Who Should Get the Centre's Money?

From Financial Express, October 3, 2013

Who should get the Centre’s money?

 A government is ideally supposed to use tax revenue to provide public goods and services to its citizens, goods that the market cannot do a good job of providing. Tax revenue can also be redistributed to make poorer citizens relatively better off than before government intervention. In a federal country like India, there is the complication of different levels of government, each with its own responsibilities and loci of authority. Because the Centre is more efficient at raising tax revenue, there are provisions for sharing central tax revenue with the states. The 14th Finance Commission is now hard at work on making those sharing decisions. Like its predecessors, it will use a formula justified according to a mix of economic and political logic and of precedent. The Finance Commission is an explicit creature of India’s Constitution.

Less firmly founded in constitutional directives, but more in the middle of political bargaining, the Planning Commission (along with various central ministries) also makes transfers to the states. These are based on more varied and discretionary criteria, with its own modified Gadgil formula playing a relatively small role. The Planning Commission introduced the concept of Special Category states, and has given them a healthy share of the pie that it disburses. These states have been, as a natural consequence of the criteria used, mountainous border states with populations whose ethnicity or religion are not part of the “mainstream” Indian identity. They were ostensibly compensated for having high cost structures for public good provision, but I have always thought of their shares of the pie partly as payments for sticking with the rest of the nation.

The Special Category designation has bothered the leaders of some bigger, poorer states, which have been demanding to be included in that classification, therefore getting more central money. Many committees have looked into the criteria to be used for such transfers (which are broadly thought of as promoting “development”) but not made much headway. Hence, a new committee, headed by the ubiquitous Raghuram Rajan, was formed, and has just given its report to the Finance Minister. This committee has created a new index of underdevelopment, combining 10 indicators into this index. In addition to the index, the report also suggested a classification based on levels of development. Indeed, Bihar and Odisha, left out of the Special Category pot, show up as the least-developed. Headlines trumpeted the ranking of Gujarat as “less developed,” despite its apparent economic success.

As anyone knows, and as a dissenting note in the committee report elucidates, the ranking can be very sensitive to how the index is constructed, and it is not clear that the committee has got everything right, from the point of view of what it was trying to achieve. A detailed conceptual discussion of the index is beyond my scope in this column, but I want to point out a couple of things about the report. First, the report is clear that it is not proposing to replace the entire current system of Centre-state transfers with the new formula, but to add another formula for making such transfers —presumably under the existing Planning Commission channel. To my mind, this just adds complexity to an already messy situation. Better to edge the Planning Commission out of this role, let ministries make explicit specific purpose transfers, and give the Finance Commission a bigger role. Better yet, allow states the freedom to piggyback on central taxes such as the individual income tax (this will need a constitutional amendment, of course).

Second, the report notes that Finance Commission transfers are only 54% of total Centre-state transfers (another source says 57%), but of the rest, only a small fraction is governed by the modified Gadgil formula and the boost for Special Category states. But the new index would give much less to the Special Category states, and more to the least-developed states. If this new index is heavily used, it represents a big change. If it is not going to govern a major portion of transfers, then why all the effort? To my mind, the new index is trying to make a major conceptual change in how state shares of transfers are done, without adequate contextual positioning.

To sum up, I don’t think the new index provides a superior guide for Finance Commission transfers (and is not meant to). But it is also not clearly the right way to go in guiding “developmental” transfers either. Those should be simpler, project-based, with measurement of concrete outcomes, not based on composite indices. Finance Commission transfers should do a better job of improving horizontal equity across states, but that also should be based on a small number of criteria—states like Bihar and Odisha would still benefit. And Special Category states should stay what they are—a politically sensitive group of smaller, mainly border states. For rethinking Centre-state transfers, I say, “back to the drawing board.”

Financial Express, August 22, 2013

An Indian Spring?

In my last column, I ended by suggesting that India can either have a true Indian Spring, with its economy and society blossoming, or instead something that veers toward what has happened in Egypt. What are the factors that will determine where the country goes? First, I want to emphasise that the current economic debate (now and perhaps forever labelled as “Sen vs Bhagwati”) has tended to miss the interaction of economics and politics. Prescriptions are sometimes offered as if by wise philosophers or technocrats, with the only issue being a sorting out of the facts of the growth process, or agreeing on the relative weighting of the welfare of different segments of society. How does politics enter into the evaluation of different policy options? 

The most obvious political process is the use of government transfers to buy votes. Empathy for the poor may matter for many of those involved in the intellectual debates, but a good first approximation to reality is that India’s politicians care most about getting re-elected. The policies that get implemented, in this case, are the ones that maximise the chance of winning the next election. India’s voters have to keep making it clear to politicians that subsidies and transfers are not going to be enough to secure their votes. There have been signs of this shift (rewarding performance over populism) in how Indians vote, and one has to hope this trend will continue.

But politics is also more complicated than that. Take Egypt, where democratic elections failed to lead to a stable, popular government, and the country is close to descending into chaos or repression. The winners of the election lost support not just, or even mainly, because they failed to deliver economic betterment. Instead, they were criticised for undermining the people’s recently-won freedoms. Basically, people want dignity and freedom as well as material improvement.

Economic reform in India has delivered an uneven mix of material and non-material benefits. For example, Dalit entrepreneurs seem to have gained on both fronts. Some of the middle classes have seen material gains, but erosion of their status and of traditional certainties. The upper crust of society has benefited disproportionately. And at the other extreme, many people in rural areas, especially in tribal regions, have seen their exploitation increase. This is a complicated story, with perhaps a couple of clear lessons. First, a majority of the population is frustrated with the corruption of, and exploitation by, those with political and economic power. Second, doling out money to win votes will not work as well as it used to, and will not stop the pot from boiling over. Social conflict in India will increase unless there is a quantum improvement in the quality of governance.

There is also another danger lurking. The growth-redistribution debate has only tangentially addressed India’s macroeconomic and financial sector policies. Here, the spectre of corruption also raises its head in the form of the government’s push to give new banking licences to powerful industrialists. But many of the problems have arisen from failure to execute the basics of macroeconomic management. The central government has not done a good job of managing its fiscal deficit, while the Reserve Bank of India (RBI) has gone backwards in managing inflation and the currency. RBI has failed to control inflation effectively, even as economic growth has not been protected. Government mismanagement of food and oil policies has contributed to the problem. Most recently, RBI’s attempts to control the exchange rate have ranged from pointless to damaging, undoing a longer-term program of creating a deeper and more robust financial system. The danger is that macroeconomic conditions will deteriorate rapidly, dealing a severe blow to the economy that will further increase social conflict.

RBI could have used earlier benign economic circumstances to push financial sector reforms that would have improved the functioning of a range of financial markets, improved financial access, and helped capital to flow to more productive uses. It did a little, but not enough, and the futile attempt to defend the rupee has undone some of the certainties of financial sector policy that should have been maintained. Confidence—a valuable commodity itself—has been eroded.

The incoming governor of RBI has a track record of speaking up for the right policies. Not long ago, he authored a vital report on financial sector reform, covering the issues from top (macroeconomic management) to bottom (financial access at the grassroots of the economy). He does not have to stand for re-election, and he does not have to rely on reappointment for his livelihood or prestige.

Raghuram Rajan has an opportunity to determine the nature of an Indian Spring, both through his immediate decisions on macroeconomic management, and through his shaping of financial sector reform over the next two or three years. What he says and does is what will matter much more for India than the shadings of the Sen-Bhagwati debate. He even has the potential to overcome the economic policy missteps of India’s politicians. Let us see what happens.