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Global Downturn and the Thirteenth Finance Commission

In the current uncertain fiscal situation following the global downturn, the Thirteenth Finance Commission is constrained in making a realistic assessment of the resources and expenditure needs of the centre and the states. Past experience clearly indicates that in a fiscal crisis resource transfers to states will witness a contraction and it would be unfair to bind the states to such a dispensation for five years. In view of the current uncertainties, the THFC should be asked to give its recommendations for two instead of five years. Such a course of action will also result in the synchronisation of the term of the Finance Commission and the period of the five-year plans, and will help address the uncertainty arising from the proposed introduction of Goods and Services Tax from 2010.

COMMENTARY

Global Downturn and the Thirteenth Finance Commission

G R Reddy

bring the liabilities on account of oil, food and fertiliser subsidies into fiscal accounting. Accordingly, in July 2008, the finance commission was asked to review the road map of fiscal adjustment and suggest a suitably revised road map with a view to

In the current uncertain fiscal situation following the global downturn, the Thirteenth Finance Commission is constrained in making a realistic assessment of the resources and expenditure needs of the centre and the states. Past experience clearly indicates that in a fiscal crisis resource transfers to states will witness a contraction and it would be unfair to bind the states to such a dispensation for five years. In view of the current uncertainties, the THFC should be asked to give its recommendations for two instead of five years. Such a course of action will also result in the synchronisation of the term of the Finance Commission and the period of the five-year plans, and will help address the uncertainty arising from the proposed introduction of Goods and Services Tax from 2010.

The author is grateful to B P R Vithal for suggesting the theme of this paper and to C H Hanumantha Rao for identifying areas for improvement. The usual disclaimers apply.

The author (reddy_grr55@yahoo.co.in) is a former official of the Indian Economic Service and is currently with the Centre for Economic and Social Studies, Hyderabad.

T
he Thirteenth Finance Commission (ThFC) was appointed in November, 2007 against the backdrop of considerable progress on the fiscal consolidation front in the years following the enactment of fiscal responsibility and budget management (FRBM) legislations by the centre and the states.

The government’s intention in taking the fiscal consolidation further was evident in the terms of reference (ToR) prescribed for the commission. The ThFC was asked to take into account the objective of not only balancing the receipts and expenditure on revenue account of all states and the union, but also generating surpluses for capital investment, while making its recommendations. Another related consideration specified for the THFC was the taxation efforts of the central government and each state government and the potential for additional resource mobilisation to improve the taxgross domestic product (GDP) and taxgross state domestic product (GSDP) ratios. Thus, the ToR of the ThFC were anchored in sustaining fiscal consolidation and in meeting the deficit reduction targets laid down under the FRBM legislations of the centre and the states.

At the time the ThFC was constituted, there was no hint that the subprime crisis in the United States (US) would turn successively into a global banking crisis, global financial crisis and a global economic crisis. At the time of presenting the union budget for 2008-09, the ramifications of the evolving global crisis on the Indian economy were not known. The then finance minister, while presenting the budget, had indicated that after the obligations on account of the Sixth Central Pay Commission became clearer, the ThFC would be requested to revisit the road map of fiscal adjustment and suggest a suitably revised road map taking into account these liabilities and the need to

april 25, 2009

maintaining the gains of fiscal consolidation through 2010 to 2015. Thus, even the additional term of reference did not mention the global down turn and its impact on the fiscal situation.

Fallout of Global Developments

The global developments unfolding since September 2008 have had an adverse impact on the Indian economy in terms of growth prospects and the fiscal situation. The growth of GDP in the third quarter of 2008-09 dipped to 5.3%, the lowest in nearly six years. The vote on account budget for 2009-10 presented to Parliament in February 2009 revealed fully the deterioration in the fiscal situation caused by growing subsidies and under-funding of expenditure on account of pay revision and farm loan waiver on the one hand and the slower growth of revenues following the downturn of the economy on the other. The year 2008-09 is likely to have ended with a revenue deficit of 4.4% of GDP and with a fiscal deficit of 6% of GDP as c ompared with the budget estimates of 1% of GDP and 2.5% of GDP, respectively. The situation is likely to worsen further in 2009-10.

The revised estimates for the states are not yet available but the indications are that states will witness a similar or even a higher deterioration in their finances. As per the revised estimates in the centre’s interim budget, the states’ share in central taxes in 2008-09 will be lower by over Rs 18,000 crore as compared with the budget estimate. It is likely that the combined fiscal deficit will exceed 12% of GDP in the year 2008-09 surpassing the levels reached in the pre-FRBM period. The objective of this note is to examine the difficulties that the ThFC will face in fulfilling its mandate given the deterioration in the finances of the centre and the states, and total uncertainty regarding the duration and depth of the present global downturn and to suggest certain alternative a pproaches to address the present uncertainity.

vol xliv no 17

EPW
Economic & Political Weekly

COMMENTARY

With a view to minimising the impact of the global downturn on the Indian economy, the union government came out with three fiscal stimulus packages in quick succession (December 2008, January 2009 and March 2009). The important policy measures announced in these packages included cuts in tax rates, increase in plan expenditure, lowering of interest rates on export and housing finance, authorisation to India Infrastructure Finance Company (IIFCL) to raise tax-free bonds to finance infrastructure projects and increasing the market borrowing limits of the states by Rs 30,000 crore.

In tandem with the fiscal measures taken by the government, the Reserve Bank of India (RBI) has been announcing cuts in key rates. The repo rate was cut from 9% in August 2008 to 5% in March 2009. The reverse repo rate was cut from 5% in December 2008 to 3.5% in March 2009. The reduction in the cash reserve ratio was from 9% in August 2008 to 5% in January 2009.

Currently, there is total uncertainty regarding the duration and depth of the present crisis and the kind of further stimulus that is needed in future. The expectation that the adverse impact of the global financial crisis will be minimal on the Indian economy has been belied. It now looks that the crisis is much deeper and recovery will take much longer than expected. Even the milder Asian financial crisis, which was followed by the implementation of the Fifth Pay Commission recommendations, had its impact on the Indian economy. GDP growth averaged 5.2% between 1997-98 and 2002-03, as compared with the average growth of 6.6% in the preceding five years. What we are now facing is a global crisis accompanied by the implementation of the recommendations of the Sixth Central Pay Commission. Obviously, one can expect the adverse impact to be much more severe and to last much longer. Finance Minister Pranab Kumar Mukherjee in his reply to the interim budget debate has indicated that the medium-term objective is to revert to the path of fiscal consolidation as early as 2010-11, provided the US and the Organisation of Economic Cooperation and Development (OECD) economies come out of their contractionary phase by the year

Economic & Political Weekly

EPW
april 25, 2009

end. This optimism of the finance minister does not sound credible going by the track record of the central government in adhering to FRBM targets. Even when growth was accelerating, the centre pressed the pause button on the FRMB targets twice so far, once in 2005-06 to accommodate the recommendations of the Twelfth Finance Commission and the second time in 2008-09 to maintain social sector expenditure. It is felt by many analysts that conventional monetary policy instruments have a limited role in the present crisis and that recourse to Keynesian policies, in particular augmenting government expenditure, is much more relevant to address the present crisis.

Credible Forecast Unlikely

In this uncertain situation, it would be difficult for the thFC to make credible forecast of the revenue and expenditure of the central and state governments for the period 2010-15. Normally, these assessments are done within a macroeconomic framework involving assumptions regarding the growth prospects of the economy. The next step involves arriving at the revenue and expenditure in the base year 2009-10. Because of the uncertainty regarding the depth and duration of the present crisis, the commission would not be in a position to make any credible estimate of the growth prospects of the economy and arrive at the realistic base year estimates of revenue and expenditure. It is equally difficult for the commission to make an estimate of the expenditure commitments of the centre and the states, particularly by way of counter-cyclical interventions. In the current situation, it would be difficult for the ThFC to make its recommendations within the framework of its ToR.

All through the crisis, the focus has remained on central initiatives and the fiscal situation of the centre. The budget estimates of the revenue and fiscal deficits of the centre in 2008-09 have drifted far away from the targets laid down in the FRBM legislation. The centre could meet the deficits by increased recourse to market borrowings. But in the case of the states, there are hard budget constraints. In an economic downturn, the tax base of the states shrinks along with their share in

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central taxes. The states will be forced to follow a contractionary fiscal policy in the absence of suitable relaxations in the FRBM targets. This will be counter to the fiscal stimulus packages being unveiled by the centre. So far, the states have been allowed to exceed their fiscal deficits by 0.5 percentage points to 3.5% of GSDP and the target for elimination of revenue deficit has been shifted by a year to 2009-10 for the purpose of availing of the incentives under the Debt Consolidation and Relief Facility recommended by the Twelfth Finance Commission. These relaxations are marginal as compared with the levels of revenue and fiscal deficits of the centre and do not even address partially the concerns of the states. They may not even meet the revenue shortfalls of states not to speak of the additional expenditure needs of states by way of counter-cyclical policy measures.

With the centre itself increasing its market borrowings from Rs 1,00,571 crore to Rs 2,61,972 crore in 2008-09 and further to Rs 3,08,647 crore in 2009-10, there will be immense pressure on the banking sector to finance these borrowings. In the process, states, particularly the poorer ones may face severe problems raising their market borrowings. In such a scenario, the centre may have to revert to the policy of on-lending to states which was dispensed with in 2005-06. It may be recalled that the improvement in the fiscal situation of the states in the post-FRBM period was entirely facilitated by higher central transfers and the growth in own revenues. With the economic downturn, both these sources of revenue are already under severe pressure. In the past, central transfers to states took the cut whenever there was a pressure on central finances. Any recommendations of the THFC based on the current situation will severally restrict the scope of transfers to states and it would be unfair to bind the states to such a dispensation for five years.

Because of the uncertainty, there is a strong case for asking the ThFC to make its recommendations for the period of two years (2010-12). Besides, the possibility of a clear picture about the economic downturn emerging by then, there are several other compelling reasons for a sking the finance commission to make its

COMMENTARY

r ecommendations for two years instead of five years.

Non-Plan Revenue Account

Because of the practical difficulties in assessing the plan revenue component, emanating from the periods of the finance commission and the five-year plans being different, the finance commissions have been restricting their assessment to nonplan revenue account. The difficulty relates to the tendency of states to suppress their committed expenditure, to overestimate their resources for the plan and to exert pressure on the Planning Commission to approve higher plan outlays.

The fixing of the higher plan outlays creates three major liabilities on the nonplan revenue expenditure beyond the plan period. These liabilities are in the form of interest payments on loans taken to finance the plan, maintenance of assets created during a plan period and the payment of salaries for the staff deployed on plan schemes transferred to non-plan side. Besides, plan grants do not fully cover the revenue component of the plan. Thus, unless the plan revenue account is taken into account by the finance commissions, there is no way the problem of a deficit on the revenue account of the state budgets can be addressed. For facilitating the finance commission to take into account the plan revenue account, it is necessary to synchronise the periods covered by the Fina nce Commission and the Planning Commission.

The ThFC is mandated to give its r ecommendations covering the period 2010-15, while the period covered by the Eleventh Five-Year Plan is 2007-08 to 2011-12. The only feasible way to synchronise the p eriods covered by the both commissions is to ask the ThFC to give its recommendations for two years. The Fourteenth Finance Commission can then be appointed in 2010 to give its recommendations for 2012-17, coterminous with the period of the Twelfth Five-Year Plan. The Constitution clearly provides for the next finance commission to be appointed e arlier than five years from the appointment of the previous finance commission. Thus, there is no constitutional bar in limiting the period covered by the ThFC to two years.

As indicated earlier, the finance commissions have been facing certain practical problems as the periods covered by a five-year plan and a finance commission were not coterminous. A few attempts were made in the past to make the periods coterminous. The Third Finance Commission was asked to give its report covering the period of four years 1962-66, so that the Fourth Finance Commission and the Fourth Five-Year Plan could be coterminous (1966-71). But the Fourth Plan was finali sed for the period 1969-74 because of the “Plan holiday” between 1966 and 1969 due to the effect of the 1965-66 droughts and the war with Pakistan. The second attempt at synchronisation was made by curtailing the period covered by the Fourth Finance Commission by two years. The Fifth Finance Commission’s recommendation covered the period 1969-74 for same as the Fourth Plan. This synchronisation continued till the Fifth Finance Commission. The third attempt at synchronisation was made at the time of the Ninth Finance Commission. The Ninth Finance Commission was asked to give two reports, the first covering the year 1989-90 and the second covering the period 1990-95 to synchronise with the Eighth Five-Year Plan. But the intended synchronisation did not take place as the Eighth Plan commenced two years later. This seems to be the right time to make the plan period and the period covered by the finance commissions coterminous.

Another valid reason for restricting the recommendations of the ThFC to two years is the presence of unknowns regarding the proposed operationalisation of the Goods and Services Tax (GST) from April 2010. The commission has been asked to take into account the impact of the proposed implementation of GST effective from 1 April 2010. Though in the long run, the GST is likely to result in a win-win situation for the centre and the states, in the short to medium term, it is quite likely that there may be gainers and losers. Right now, there appears a broad understanding on the dual nature of the tax consisting of a central GST and the state GST. Beyond this understanding, the details regarding the tax base, coverage and rates, the l egislative mandate, the rules for the tax incidence, and the implementation

april 25, 2009

arrangements are yet to be designed, discussed and agreed upon. States have basically three main concerns, namely, (a) uncertainty emanating from the change in the tax base, (b) possibility of accentuation of vertical imbalance in favour of the centre because of the possibility of a higher GST rate for the centre, and (c) difficulties involved in evolving a revenue neutral rate that protects the own revenue of individual states. In view of several uncertainties, it would be difficult for the ThFC to recommend appropriate horizontal distribution of tax revenue. By 2012, a clear picture is likely to emerge on the structure of GST and its revenue implications for the centre and the states. A new finance commission with mandate to cover the period 2012-17 would be in a b etter position to make recommendations on the horizontal tax sharing in the post-GST regime.

Case for Two-Year Recommendation

To sum up, there is a strong case for asking the ThFC to make recommendations covering the two years of 2010-11 and 2011-12. It would be difficult for the finance commission to make an assessment of the resources and needs of the centre and the states in view of the prevailing uncertainty emanating from the global downturn. Cutting short the period covered by the ThFC would also serve two other purposes. It would make the periods covered by the finance commission and the plan period coterminous thereby addressing the vexatious issue of non-plan and plan revenue expenditure dichotomy. Finally, it would help address uncertainty arising from the proposed introduction of GST from April 2010.

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Economic & Political Weekly

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