Assessing fiscal needs of States better

We have seen a heated debated on one of the terms of reference of the 15^th Finance Commission that mandates it to look at the 2011 census data for population. This changes the practice of keeping the reference point at the 1971 census data, anachronistic in our times but still providing comfort to some of the States that have lowered their fertility rate and do not want a lower share of taxes from the Centre just because they have managed population better. The 40 year gap between 1971 and 2011 is huge – India has transformed and the Southern States, which have done better in terms of population management, worry that they will be penalised while the so-called erstwhile ‘bemaru’ States will in effect be rewarded for not doing as much work in terms of managing population growth.

This is a passionate issue, even a political one. However, the unidimensional focus on population benchmarks has left many other important issues undiscussed. 

The Finance Commission is also mandated to recommend a fiscal consolidation roadmap for State governments, which is also a bone of contention given that the Commission is primarily seen to perform the task of devolution of resources between the Centre and the States for a “vertical” balance and the share of the various States to have a ”horizontal” balance.  After some of the southern State Finance Ministers met in Kerala this month, the Kerala Chief Minister Pinarayi Vijayan noted: “It is not the task of a Finance Commission to create roadmaps for fiscal management or impose its perception of what policies are good for the people of the State —that is for the democratically elected State governments to decide.” This brings the debate squarely to the issue of ballooning fiscal deficits, the role of the Central government in managing this, the Fiscal Responsibility & Budget Management Act (FRBM) and how the Finance Commission may look at the challenge, which is made more complex by FRBM changes announced in the Union Budgets 2017-18 and 2018-19. Notably, the plan and non-plan components of revenue and capital expenditure have been done away with and fiscal deficit will be the target variable in the FRBM Act, not the revenue deficit. This decision came on the recommendation of the committee on FRBM, where the Chairman incidentally was N K Singh, also the Chairman of the 15^th Finance Commission.

Historically, Finance Commissions have looked at the non-plan revenue deficit component of States and awarded grants for this purpose. This approach will have to be re-designed in the event of discontinuance of plan and non-plan expenditure at the States, which is expected as they follow in the footsteps of the Centre. More importantly, fiscal deficit becoming the target variable by itself has many shortcomings.

Fiscal deficit reflects the net borrowing requirements of the Central and State government. This is a “hole” mechanistically filled in and the process continues year-on-year, allowing for no health check on funds required, spends or their quality. In effect, the sanctity of the budgetary process is lost.

The fiscal deficit and its financing gives no view of the demand for resources and the capacity of the government to raise these resources (own and borrowed resources), apart from the Finance Commission awards in terms of tax devolution and statutory grants. Furthermore, the fiscal deficit is a fuzzy number because it can be under- or over-estimated (in the public account, components of reserve funds and deposits can be intra-governmental and may not carry even interest payments). Moreover, fiscal deficit is a net concept; it does not recognise repayment obligations by State governments. Since the market borrowings by the State governments have grown following the recommendations of the 12th Finance Commission to do away with loan components from the Centre, it is important to examine the process of the fiscal roadmap taking into account the repayments on market borrowings.

It is because of these shortcomings that one of the two authors here offered in an RBI paper a new and innovative resource gap approach in respect of State governments, called the Basic Resource Gap (BRG). There are three concepts of BRG, termed BRG1, BRG2 and BRG3. Total Expenditure is the same but the various versions give a differentiated view of the “gap” by accounting for different classes of receipts.

BRG1 takes into account the total expenditure (TE) and the State’s own revenues, both tax and non-tax, of the State governments. Thus, BRG1 is the starting point of the resource gap, a clean indicator of how much money is required and how much of it is in the bag. BRG2 adds to government revenues another head: own capital receipts, which includes all public accounts borrowings such as provident funds, reserve funds and deposits of the State governments. BRG3 takes into account the constitutional transfers from the Central government in terms of tax devolution and statutory grants-in–aid, non-statutory grants on the revenue receipt side and loans from the Centre, including repayments and consolidated fund borrowings or repayments thereof.

In principle, Ways and Means Advances (WMA) and overdraft from RBI should not constitute resources for State governments as these are to meet sudden and temporary mismatches. Thus, ultimately BRG- version 3 becomes the Total Resource Requirement (TRR) and we have the fiscal “golden rule” that says: TE=TRR.

 The operational relevance of three variants of BRG is that these concepts help us look at the dynamics of the evolving fiscal position. The Resource Dependency Ratio (RDR) is calculated with a ratio of BRG1 and BRG 2 to total expenditure and gives a view of resources required from the Finance Commission award; it can show to what extent the award of the Finance Commission will be helpful to meet the total expenditure needs of the State governments. The ratios of BRG3 and BRG1 and BRG3 and BRG2 mirror the Resource Stress Ratios (RSR) for the State governments originating from three institutional sources viz: Finance Commission (tax devolution and statutory grants), Central Government (loans from Centre and non-statutory grants) and the Financial Market (consolidated fund market borrowings.)

To sum up, the fiscal consolidation roadmap with the three variants of BRG has the merit of recognising the fiscal dependency in a federal set up and fiscal stress in a market oriented approach to raise resources.

This helps navigate ahead at a time of crisis, when trust is low and the very idea of the Finance Commission suggesting and opining on State spends has raised a red flag with some southern States. A deficit signals a deficiency. A resource gap attaches no stigma. It’s a mature calculation of needs to fulfil required expenditures – and offers a granular view that can hold a mirror to what is required and what needs to be done – or not done in the process of making a budget and running a government.