Thursday, January 22, 2015

Finance Commission and optimal currency areas

The Thirteenth Finance Commission's recommendations may have set the cat amongst the pigeons by sharply hiking the states share of the central taxes by ten percentage points from 32% to 42%. Coming on the back of the scrapping of the Planning Commission, this effectively means the end of many centrally sponsored schemes (CSS).

This is an undoubtedly welcome move in so far as it paves the way for more effective utilization of development spending. The increased transfers and cut backs in CSS will endow states with the resources and flexibility to design and implement state-specific sectoral programs. However, while the curtailment of the one-size-fits-all CSS programs is to be welcomed, a sharp and substantial erosion of the central government's fiscal space may be a matter of concern. In particular, the extent to which it will limit the central government's fiscal space for macroeconomic stabilization.

Consider the impact of the global financial crisis and the resultant recession. In the 2008-10 period, the central government indulged in additional fiscal spending, which helped mitigate the adverse effects of the global economic weakness and stabilize the Indian economy. This allowed state governments to tide over the crisis with their balance sheets in tact. In fact, even as the central government today faces a 4.1% fiscal deficit, the state governments have a consolidated fiscal surplus, and just three face deficits. It is a different matter that the resources could have been better spent on productive infrastructure creation than on populist subsidies.

Given that many Indian states are atleast as large as Eurozone countries, the responses of the respective governments to the great recession are instructive. In contrast to the central government in India, the European Commission has advocated sharp spending cuts and refrained from additional fiscal transfers to the worst affected peripheral economies. As the credit markets froze, peripheral economies struggled to raise resources, some even lost market access, and the human and economic costs of the absence of fiscal transfers has been substantial.

This is in keeping with the literature on Optimal Currency Areas (OCAs). A strong fiscal authority is an important ingredient in the success of any OCA. Apart from its role in macroeconomic stabilization when members (states in India or countries in Eurozone) have varying business cycles,   such fiscal transfers help stabilize the economy in times of more uniform economic weakness when members may lose market access or may struggle to raise resources for demand management policies. In fact, the availability of this fiscal cushion is critical to effective fiscal federalism. 

No comments: