The book titled “Indian Fiscal Federalism” co-authored by Y V Reddy and G R Reddy is written from a “practioner’s perspective”. The simplicity of this book is appealing, especially when the content of the book is about a very complex set of rules and games between the Centre and the States. I have identified a few “empirical questions” in the book. Let me confine my discussion to these empirical aspects.

 

One aspect that received less adequate recognition in the context of “what holds India together” is the role of Finance Commissions¹. The book rightly highlights the significance of the existing institutional mechanisms for providing “predictability in the federal fiscal relations” along with the smooth transition of political regimes through peaceful elections, State Re-organization mechanisms and the other institutions of economic management.  The book throws light into these aspects of “asymmetric” and “co-operative” federalism in India.  There was “continuity”. There was “change”. The effectiveness of such processes in creating “convergence” is an empirical question. Such empirical questions have gained significance globally. In Brooking Papers (2017)² there was a similar analysis of “economic convergence” about whether “Europe as a political project too ambitious?” They have found that there is a great extent of “economic convergence” within the European Union, despite widening cultural and institutional heterogeneities within an “economically integrated” Europe. However, the “cultural divergence” – “nationalism” – is the stumbling block. Such issues have started appearing even in the well-functioning federations like the US, with “protectionist” policies.

 

In India, has the “equality of processes” in fiscal federalism resulted in “equality of outcomes”? Has this goal of economic convergence been achieved, with poor States “catching up” in growth with the richer States in India? Existing empirical evidence is mixed³ . There is “convergence” in social sector outcomes, but there is no “economic convergence”. Further empirical research is required in this area, incorporating fiscal federal variables, especially ex-post to the phasing out of Planning Commission transfers which were designed to address such spatial inequalities. The book has effectively analysed the how the formation of States, economic convergence and the efficiency-equity principles have influenced the thought processes of Finance Commissions intertemporally. Do you think we have “empirically” answered all the questions pertaining to Indian fiscal federalism the book highlights? The answer is “No”. One of such crucial empirical questions is about the reliance of an economy on history. The book delves deep into the significance of history of Indian fiscal federalism in understanding the contemporary debates – and such analysis is rare in federalism literature in India. When global recession gripped the schools of thought in economics, the macroeconomists have started realizing the reliance of financial economics on history. However, we still do not understand very well the significance of the impact of this “hysteresis” in the evolution of fiscal federal design on macroeconomic stability, growth and development. 

 

There is a debate about the significance of conditional versus unconditional fiscal transfers. Some policy economists believed a quick rebound of economy to “global goals” and economic convergence through designing a plethora of “conditional transfers”, while some others  raise concerns over such transfers which are broadly of “one size fits all” design. They highlighted the lack of State capacity (and the subnational finance matching component) to implement such transfers and suggested “unconditionality” in fiscal transfers. The book highlights these questions and remain “stoic” about it, leaving a cue that researchers need to examine it empirically – scientifically – through the “progressivity” analysis of tax transfers versus grants. 

 

In the chapter on Public Debt, the book rightly recalls the extensive recourse to “seigniorage financing” – the automatic monetization – since 1957 by providing net RBI credit to the government to finance deficits, and the subsequent shift in the financing pattern from money-financing to bond-financing since 1990s, ex-post to the “economic reforms”. At the State level, the book further points out that “fiscal rules” determine State’s access to debt, subject to the approval of Central government. It is interesting to recall the changing perceptions on public debt in macroeconomic debates globally. The recent FRBM/rule-based fiscal policy in India stipulates 60 per cent threshold for public debt as part of fiscal consolidation.  An empirical question I could gather here is whether State’s access to public debt, though “not good”, can be “so bad”? Of course the answer is “it is context-specific”.  So what could be the plausible analytical frameworks to be considered when a Finance Commission take steps towards public debt management? This portion on “Public Debt” in the book has reminded me the Presidential Address⁴ by Oliver Blanchard in American Economic Association (AEA) meetings in Atlanta in January 2019 which I have attended. In his talk, he had put it upfront that “public debt has no fiscal costs if real rate of interest is not greater than real rate of growth of economy”. He also highlighted that high public debt is not catastrophic if “more debt” can be justified by clear benefits like public investment or “output gap” reduction. (Output gap is the difference between actual GDP and potential GDP). He also highlighted the “hysteresis effects” (the persistent impact of short-run fluctuations on the long-term potential output) and suggested that a temporary fiscal expansion during a contraction could even reduce debt on a longer horizon. 

 

There is an increasing recognition of the fact that public investment has suffered from fiscal consolidation across advanced and emerging economies⁵. This is particularly important, when public investment is one of the crucial determinants in strengthening private corporate investment in the context of emerging economies⁶. Blanchard mentioned that if we are worried about a “bad equilibrium”, it is better to have a “contingent fiscal rule” (which may not need to be used) rather than steady fiscal consolidation. Similarly, the book noted that “a uniform and rigid fiscal rule not only undermine the fiscal autonomy of the States, but would also result in “public (developmental) expenditure compression” to comply with numerical threshold ratio”. This is refreshing, especially in the context when the path towards fiscal consolidation is equally important as the debt target thresholds, because the fiscal consolidation through strengthening the tax buoyancy than public expenditure compression can be less detrimental to economic growth. However the “output gap” can be a difficult notion for Finance Commission. Extreme precaution is required when we measure “deficits”. It may be incorrect to think that “cyclical neutral fiscal deficit” instead of fiscal deficit, is what Finance Commissions need to focus. The empirical literature flags that we do not know whether “disruptions” or “downturns” permanently depress the level of output and employment or whether the economy can bounce back to its initial upward trend after a decline (the notion of “business cycle”). Gita Gopinath (Chief Economist, IMF) in her co-authored work⁷ flagged that in emerging economies, there could be a “drop” from the trend growth than a “deviation” from the trend and she calls it “cycle is the trend”. If empirical research proves that in Indian context “business cycle does not exist”, then Finance Commission using the cyclicality of deficits can be challenging. 

 

Here is why Finance Commissions so far have resisted from using such sophisticated notions of “cyclical” and “structural” deficits. Finance Commissions cannot incorrectly assume that an upturn in business cycle can eliminate the “cyclical” part of deficit, while such things cannot happen if there is no return of economic growth cycle to prior trend growth path and therefore the buoyancy of revenue receipts could remain below the prior-potential level⁸. 

 

The Chapter 8 in the book titled “The Detail Matters” provides us a rare empirical sense of projections and actuals of macro-fiscal variables used by the various Finance Commissions and an analysis of any significant deviation between the two or not. This chapter leads us to examine the “fiscal marksmanship” (the fiscal forecasting errors) of various Commissions. Technically, researchers can use this empirics provided in the book to analyse the magnitude of errors of macro-fiscal variables, and the source of errors of Finance Commission projections (whether it is a “random error” and beyond the control of fiscal forecaster, or whether the “errors are systemic and biased”). We can also analyse whether the magnitude of errors was higher for revenue or expenditure; and whether for capital budget or revenue budget.

 

The book has given importance to fiscal decentralisation (Chapter 9). When it comes to third tier, the real issue is “unfunded mandates”. To analyse this empirically, we need reliable data at the third tier. In India, general government data is a challenge. IMF Government Finance Statistics (GFS) gives cross-country data on general government. However, we need to build up the third tier fiscal data. The role of State Finance Commissions (SFCs) also need to be emphasized for their significance in providing steady flow of funds to the local self-governments. The SFC has a prominent role in making the devolution less “arbitrary” and less “ad hoc” at the third tier.

 

Revisiting Chapter 3, before I conclude, is relevant to analyse the composition of Finance Commissions. In chapter 3, the book talks about the “growing prominence of economists in the Commissions after the economic reforms”, quite contrary to the initial FCs’ composition of more lawyers to interpret Constitutional clauses on federalism. This takes me to an upcoming empirical literature on “career theories” of a leader, whether a leader’s traits influence the policy outcomes? For instance, in the context of Western Europe, an analysis was done to examine – this is a paper published in Public Choice⁹ - whether the “personal characteristics” (education, work experience, ideology/political affiliation) affect changes in public debt. In monetary-macro, we can ask this empirical question whether the personal characteristics of Central Bank Governor affects the policy rate decisions. Timothy Besley of London School also analysed the leadership effectiveness on policy outcomes. In fiscal federal literature, in future, such empirical questions may be asked by scholars, whether the personal characteristics of the Chairperson of Finance Commission influences the magnitude and criteria of tax transfers; and the debt-deficit dynamics at the subnational level.

 

Finally, I noted the absence of a cross-country backdrop on federalism experiences in the book. But I realize how different Indian fiscal federalism is from other country models. In other federations, intergovernmental fiscal transfers (IGFT) is predominantly “grants”, not “tax transfers”. So such “fiscal equalization models” may be of different relevance to India. 

 

This book is a must-read for the scholars who are interested in federalism, as it helps us to understand the nuances of federalism to “innovate” Finance Commissions better and to “explore” more empirical questions in fiscal federalism.

 

[[This was presented in the panel to the launching of book “Indian Fiscal Federalism” by Y V Reddy and G R Reddy, organized by ICRIER and Oxford University Press at India International Centre, New Delhi, March 28th 2019. The other panelists were Montek Singh Ahluwalia (former Planning Commission Vice Chairman), Bibek Debroy (Chairman, Prime Minister’s Economic Advisory Council) and Haseeb Drabu (former Finance Minister, Jammu and Kashmir). The video of the event can be accessed at http://youtu.be/5Kfiaw1At_4.The link to the book is here https://global.oup.com/academic/product/indian-fiscal-federalism-9780199493623?cc=in&lang=en&#]

 

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