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Report of the Eleventh Finance Commission - I : Missing the equity goal?

The Eleventh Finance Commission has provided for the distribution of about 34 per cent of Union taxes and duties to the State governments. But it has drastically cut down the potential and even actual shares of a number of States in the name of equity. The Commission also seems to have bargained for huge inflation, which is the outcome of the non-fulfillment of certain crucial assumptions, says P. R. Brahmananda.

THE ELEVENTH Finance Commission submitted its final report about 10 days ago. Its members were Professor A. M. Khusro (Chairman), Dr. A. Bagchi, Mr. J. C. Jetly, and Mr. T. N. Srivastava. There was no member from the high-income and lead States of Mahara shtra, Gujarat, Tamil Nadu, Karnataka, Andhra Pradesh and Kerala. Though the distinguished Chairman originally hailed from Andhra Pradesh, he has been functioning almost all along at New Delhi.

The Commission was appointed in July 1998 and submitted its interim report in January 2000. According to its terms of reference, which were rather wide, it was expected to make a survey of the finances of both the Central and the State governments. It wa s also to take into account ways to supplement the resources of the panchayats and municipalities. The primary terms related to the proportion of net proceeds of the taxes and duties of the Centre to form the divisible pool for the States; the apportionm ent of such net proceeds among the different State governments; and the determination of special accommodations and grants-in-aid among the latter.

During the Commission's tenure, a major Constitutional amendment took place, by means of which the net proceeds of all Union taxes and duties were placed potentially in the divisible pool. The provision stipulating the levy collection and distribution of some of the taxes assigned to the States was modified, and additional duties of excise and the tax under railway passenger fares included in the proceeds. While income-tax was earlier statutorily sharable with the States, the States surrendered their ri ghts to levy sales taxes on certain commodities and taxes on passenger fares.

At the time of the surrender it was agreed that the States would, in the minimum, be compensated for the tax receipts they had foregone by voluntary centralisation. In a growing economy, where prices were also rising, it was understood that the minimum w ould be in terms of the potential proportion of sales taxes and taxes on passenger fares surrendered.

But at the time the Constitutional amendment took place, the States seem to have forgotten to safeguard themselves regarding the statutory identity of income-tax, and the agreement of identity regarding the additional excise and receipts due to the tax o n rail fares. They were happy that some proportion of all taxes and duties of the Union Government would now become the base for the divisible pool.

The Eleventh Finance Commission has naturally made provision for the distribution of about 34 per cent of Union taxes and duties to the State governments. Thus, the claim of vertical equity in our abstract quasi-Federation has been partly satisfied. (`Ab stract' and `Quasi' because the physical identities of different States can constantly change, and their number can go on increasing! Note that there are three new States now.)

But the Commission has drastically cut down the potential and even actual shares, compared to what would accrue, by the previous Commission's award, to a number of State governments which, by and large, have relatively high per capita incomes, high level s of own tax ratios and high growth rates. In the name of horizontal equity it has pressed to the hilt the claim of equity from the angle of the other States.

The Committee should be congratulated for the total perspective it has adopted on finances of both the Central and State governments taken together. It has made a number of strange assumptions about the normative performance of the economy between 2000-0 1 and 2004-05. These are that:

*The economy will grow 7.5-8 per cent per year, on an average, and prices would rise 5-5.5 per cent per year, on average;

*Current account deficit will be below 1.5 per cent of GDP;

*The States will achieve a balance on the revenue account, the Centre incurring about 1 per cent of GDP as revenue deficit; The combined fiscal deficit of the Centre and the States would be brought down to 6.5 per cent of GDP, with the capital expenditur e of the Centre and States together rising to 6.6 per cent of GDP;

*The tax-GDP ratio at the Centre will go up by 1.48 percentage points, and that of the States by 1.15 percentage points; and

*Non-tax revenue of the Centre will go up by 0.25 percentage point, and that of the States by 0.5 percentage point.

These are heroic assumptions and wishes. The Commission has used these assumptions to forecast Central and State budgets rather optimistically. One may question why an inflation rate should be built into the forecasts. Y. B. Chavan had strongly objected to such a building-in of inflation within the forecasts. Unfortunately, these forecasts will imply huge transfers from the Central government, and equally huge fiscal efforts by most of the States, especially those that received a raw deal from the Commi ssion.

Several State governments, such as Punjab, Andhra Pradesh, Maharashtra and UP, are facing a severe fiscal crisis. Economic growth and relative high incomes do not automatically imply strong and full treasuries. The reforms themselves are responsible for this state of affairs as, by and large, equity and progressiveness have been abandoned in tax rates, tax coverage and fiscal policies, both at the Central and State layers.

To talk of equity across the States, and to abandon equity in inter-personal and inter-class incomes surely shows a severe inconsistency. The Eleventh Finance Commission seems to have bargained for huge inflation, which is the residual outcome of non-ful fillment of the crucial assumptions.

As noted above, the Commission has recommended that 28 per cent of the net proceeds of Union taxes and duties should be distributed to the States plus 1.5 per cent of the net proceeds of the Union taxes in lieu of additional excise duties. Thus 29.5 per cent of Union taxes and duties now form the divisible pool. This is almost about the same as in 1999-2000. The Commission has suggested that the above 1.5 per cent should be distributed in the same manner as the 28 per cent.

However, the State governments can levy sales taxes on sugar, textiles and tobacco, but if they do so they will not get any share in the 1.5 per cent. Surely, some of the States, such as Maharashtra, Gujarat, Tamil Nadu, Karnataka and Kerala, might foreg o their meagre share in the 1.5 per cent and opt for sales taxes on the above commodities. In other words, we would be witnessing a process of de-Chellainisation of tax policies, particularly from the high-income and fast-growing States.

I referred earlier to the notion of horizontal equity. This term has been interpreted by the Finance Commission as the closing of the estimated gaps over the current and the next four years between the estimated non-Plan revenue expenditure of the States , taken individually, and their own estimated tax and non-tax revenues. On this basis, only Gujarat, Haryana, Karnataka and Maharashtra had surpluses throughout, whereas Andhra Pradesh in the later four years, Kerala and Punjab in the first four years an d Tamil Nadu in the last two years had surpluses.

The Commission did not ask whether their revenue expenditures were at satisfactory levels from a comparative angle, and whether these States had obtained the surpluses by levying higher own taxes and non-tax charges on their inhabitants.

Despite massive tax shares in some cases and moderate shares in others, some States were still left with deficits, and the tax sharing had not closed the gaps. These are: Assam, Punjab and UP in the first year, Rajasthan in the first two years, and Oriss a and West Bengal in the first three years.

For these States the projected deficits have been covered by non-Plan revenue grants. Thus, by devoluting differential tax transfers and grants, the Commission has sought to achieve the objective of balances in the revenue budgets, excluding the impact o f the Plan grants and expenditures.

The aggregate taxes shared amount to about Rs. 3.763 lakh crores, and the grants given to Rs. 35,360 crores. Besides, the upgradation grants amount to Rs. 4,973 crores, grants-in-aid to panchayats to Rs. 8,000 crores, to municipalities Rs. 2,000 crores, and relief expenditure grants to Rs. 8,257 crores. The total grants amount to Rs. 59,000 crores, a ratio of about 15.6 per cent to taxes shared.

The next article will deal with the pattern of tax-sharing among the States and examine whether the equity principle has been observed.