the discipline, but in all likelihood, these states will find it hard to raise money from markets for any project and central intervention will be inevitable.

Three other sets of recommendations cover devolution to local bodies, calamity relief, and grants-in-aid to states to cover non-plan revenue deficits.

Fairly detailed guidelines relating to activities undertaken by local bodies are prescribed, including requirements for public-private partnerships and contracting out services.

On calamity relief, the status quo on a 75:25 split in contributions from the Centre and states respectively is maintained. With regard to grants-in-aid, for some states, in the "special" category, which are basically all the hill states, it is recognised that they will simply not be able to plug the hole on their own.

Some other states have been given this relief for short periods of time.

What does all of this add up to in terms of the fiscal situation five years hence? Of course, revenue deficits will disappear and the combined fiscal deficits of the Centre and states will be 6 per cent of GDP.

Interest payments as a share of revenue receipts would come down to 28 per cent of total revenue receipts for the Centre from about 47 per cent today and 15 per cent for the states from about 25 per cent today.

Aggregate debt (including external debt) will come down to 75 per cent of GDP from 81 per cent today.

The dominant theme running through the recommendations is, in a word, conditionality. The way in which state governments have been managing their finances in the last few years bodes ill for the sustainability of even basic public services, let alone critical investments in infrastructure and other areas.

Some of the decline has been driven by extraneous factors, but there is enough within their control to warrant far better performance. And, it is entirely fair that states be allowed to extract the maximum benefits from the favourable macroeconomic scenario, most directly through lower interest rates.

By concretely linking the magnitude of transfers, both in the mandatory and discretionary categories, to very specific reforms""not just initiatives but outcomes as well""the Commission has made it not just rewarding for states to get their fiscal act together but also costly for not doing so.

(The author is chief economist, Crisil. The views here are personal)