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Response to Rakshit on the Finance Commission

Response to Rakshit on the Finance Commission Indira Rajaraman and 13% in the first two years, followed by 13.5% in the last three years, did not factor in the output gap in the pre-award year 2009-10.

DISCUSSION

Response to Rakshit on the Finance Commission

Indira Rajaraman

and 13% in the first two years, followed by 13.5% in the last three years, did not factor in the output gap in the pre-award year 2009-10. “With underutilised resources and weak private demand, not only is a relatively large public investment required for closing the output gap, but such

F
ollowing a succinct summary of the principal recommendations of the Thirteenth Finance Commission (THFC) for fiscal consolidation, Mihir Rakshit’s article, “Fiscal Consolidation and Inclusive Growth: The Finance Commission Approach” (EPW, 27 November 2010) raises several issues. They are listed below, followed by my response to each.

(1) The Targets of the Fiscal Adjustment Programme (FAP): Rakshit’s principal criticism is: “The overarching goal of FAP, we have noted, is to bring down the debt-GDP ratio to 68% by 2014-15. Yet it is not explained why this constitutes the primary target or how its magnitude is estimated.” Debt reduction was a goal of our, as of any, fiscal consolidation exercise, but the actual numerical level of 68% by 2014-15 was a projected outcome, not the primary target. The primary targets were to bring the revenue defi cit down to a balance of zero consistent with feasible projections of revenue and expenditure; and to protect public investment up to a permissible limit of 3% of GDP (for the centre, and separat ely for states in aggregate). Pursuit of fi scal correction along these lines over fi ve years led to debt reduction to 68% of GDP, as an outcome.

The following extended quote from para 9.5 of the THFC report states the approach adopted quite clearly: “In our view, it should be possible to reduce the combined debt of Centre and states to around 68% of GDP by 2014-15. This target has been arrived at as the feasible and desirable correction, based on our projections of the medium-term macroeconomic situation during the award period and our a ssessment of the resource position of the Centre and states over this horizon.” The correction was what was deemed possible and consistent with protection of

Economic & Political Weekly

EPW
march 26, 2011

public investment at 3% of GDP at each level of government.

It is most certainly true that debt sustainability, or the lack thereof, is a function of a large number of factors, including the growth potential of the economy. But insofar as that potential itself is a function of the availability of capital for private investment at reasonable cost, we believed that reduction of public debt was a necessary condition for realisation of it. We saw the growth potential of the country as endogenous, and inversely related, to the level of public debt. Rakshit’s subsequent statements follow from that initial misreading of our exercise: “Given the initial situation, fi xing the terminal year debt target fi rst and then constructing the debt-defi cit timepath over the award period are in violation of economic logic…”

I am sure Rakshit will be happy to know that we were not in violation of economic logic, and that our terminal target was an outcome of the feasible debt-defi cit timepath constructed by us. The watchword in our construction of this time path was feasibility, for both the centre and the states. We did not want to prescribe a correction path that would be sure to be violated. And developments subsequent to our report have confirmed our belief that the recommended path is indeed feasible and attainable.

We were well aware that prescription of state limits at 3% of Gross State Domestic Product (GSDP), which is available only at factor cost, scales down to an aggregate limit of 2.4% of GDP at market prices (Table 9.7 in the report). Our retention of 3% of GSDP for states was a concession to continuity.

(2) The Projected GDP Growth Path:

Rakshit believes that the growth path underlying our fiscal prescriptions, 12.5%

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expenditures involve little opportunity cost or crowding out.” An excellent point, but consider the implications. If we had prescribed a large public investment in the very first year, 2010-11, the governments at the centre and states would have had a lead-time of less than two months between issue of the report and formulation of their budgets for 2010-11. Capital expenditure that is productive, and not of the make-work variety, requires considerably more lead time. The diffi culty with prescribing a jump-start, as happened also with the US response to the crisis of 2008, was that shovel-ready capital projects are not always conveniently at hand. By phasing capital expenditure evenly over the five years, we believe we recognise this important practical limitation. In this, as in our fiscal correction programme, we chose the feasible, over the optimal but infeasible.

(3) Crowding Out: No one would disagree with Rakshit when he says: “…even in the worst-case scenario of one-for-one crowding out, compared with private capital formation, public investment could be both growth and equity-promoting”. The key word there is “could”. Yes, it could. But alas, given the vast scope for corruption in public capital expenditure, which for political economy reasons will remain in place until political parties find other ways by which to fund themselves, there has to be a limit even on public investment, desperate as our need for such investment might be. The hope is that, when public investment is limited by fiscal rules, the productive fraction may well be higher than in an uncapped situation, since some physical outcomes have to be shown against the limited expenditure. Uncapped public investment could unleash a terrifying lack of both public infrastructure and private investment.

DISCUSSION

  • (4) Disinvestment: Rakshit argues: “In fact, given the prospective profile of returns on PSUs and the fact that the borrowing costs of the government are significantly less than private sector discount rates, disinvestment, contrary to popular belief, constitutes a costlier means of financing public investment.” The natural corollary is that all investment should be funded publicly as long as borrowing costs of government are significantly below private sector discount rates. Clearly, market assessment of the sovereign appeal of public debt can reach the tipping point, as happened last year in Greece. The issue is really one of the level and projected trajectory of public debt, and how close governments wish to skate to the tipping point. Disinvestment has finite limits, but offers a supplementary alternative to borrowing in the present case where (in the judgment of the THFC), the debt/GDP ratio was already at a level high enough to ramp up the cost of government borrowing. The recommendation of the THFC (para 6.46) is that the proceeds from disinvestment be utilised to finance the changing requirements of the public capital portfolio. Thus, one class of assets in the form of government equity is to be replaced by another form of assets, either social infrastructure such as school buildings and hospitals, or urban transport systems or infrastructure for environmental protection.
  • (5) Financial Inclusion: Raskhit recommends that direct budgetary support to financial institutions like public sector banks, the National Bank for Agriculture and Rural Development (NABARD) and Small Industries Development Bank of I ndia (SIDBI), for on-lending to small and medium enterprises (SMEs), could actually strengthen rather than impair fi scal viability. He recognises that administrative costs of lending to SMEs will be high, and does not recommend an interest subsidy, but sees direct deployment of public funds for removal of the credit constraint facing unorganised enterprises as profi table even so, because the government’s borrowing cost is lower than the return on private investment. He concedes that this support will have to be phased in only after the front-loaded expenditure
  • on public infrastructure that he earlier argues for. Thus, the whole argument for publicly-funded financial inclusion presupposes an earlier successful corruptionfree front-loaded thrust on public investment. Since the fiscal programme of the THFC did not, for reasons spelled out above (point 2), either front-load public investment, or leave it uncapped, the issue of a backloaded publicly funded thrust towards fi nancial inclusion simply did not arise. Summing together both the Rakshit reasons, it would appear that he thought a starting public debt to GDP ratio of a little under 80% in 2009-10 was a good jumping off point for such a further unbridled expansion of public debt. We fundamentally disagreed there. At present levels of efficiency of public expenditure, such an expansion would have (rightly) frightened prospective private investors. And to have assumed a radical overnight improvement in government effi ciency would have been irresponsible. We believe our prescription for a steady accumulation of public investment in infrastructure, at an average of 6% of GDP each year over 2010-15, provides the potential for a widely-fl ung net of public infrastructure that will naturally attract private initiative and private funding.

    (6) Human Capital Formation: Rakshit argues, as many have done, that expenditure on human capital is as much an addition to productive capacity as expenditure on physical capital. He sees a problem with the THFC having accepted the conventional budgetary (and national accounts) classification of expenditure on human capital formation as current, not capital, expenditure. To quote him: “Clearly, the entire expenditure on education and a major part of healthcare cost constitute investment (as do expenditures on R&D, including payments to researchers)… What is worse, given the overarching requirement of non-negative revenue balance, clubbing HRD expenditures with current ones not only leaves little scope for enlarging investment in human capital, but the stipulated FRBM targets might in all probability be met through a slowdown in HRD spending.”

    The Sixth Pay Commission, like all pay commissions before it, ramped up

    march 26, 2011

    expenditure on education and healthcare, relative to other state-level functions, because these are the most salary-intensive. A matrix for any state of functional by economic classification would show that the education and healthcare functions are ranked at the top in terms of salary content. There is no established link between salary levels and performance indicators like student achievement levels or teacher presence (teacher absenteeism in India is commonly estimated at 25%). On the contrary, states that have improved delivery of these functions have been those that tried to stretch a given budgetary allocation by hiring of contract teachers. Several recent econometric studies show that c ontract teachers, paid between oneseventh to one-ninth of tenured teachers, perform as well or better. Some states such as Madhya Pradesh and Chhattisgarh have allowed panchayati raj institutions to recruit teachers at pay scales different from the government pay scales. The state government continues to bear the cost of the salaries of the teachers but since they are now appointed by panchayats, they are more accountable at the grass roots. The panchayats too are more empowered.

    It is precisely because education expenditure was curbed by limits on revenue deficits that effectiveness of delivery was looked to. Had the fiscal curb not e xisted, we would have seen skyrocketing expenditure on health and education, sanctified by being equated to physical capital, with no commensurate impact on outcomes. Expenditure on physical capital, even though anchored to physical outcomes, has a high corruption element. The slack in expenditure on human capital is that much harder to measure. This measurement difficulty must necessarily inform prescriptions for public expenditure far more than the conceptual similarity between physical and human capital formation, which surely does exist. There can be no denying Rakshit’s point that “a fiscal road map for securing rapid and i nclusive growth has to ensure speedy r emoval of the human capital constraint.” This is not secured however by transferring these expenditures out of the current expenditure limit. It will be most effectively removed when the curbs on current expenditure force an examination (as it

    vol xlvi no 13

    EPW
    Economic & Political Weekly

    DISCUSSION

    already has done to some degree) on how on a continually revised projection reset to variables, not parameters. Policy varia
    best to secure better outcomes (which is the growth performance of the state, as bles, yes, but they do parametrically
    what we all want), rather than by merely r evealed by the most recent GSDP estimates. underpin fiscal projections nevertheless.
    lifting the lid on public expenditures. A growth performer like Gujarat will thus His principal point on this, as in item 2,
    G iven the pressure from the population indeed reap the rewards of its better growth is the possible need for expansion due to
    for education (Mahal and Rajaraman by having its borrowing entitlement set as a an output gap, “which, barring the recent
    2010), it is unlikely that HRD expenditures percentage of a GSDP projection informed crisis, has generally been driven by vola
    will be reduced in either nominal or real by its growth achievement. tility of private investment – a factor to
    terms. And if the fiscal pressure leads to Setting projections on the basis of cur tally missing in the THFC list.” It was the
    better modes of public delivery, perhaps rent GSDP estimates is a major departure very need to fortify the outlook for private
    we will have better human capital formafrom convention for another reason. Any investment that we prescribed our fi scal
    tion, which is the ultimate objective. one familiar with fi nance commissions consolidation path.
    knows that they are compelled to use not Finally, Rakshit advises: “clear signals
    (7) Reducing Input Subsidies: Rakshit the GSDP estimates of states, as reported of demand deficiency should be enough to
    commends our attention to reducing subon the Central Statistical Organisation (CSO) permit departure from FRBM targets…
    sidies, but says we do not go far enough. website, but a set of “comparable” esti- While countering recessions the govern-
    We totally agree there. Ideally, we should mates issued by the CSO, on the grounds ment, our analysis suggests, should rely
    have reduced all input subsidies to zero, as that states are said not to be using compa more on investment in critical areas than
    he suggests. In this, as in all our deliberarable methodology for their estimates on tax concession, and on seignorage rather
    tions, we debated on whether to prescribe (although why that should be so when [than] borrowing from the public or exter
    the ideal target, knowing well its infeasithe estimates are issued after discussions nal sources.” This pre-supposes an earlier
    bility from a political economy perspecwith the CSO remains unclear). State bor era of forced absorption of primary securi
    tive, or to go with the feasible. We chose rowing entitlements over 2005-10 were ties by the central bank, an era now irre
    the second option, in order to underline based on projections of the Twelfth Fi versibly behind us. An FRBM is a signalling
    that the FAP we prescribed was achievanance Commission from the comparable of the intent of a government to abide by a
    ble, in our considered judgment. estimates, but states were actually judged projected path of fiscal discipline. Finan
    by their achievements in fi scal consolida cial markets are reassured if there is legis
    (8) Seignorage: Rakshit sees the complete tion with respect to the website fi gures. lated evidence of commitment to fi scal
    disregard of seignorage by the THFC as Thus, Haryana, for which the comparable governance. Clearly, in any crisis like the
    glaring. A glaring example of our wisdom, estimate was systematically below the one in 2008, the need for an immediate
    I would have thought. The RBI is in any website figure by an average of 8.5%, rang fiscal and monetary response will be
    case no longer compelled to accept primary ing up to 13% in some years, looks like an widely understood. In asking that the
    securities issued by the government, and is unduly fiscally conservative state when three price parameters be specifi ed, we
    free to set its own limits of absorption on its fi scal deficit is normalised by the higher did not imagine that the whole gamut of
    the secondary market. Yes, the negative website figure. The reverse would be true possibilities was thereby covered. In
    seignorage of the pre-crisis era carried for other states for which the comparable an uncertain world, cognisance of the
    heavy fiscal costs, but the alternative comestimate was systematically above the p arameter-dependence of the projections
    bination of letting the capital infl ow lead website fi gure. adds transparency and credibility to fi scal
    to rupee appreciation, in conjunction with projections and adds further reassurance
    heavy direct borrowing by the govern(10) Fiscal Adjustment for Macro Stabi to that very same private investor, whose
    ment from the Reserve Bank of India (were lisation: Rakshit seems to agree with the centrality in preventing an output gap is
    that for argument’s sake an option), would provisions of the commission for building conceded by Rakshit.
    surely not have been a happy alternative. stabilisation flexibility into the FAP. Specifically, we asked that the range in the Indira Rajaraman (indira_raja@yahoo.com) was a member of the Thirteenth Finance
    (9) Rewarding Performing States: Raksvalues of key parameters underpinning Commission and is now honorary visiting
    hit says: “…allocative efficiency of public the projections, like the international professor, Indian Statistical Institute,
    investment will improve if better performprice of oil, the exchange rate and the New Delhi.
    ing states are permitted (within limits) to i nterest rate, be specifi ed.
    borrow more, taking advantage of their Rakshit says the elimination of petrol References
    higher credit worthiness”. We did precisely and fertiliser subsidies would insulate the Finance Commission (2009): Report of the Thirteenth
    that. The major change in our equation determining state entitlements to borrow over budget from petroleum price volatility. As explained in item 7 above, that happy Finance Commission 2010-15, New Delhi. Mahal, Ajay and Indira Rajaraman (2010): “Decentralisation, Preference Diversity and Public Spending:
    2010-15 (para 9.85) will be that borrowing entitlements, set in year (t-1) for year t, will nirvana of subsidy elimination was not seen by us as achievable over the horizon Health and Education in India”, Economic & Political Weekly, XLV: 43, 23 October, 57-63. Rakshit, Mihir (2010): “Fiscal Consolidation and
    be determined, not on the basis of GSDP for year t as projected by the commission, but 2010-15. As for the interest rate and exchange rate, he sees them as policy I nclusive Growth: The Finance Commission A pproach”, Economic & Political Weekly, XLV: 48, 27 November, 38-45.
    Economic & Political Weekly march 26, 2011 vol xlvi no 13 139
    EPW

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