'Our recommendations also helped cut the deficit'

Q&A: C Rangarajan

C Rangarajan

With the finance minister blaming the 12th Finance Commission (FC) for forcing him to press the "pause button" on fiscal correction, the FC Chief C Rangarajan puts his report in perspective. He argues that it is well known that in the first year after any finance commission's report, transfers to states always pick up "" in other words, he implies, the finance minister should have factored this in and cut other expenses.

Rangarajan points out that even if you leave this aside, other FC recommendations, such as the one to get states to raise funds on their own, have helped cut the deficit by roughly an equivalent account. In other words, the recommendations of the FC are broadly fiscal deficit neutral in even the first year, and will help lower the fiscal deficit in later years. Excerpts from an interview with Business Standard:

How justified is putting the blame on your Finance Commission for forcing the FM to press the "pause button" on fiscal reforms?

The sharp increase in revenue expenditures, partly arising from Central transfers to states under the Twelfth Finance Commission (TFC) award, has created a difficult situation on the fiscal front in 2005-06.

But it is well-known that (in comparison with the last year of the previous Commissions) in the first year of any Finance Commission award, there is an abrupt jump in transfers but this tapers off in terms of percentage of GDP in subsequent years.

In 2005-06, the first year of the award, the increase in transfers to states on account of the Twelfth Finance Commission award will be in the range of Rs 20,000 to 25,000 crore, depending upon the base figure taken. Indeed, it was to avoid a higher burden that the grants in the first year were primarily restricted to revenue deficit gap grants while deferring several other grants to subsequent years.

The question really is one of adjusting expenditure to meet the Fiscal Responsibility and Budget Management Act (FRBMA) targets. In 2004-05, for instance, the Centre was able to make an adjustment in the revenue deficit of 0.9 percentage points. This shows that the target reduction of 0.5 per cent each year is achievable.

Further, the TFC recommendations enabling states to borrow directly from the market has helped reduce the fiscal deficit of the Centre. It should be possible for the Centre to reduce the fiscal and revenue deficits in the coming years as the Finance Commission grants come down as a proportion of GDP. It is important for the Centre to abide by the FRBMA deficit targets since it will send the right signals to the states that are being asked to enact suitable fiscal responsibility legislations.

But why did the Commission increase grants by such a large amount?

The share of grants awarded by the TFC is around 19 per cent of total transfers compared to around 13 per cent in the Eleventh Finance Commission. Increasing the grant component serves three purposes "" provides greater stability to revenues of states, as these are in absolute amount; it becomes possible to introduce the equalisation principle; and specific purpose and conditional grants could be given to promote certain objectives.

Applying the equalisation principle, the Twelfth Finance Commission had recommended special grants for health and education, which will enable the poorer states to raise per capita expenditures in these vital areas of human development to a certain minimum level. Special purpose grants include those for maintenance of roads and bridges, buildings and forests. Grants for the purpose of improving the finances of local bodies are equal to almost to 1 per cent of the gross revenue receipts of the Centre.

But hasn't the Finance Commission just softened the Budget constraint for the states? They'll now have lower debt and interest obligations if they enact an FRBM, but like the Centre, they too can press the "pause button" on reforms.

We have suggested institutional changes like the Loan Council to ensure that states do not borrow beyond sustainable levels. Debt write-off and interest rate cuts have been done earlier, but without linking them to incentives for fiscal correction. We have tried to link these to fiscal corrections. Interest rate relief alone amounts to Rs 21,000 crore. But this will be available only to states passing suitable fiscal responsibility legislations.

Legislative oversight will not be infallible as you suggest, but it is the best available option. The debt write-off, in fact, is specifically linked to the extent of reduction in revenue deficit in absolute amount. The fact that states will have to borrow directly from the market will mean that they will have to be assessed and that again will bring in some level of fiscal discipline.

Aren't all finance commissions, including yours, guilty of what's called "fiscal dentistry", a gap-filling approach? The states project their gap, you have no idea how correct this is, and just try and fill it up.

The gap filling approach has been misunderstood. We do not go by just the gaps projected by the states. We examined each item of expenditure and adjustments were made as elaborated in the Report. Similarly, adjustments were made for revenue projections as well.

Even the base year figures were adjusted. For instance, if a state had a tax GDP ratio of say "a" and the group to which the state belonged had a higher ratio of, say, "b", the base tax GDP ratio was not taken to be "a" but "a" plus 30 per cent of the gap between "b" and "a".

Thus, an adjustment was made for fiscal capacity, as it should be. The assessed pre-devolution non-plan revenue deficit was 25 per cent of the states' projections. It may be noted that nearly 85 per cent of non-plan revenue deficit grant goes to special category states.

That's still a rule-of-thumb approach. You've still not been able to ensure that states try to raise more taxes. After all, if Haryana is able to raise its tax-to-GDP ratio dramatically, you should know how this happened and ensure other states also try the same.

An attempt has been made to look at the performance of various states and draw lessons. The chapters on "Restructuring of Public Finance" as well as "Issues and Approach" bring out the various technical issues.

The members of the Commission come with rich and varied experiences relating to public finance. However, I must admit that the time given to our Commission, or for that matter to any Commission, is not enough to undertake exhaustive research on various issues.

While the Commission does initiate several studies, by the time the scholars come out with their reports, the Commission is almost ready to write the report. A permanent secretariat that is collecting data on a regular basis, monitoring developments continuously and commissioning research studies that are relevant to fiscal federalism is needed and we have recommended the same.