India Transformed

by Rakesh Mohan

  What is not clear is whether business brings new data and ideas to such a dialogue, and whether business uses such valuable opportunities to ‘whine’ about problems and constraints rather than talk of future strategy. Business needs to add value, which means data, analysis and ideas. These would enhance their position in connecting to the government, which, in turn, would respect such value addition. Research backup for business to make a difference is critical.

  The expectation of the prime minister from such a dialogue is also unclear. Is it a ‘listening brief’? Is it a two-way dialogue? Is it to communicate clear messages to business in terms of expectations of the government? Or a mix of all of these?

  Business has supported mega events of the government, relating to ‘Make in India’ and other initiatives. Make in India, Swachh Bharat (Clean India), Smart Cities, Skills Mission are some major missions of the current government, and business is associated with all of these. But the quality and depth of business involvement is unclear. These seem to be essentially government-led. Individual, selected CEOs have travelled with Modi to certain countries where CEO forum meetings have been held. It is known that the prime minister has also made time on some of his overseas visits to interact with the Indian Business Delegation.

  There has been a change in the psychology of business leaders. Many corporates have become giants. They want to interact with the prime minister because they see him as powerful and decisive. Big businesses have big egos, more than ever before. So, the consultation process appears to be essentially with the finance minister who is, of course, very important. Sadly, it is less so with the commerce and industry minister and least of all with the prime minister, though his principal secretary and other PMO officials are engaged with business. In the 1990s, business leaders were comfortable working with even mid-level officials. Currently, the focus seems to be on ministerial-level engagement. One reason could be the frequent transfer of officials.

  Perhaps the government has yet to settle into a ‘trust’-based relationship, a ‘partnership’ with business as distinct from an ‘event’-based engagement where the industry is the organizer and implementer under the direction of the government. Time will tell. However, clearly, murmurs of disappointment have been emerging from business about the lack of deep engagement with the prime minister and some of his ministers. Perhaps expectations of business were excessive in 2014 and, in retrospect, it needs to be remembered that PM Narasimha Rao, PM Atal Bihari Vajpayee and PM Manmohan Singh all interacted with industry and business infrequently. There was no rationale to expect differently from PM Modi.

  At one level, with deregulation and a steadily opening economy, the role of the private sector has increased in the national economy. On the other hand, distance between the government and business remains. It does not appear to be ‘India Inc.’ at work, unfortunately; it needs to be so, based on clearly understood guidelines and boundaries, mutually accepted and followed. Bringing the government and business together in a transparent, non-crony team is the way forward. India has yet to achieve this.

  One of the challenges for business has always been the sensitivity of the government to public (as distinct from private) criticism or difference of opinion. Often, business is ‘pulled up’ for media reports of criticism of government policies and procedures. Sometimes, the ‘cold shoulder’ treatment is meted out by way of ‘non-response’ and avoidance of meetings and contacts. Ministers have been known to cancel, last minute, engagements and meetings with business to show displeasure. At other times, calls are received by business to bring out advertisements or press statements supporting the government. These are done but with reluctance and resentment.

  In the past, the government has had ministers and officials who would take swipes at business at public events because these made media headlines. It lead to business withdrawing from dialogue, drawing into a shell and quietly resenting the criticism.

  Business too has a constituency that pushes for publicly expressed critical statements. This has always been a ‘no-win’ game. It actually sets the government–business relationship back in time and then it takes time to rebuild and renew dialogue and trust.

  All of this is immature, unnecessary and unwise. Government and business need each other to strengthen the national economy and the economic growth process in the country. They are two sides of the same coin. Both need each other. To remember this fact of life and stick to dialogue, irrespective of media pressure and the short-term attractiveness of media headlines, is the real need.

  The best strategy, learnt over many years of experience of dealing with different governments, is to engage in quiet dialogue. Away from media attention—private, informal, frank, but not offensive. This ensures that solutions are achieved, egos are not bruised and confrontation is avoided. Public positions are not adopted. Time and again, quiet dialogue has led to a consensus being worked out to mutual satisfaction. What is important is to set up a system and structure, to not be ad hoc.

  Unfortunately, private, quiet dialogue is often seen, by those not in the room, as mysterious and sinister, implying that deals are being done without taking into account all views. To make dialogue work, it has to include a group of persons from both sides. It cannot be a one-to-one exercise.

  This is particularly so because the societal image of business is generally unfavourable and negative. Barring rare exceptions, business is perceived as selfish and self-centred, driven by profit and material gains, short-term in targets, adding to inequality by a huge disparity in emoluments between CEOs and employees, avoiding taxes, not treating labor right, not being generous in contributing through finance and effort to deal with crucial national challenges such as education, healthcare, skills development, sports, and so on. As a result, these negative images impact the government’s willingness to engage deeply and fully. Often, the government is necessarily selective in collaborative efforts based on the level of trust.

  At the same time, there is growing recognition in the government that it needs this partnership. It is for business leadership to earn trust on a sustained basis through self-regulation and self-discipline, through the right actions, not just words. This is a huge challenge for business and its leadership—to introspect and review its own actions and policies and turn a new leaf.

  If business is able to respond positively to Manmohan Singh’s ten-point charter, which is not difficult, then a new alignment will emerge—of business, government and society in step, together.

  In society, in the economy, business is the most capable resource in terms of education, knowledge, leadership, management skills, wealth, standards of living, etc. Business needs to put the nation and society first and itself last. This will, then, help to build trust in business and the ‘colours’ of government–business relations will take on the happy, cheerful colours of the ‘rainbow’. Unfortunately, as of now, there is still some distance to cover to reach that stage.

  12

  Union–State Relations and Reforms1

  Y. Venugopal Reddy

  The practice of fiscal federalism in India has been commendable over a long-term perspective in view of the severe challenges posed since independence. Greater role of states in the pursuit of decentralized development should not undermine the role the Union government has to play in maintaining macroeconomic stability.

  The paper is an analytical account of Union–state relations, with a main focus on the reforms since 1991. Macro-fiscal stabilization in a multilevel fiscal system is not easy, especially when the subnational deficit is high. Deficit management challenges in the multilevel fiscal system of India have given shape to the Union–state fiscal relations post 1991 in a major way. The paper postulates that the practice of fiscal federalism in India has been commendable over a long-term perspective in view of the severe challenges posed since Independence. Due to the severe macro-fiscal imbalances that existed then, an important element of the reforms undertaken in 1991 has been a correction of fiscal imbal
ances of both the Union government and state governments. A study of the path of fiscal adjustment since then shows that reduction in fiscal imbalances has almost continuously fallen short of goals set regarding the central government, and an asymmetric fiscal-adjustment burden has fallen on the states. In particular, correction of imbalances at the state level was impressive in the second half of the period of reform, but the fiscal space vacated by them was often occupied by the Union. The contrast in their performances is striking with regard to revenue deficit, with the Union failing to eliminate it in each of the years of reform.

  The paper explains that the era of rule-based fiscal control initiated in the second half of the reform period provides explanations for this asymmetry. The fiscal rules, imposed by the Union on itself, were changed frequently to accommodate the pressures. However, the states had less headroom to be flexible due to the role of the Union in ensuring fiscal discipline by the states through a well-defined structure of incentive-compatible deficit reduction proposed by the Twelfth and Thirteenth Finance Commissions. In other words, the Union used the instrumentality of the Finance Commissions to bring about changes in the transfer system and promote observance of fiscal rules among the states.

  The other important aspect of reform is changes in the nature of intergovernmental fiscal relations outside the ambit of the Finance Commission post-1991. Due to the proliferation of big-ticket centrally sponsored schemes (CSS), the intergovernmental transfers outside the purview of Finance Commissions, i.e., under the Plan mechanism, increased to an unprecedented extent since reforms commenced. This in turn resulted in a sharp decline in the share of central assistance to state plans, which was formula-based, resulting in substantial reduction in fiscal autonomy at the state level. Although reforms over the years improved the revenues of the general government as a share of GDP, relative shares of the Union and the states remained unchanged. Moreover, due to the proliferation of conditional transfers through CSS, the fiscal policy space available to the states shrank during the reform period. The changes in the transfer system, the recommendations by the Fourteenth Finance Commission, and the replacement of Planning Commission with NITI Aayog need to be seen in this context.

  Reforms were not confined to just the transfer system in taxation—neither at the central nor at the state level. Significant tax reforms were undertaken both by the Union and the states, especially with regard to the levy of service tax by the Union and value added tax (VAT) by the states. The elimination of on-lending to states by the central government is also significant. Reforms in the power sector represent a complex arrangement between Union and state governments, involving central– as well as state–public enterprises. They encompass conditionality and, hence, quasi-fiscal operations of large magnitudes with significant fiscal impact.

  The paper invites attention to some recent developments that indicate a new trend in Union–state relations. It suggests that for the first time since 2015, India is at a crucial moment of redefining these relations. The paper concludes with the detailing of the unfinished agenda for rebalancing of Union–state relations after launching NITI Aayog, the new dynamic that is in the offing in the form of the Goods and Services Tax Council, which will impact both vertical and horizontal balances. The paper urges a new agenda for reform, which combines decentralization with deregulation.

  Record of Fiscal Federalism

  The record of the practice of fiscal federalism in India must be viewed in constitutional and political contexts, in terms of economic management, including the external sector, while considering intergovernmental fiscal arrangements.

  First, India had to simultaneously design the units that would constitute the new federation while setting in motion the processes to form the ‘Union’. That unprecedented task has been performed well. It is remarkable that national integration in India has been facilitated by the Union, which recognized and accepted diversity as it emerged and asserted from time to time. This is reflected in the process of reorganization of the states since 1956, if not 1953, when Andhra Pradesh was formed on a linguistic basis.

  Second, with regard to the political context, India can boast of peaceful change of political regimes in a regular and systematic manner. Credit for that goes as much to the states as to the Union. All elections, to Parliament as well as state legislature, are conducted wholly by the bureaucracy belonging to different states under the aegis of the Central Election Commission. The Union government has no administrative machinery of its own to conduct such operations, and the Election Commission operates through state governments.

  Third, in terms of economic management, many, if not all, states have improved their capabilities to plan, allocate resources, and implement policies and programmes. The gap between expertise at Union level and state level in many cases has narrowed in recent years for several reasons, especially technological development and globalization. In fact, many states legitimately claim that almost all flagship schemes of the Union government in recent years were, in fact, initiated at the state level. They were initially viewed with disfavour by the Union government. But in recent years, the debate has not been between the Mahalanobis Brahmananda models, but between the Tamil Nadu, Bihar and Gujarat models.

  Fourth, as per the Constitution, the borrowing programme of a state must be approved by the Union as long as it owes debt to the Union. This enables exercise of restraint on borrowings by states. The Union has exercised its powers responsibly, despite some complaints. The Reserve Bank of India (RBI) is the debt manager for both the Union and the states. The involvement of RBI provides a degree of comfort to the financial markets.

  Fifth, constitutional provisions prohibit external borrowings by states. This ensures that problems in the external sector do not arise on account of the states’ incurring external liabilities beyond sustainable levels. Many other developing countries have faced problems on this account.

  Sixth, in terms of arrangements for fiscal transfers to subnational governments, the basic structure of fiscal federalism was drawn from the Government of India Act, 1935. It will be appropriate to compare the Indian experience with other federations among emerging economies, such as South Africa, China, Brazil and Indonesia. The arrangements for transfer in most of these countries provide a far greater discretion to the federal government than in India. The primary mode of transfers in these countries is grants from the higher to lower levels of government, and such transfers are often discretionary. These countries do not have a constitutional provision for sharing of national-level taxes, unlike in the case of India and Pakistan. In India, the arrangements for transfers to local bodies have undergone changes in recent years, but arrangements for Union–state transfers remain the same.

  In our Constitution, the Finance Commission was devised as a mechanism for providing predictability in the fiscal federal relations for five years. Generally, flexibility to review and revise the relations was available only every five years. The Planning Commission was an innovation of the Union government. It not only had expertise but its functioning also allowed for flexibility to accommodate fiscal needs arising out of sociopolitical developments from time to time. This has since been replaced by NITI Aayog, effective from 1 January 2015. This measure, along with the acceptance of recommendations of the Fourteenth Finance Commission, represents a new setting for fiscal federalism. Since 1991, Union–state fiscal relations were incidental to reforms at the national level, while the new setting since 2005 represents reforms in fiscal federalism.

  The Path of Fiscal Adjustment

  Large fiscal imbalances resulted in a major macroeconomic crisis in 1991, which warranted structural adjustment to focus initially on fiscal deficit reduction of the central government. A major tax reform was also initiated to simplify the tax system and to reduce progressively both the direct and indirect tax rates at the Union level. The move towards convergence of excise duty structure and sharp reduction in customs duty resulted in significant reduction in tax to GDP ratio of
the Union government. As macroeconomic stabilization required reduction in fiscal deficit, the entire burden of fiscal adjustment fell on the expenditure side of the budget resulting in decline in capital expenditure to GDP ratio sharply at the Union level. During this period, no major initiative was undertaken at the state level to reduce the fiscal deficit. In fact, managing burgeoning fiscal deficits at the state level became a major challenge. Thus, the combined deficit remained high despite reduction in fiscal deficit at the Union level. During this period, some states signed memoranda of understanding with the Ministry of Finance of the Government of India (GoI) with a commitment to improve their fiscal positions through sectoral reform, especially in the power sector. But there was no broad-based fiscal reform at the state level during this period. The fiscal situation of the states further deteriorated due to the implementation of the award of the Fifth Pay Commission during the second half of 1990s. During this period, multilateral lending institutions such as Asian Development Bank and World Bank, through structural adjustment loans to the states, introduced fiscal reforms in some states.

  The situation started changing from 2000–01. There was a consistent decline in the level of deficits at both levels of government up to 2007–08. The North Atlantic financial crisis (NAFC) and consequent fiscal expansion increased the level of fiscal deficits, particularly at the central level, after 2007–08.2

  Gross fiscal deficit (GFD) of the Union as a percentage of GDP increased from 2.5 per cent in 2007–08 to 6 per cent in 2008–09 and 6.5 per cent in 2009–10. Correspondingly, revenue deficit of the Union increased from 1.1 to 4.5 per cent and 5.2 per cent in the same period. The fiscal stimulus was almost entirely on revenue account. The fiscal deficit of the Union continued to be above 4 per cent till 2014–15, and has remained close to 4 per cent since then. GFD of the states, however, remained in the range of 1.5 per cent to 2.9 per cent from 2007–08 till 2014–15. In 2015–16, it is estimated to be 3.3 per cent; revenue account was in marginal surplus or deficit during the period. These differences in the path of reforms in fiscal management at central and state levels can be explained in terms of the manner in which rule-based fiscal control operates asymmetrically between the Union and the states.3