Yesterday, I attended the fourth Ambirajan Memorial Lecture held at the IMAGE auditorium, MRC Nagar, Chennai, organised under the auspices of the Public Expenditure Round Table (PERT), a Chennai-based think tank on public finance issues and the Institute of Economic Education (Chennai). The speaker was Dr. Raja Chelliah, the noted economist and founder chariman of the Madras School of Economics, and the topic of the lecture was The malady of continuing fiscal imbalance: The impossible quadrangle. The full transcript of the lecture (pdf) is available online.
The substance of Dr. Chelliah's speech (excerpted from the transcript) was as follows:
The root causes of the endemic fiscal crisis, especially at the level of the states, (which then affects the central fisc) are to be found in the simultaneous pursuit of fiscal objectives and policies which are in themselves incompatible.
Macroeconomists speak of the "Impossible Trinity" in the area of monetary-external sector policy. They argue convincingly that the policy of fixed exchange rate, full capital account convertibility and freedom to follow monetary and fiscal policies required by domestic circumstances cannot all be pursued simultaneously. They are incompatible and one of them will have to give way.
In India, under the auspices of the central government, four major policies affecting the government finances are being pursued which are incompatible. These are:
- adoption of the "gap-filling approach" by the Finance Commissions,
- the policy of the Planning Commission of extending loan "assistance" to the states according to a set of entitlement formulae with no reference to borrowing or repayment capacity or the existing level of public debt - the same criteria are used for the distribution of loans as for the distribution of grants,
- the policy of pay revision of government servants through the appointment of pay commissions periodically and the adoption of the same recommended revisions by the central government and by all the state governments, regardless of the size of the government labour force in different states, the capacity to pay of the governments of the different states, their per capita incomes and the general level of salaries in those states, and
- the pursuit of the objective of achieving fiscal health through getting the governments to maintain reasonably low levels of fiscal deficit, through responsible fiscal policies, that is, each government assuming responsibility for balancing its budget.
The last-mentioned is a basic objective of the central government's macroeconomic policy. However, the other three policies generate trends that make it impossible to achieve, in the medium or long-term, a state of fiscal balance. This incompatibility may be christened "the Impossible Quadrangle". The incompatibility basically arises from the fact that the policies relating to central transfers and loans to the states generate wrong incentives and violate economic considerations while the policies relating to the recruitment of government servants and their pay revisions do not take into account incentives, economic considerations or capacity to bear higher tax burden. The tendencies and impulses generated by the policies in the first three areas militate against the objective of attaining and maintaining fiscal balance. The planning mode applied to public financial activities proceeds on the basis that finances can be managed without reference to incentives, financial capacity of sub-national governments or fiscal discipline (essentially meaning that the governmental authority undertaking an increase in public expenditure on its own volition must pay for it). Fiscal responsibility cannot be planned from above; such conditions and rules must be created that fiscal responsibility will be practised in a federation in which the sub-national governments / states have a good deal of autonomy.
The impact of "the gap filling approach" on a state government is graphically described by Dr. D.K. Srivastava (a member of the 12th Finance commission) in the following words: "Borrow to spend in the current period. Accumulate interest liabilities. Show a record of higher expenditure. Get transfers to cover this historically attained level of expenditure. Also get transfers to meet additional interest liabilities which become a committed liability. Now borrow again. Also ask for relief on past debt liability."
Dr. Chelliah, proposed a new approach to address the problem.
Certain basic policy decisions will have to be taken.
- First, the states should be treated as autonomous units and they should be allowed to determine for themselves levels of revenues and expenditure. They will have the primary responsibility to maintain fiscal balance in their respective jurisdictions.
- Second, the percentage share of central taxes going to the states must remain constant for at least 15 years.
- Third, block grants should be aimed at making up deficiency in fiscal capacity. "Need" must be defined as deficiency in fiscal capacity. Cost disadvantages could also be compensated. The proportion of block grants to devolution could rise.
- Fourth, the distinction between plan and non-plan expenditure should be done away with, at least as far as revenue expenditure is concerned. The Planning Commission should deal with only capital expenditure.
- Fifth, while loans could be extended to states by the centre to a limited extent, states should be required to borrow from the market within the limits set by the centre . The centre could subside a small part of the interest (to differing extent) in respect of states that have less than average taxable capacity. Concurrently, in the place of plan loans, some capital grant assistance should be given with higher per capita amounts for the states with lower capacity. Collections of small savings should go into a fund as of now, and the states should negotiate loans (within the cap) with the fund, the lending rate of interest being determined by the borrowing rate and the credit worthiness of the states concerned.
When this new approach is adopted, it may be necessary to write-off 50 per cent of the debt which the states are now holding in order to enable the states to cope with the new situation (only that part of the debt which consists of central loans and market borrowing). But this will be on the understanding that there will be no more debt relief. With this new approach, our federal fiscal policy would become more rational, equitable and efficient and fiscal balance will be gradually restored.
Prof. S. Ambirajan, an economist, taught at the Indian Institute of Techonology (Chennai) for many years and was later honorary proferssor at the Madras School of Economics in Chennai. He passed away on February 04, 2001.
Here is a list of other speeches that I have attended or come across (along with a brief summary and/or a transcript of the speech).