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It is not Finance Commission’s business to judge states’ capability to utilise funds: Former RBI Governor

The recommendations of the 14th Finance Commission headed by former RBI Governor YV Reddy, which was accepted by the government and announced during this year’s Budget marks a huge transformative shift in public finance and in terms of fiscal autonomy for states with higher transfer of funds — 42 per cent compared to previous Commissions. The Commission’s award is expected to usher in a new era of both co-operative and competitive federalism. Dr Reddy, spoke to Shaji
Vikraman of Indian Express in Hyderabad, where he is now based, on the implications of the Commission’s recommendations and how he expects it to play out over the next few years.
There is a recognition that the FC’s recommendation this time marks a seminal shift. How do you see this playing out?
If you look at it carefully, there is no big shift in aggregate transfers to States in the assumptions. It will remain about the same although P Chidambaram says the Commission has been too generous. The total transfers from the Union to the state put together works out roughly to 63 per cent of the divisible pool. Actually, our projections don’t assume any increase in overall transfers. The seminal shift really is in terms of the composition of transfer. The real difference has been in terms of the freedom available to states. So it is not a quantitative shift but a qualitative shift.
You can’t compare the earlier Commissions and this. The past Commissions said that surcharge should be made part of the divisible pool, but that was not done by Union. So, we made up for it. The expenditure projections of States by this Commission, includes plan expenditures also. Yes, share of states in divisible pool is increased, which means more assured flow as a matter of right to states with freedom to allocate.

There has been no reduction in the fiscal space available to the Central government with regard to aggregate transfers to states. The aggregate amount available to the Centre to discharge its responsibilities remains unchanged. Earlier, there was large scope for the Central government to transfer funds outside of the award of the Finance Commissions as “other transfers”. If the Union wants to retain its space for discharging its obligations, then it has to reduce the “other transfers” to states to accommodate higher level of transfers in divisible pool. We have taken comprehensive view of both Finance Commission and other transfers from Union to states in considering fiscal space for Union.Hasn’t the fiscal space for the Centre shrunk ?
How do you see Centre-State relationship now evolving?
What we have done is to consider the constitutional spirit of autonomy of states in relation to Union. In fact, we have legitimised transfer of funds by the Centre other than what is generally the awards recommended by the Finance Commission, but indicated the need for justification. The discretion available to the Centre to distribute funds to states at its will and pleasure has been questioned by states. We addressed this through a qualitative and not really a quantitative change. By implication, the existing system of transfer of funds from the Centre to states under “other transfers” will have to be reviewed. An institutional body which we have recommended, is expected to have a look at such matters.
Are states capable of using higher transfers of funds effectively?
The idea that all Centrally Sponsored Schemes are more effective or work well, is not validated in our discussions. After all, they are implemented by the states. The Union is providing money to states to finance activities which are under Constitution in the domain of the states. That is the reason for implementation being mostly with states. It is not the business of the Finance Commission to sit in judgement on the capability of states to utilise such funds. Now, the so called welfare schemes of today — at the Central level and over the last five years such as distribution through the PDS were the ones criticised by the Central government many years ago when they were first implemented by states — saying they were populist.
Assuming that some States are average performers and may not be in a position to utilise the funds effectively, can the Finance Commission discriminate based on its view of the capacity of states? The financial markets may do, but not a constitutional body like the Commission. Centralisation is not the solution that Finance Commission can offer on the basis of a judgement on efficiency of states. Discretion, distribution and design of schemes by the Union in Central transfers were major concerns for states. The concerns of states of a unilateral, discretionary and one size fits all approach on the part of the Centre have been addressed by the Commission, to a limited extent.
Is this competitive federalism which is now being advocated, healthy?
Look, if a state is not capable of implementing schemes, it is not capable. That’s it. The notion that Central schemes are better implemented in a state than what a state will do with its own schemes, is not necessarily right. After all, it is states which are implementing it! And there is no empirical evidence to prove that money given by the Centre is used better. Something which is totally in the domain of states should normally be left to states only. The idea that the Centre knows best on all matters is difficult to justify.
In fact, the capital outlay of the Centre relative to revenues has been coming down, whereas states have been doing a better job in the last few years on capital outlays in aggregate. Finally, can we pick and choose? Can the Finance Commission discriminate based on capacity of states? If I say, some states won’t be doing well and, therefore, give an average treatment to all states, it will amount to penalising well-performing states. Let some states learn from those which are doing well.
On fiscal consolidation or deficit reduction, the Commission appears to have been quite accommodative.
You mean accommodative to Union? Actually we have to make a judgement while going by the projections given to us by the finance ministry. Naturally, the Commission will follow that unless there are reasons to deviate. We have to look at both what is desirable and what is feasible. And we basically follow the path given by the Government of India with minor changes. In fact people accuse the Commission of being soft on this issue. It is not prescribing targets. What we have said is that we generally accept the projections but atleast stick to it. So going by past record, it reinforces the need for the Commission to be realistic rather than be ambitious. Besides, if we were to be too optimistic in our revenue projections, then the states claim over Central resources would have been increased.
Hasn’t the track record of states been better on fiscal management compared to the Centre over the last decade?
Basically, in the Commission, our impression is that states were fiscally more responsible — essentially because they are subject to fiscal rules that are imposed by the Centre. There was an enforcement mechanism on fiscal management of states. But when it comes to the Centre, there is only a self-imposed constraint through its own FRBM. There was no enforcement mechanism. The fiscal enforcement mechanism available now is reasonably adequate for states but not for the Centre. That’s why we have recommended replacing the FRBM with a new law which will have greater sanctity and legitimacy. We have also recommended Fiscal Council for Union to improve fiscal management, consistent with best global practices.
One of the criticisms of the Commission has been that nearly one-fifth of the award goes to states which have a relatively poor track-record of using funds.
I am still wondering, where is the evidence? Anecdotal evidence is different. My limited point is that, on what grounds do we say in the Commission, that a state has a poor record of using funds. Assignment of funds through vertical and horizontal balance has to be based on assessment of resources and needs. Where does efficient utilisation of funds come in? There are mechanisms that govern proper use of funds and they should take care of the issue. We have said that no debt restructuring or debt write-offs as it is less transparent way of giving funds to states which have been profligate — that’s all that we could do.
Do you think there is a case for a pro-cyclical or a counter cyclical fiscal policy ?
In theory: Yes. But international experience is equivocal. There are very few countries where counter-cyclical policies are built into law. It is very difficult to operationalise counter-cyclical policies through law since it is difficult to define the counter-cyclicality. In the current Indian context, it is not possible because now and in our history, it has always been a problem of fiscal consolidation. The Finance Commission discussed this at length and we came to the conclusion that there is no scope for such a policy to be built into law now. The possibility does not arise now because of our experience and record. Perhaps, some studies can be done and based on that later, if there is strong evidence, may be next Finance Commission can look at it.

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