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An insightful RBI report on state finances

LiveMint logoLiveMint 13-07-2017 Soumya Kanti Ghosh

In the midst of all the hullabaloo regarding the announcement of loan waiver in several states, I am surprised that not enough has been written on the Reserve Bank of India (RBI) report on state finances. This report is an annual publication of RBI which highlights the status of states’ fiscal health and weaves a topical issue into the narrative. Over the last few years, the quality of the report has ratcheted up significantly in terms of exposition, coverage and analysis.

The report essentially brings forth the issue of the “absence of fiscal marksmanship in states” and objectively discusses several issues, like the impact of UDAY (Ujwal DISCOM Assurance Yojana) on state finances, goods and services tax (GST), cooperative fiscal federalism, the issue of the revenue neutral rate and Central transfers. Let us take up these issues one by one.

Along with other aspects of the economy, the Indian taxation system has undergone significant reforms since 1991. With the introduction of GST from 1 July, the reform process has got a major push. The report makes a powerful argument in favour of GST by gleaning inferences from the experience of actual VAT (value-added tax) implementation in states earlier. The distilling of the inflation impact of VAT/GST introduction from the experience of other countries would be compulsory reading for policymakers deciding on whether GST rates should converge.

The most important aspect, however, is that the RBI report concludes that there can be no single optimal rate for taxing commodities. This is important as GST has sometimes been roundly criticized for its four-tier structure.

When it comes to the optimal rate of taxing commodities, there is a vast amount of literature offering solutions in the form of different principles. The pioneering work in this regard was done by F.P. Ramsey (1927), who came up with principles for optimal commodity taxation based on a number of assumptions. He said: “In raising an infinitesimal revenue by proportionate taxes on given commodities the taxes should be such as to diminish in the same proportion the production of each commodity taxed”, subject to certain conditions. This leads one to the inverse elasticity rule in which elastic goods are taxed less than inelastic goods. However, since the demand for necessities is more inelastic than the demand for luxuries, this rule is difficult to implement without grossly violating the principle of equity. Interestingly, Ramsey himself has a disclaimer at the beginning of the paper that he is not tackling the aspects of distribution while reaching for a solution for optimal taxation.

There is a lot of empirical literature on such optimal tax rates, particularly against them. For example, John T. Revesz (2014) points out through evidence that goods and services produced and marketed by large organizations are less evasion-prone than small businesses. Other goods with lower evasion propensities include products passing through border checkpoints. Hence, in view of widely differing evasion propensities, it is highly unlikely that uniform tax rates will lead to a less costly and more effective tax administration. In fact, in countries that face severe compliance problems, the optimal solution is likely to involve markedly differentiated tax rates based on purely administrative purposes. Additionally, almost all empirical-computational studies published so far yield non-uniform optimal tax rates.

Against this background, the GST council has devised a four-tier tax structure. In a country like India where there is high level of inequality and imperfect markets, this seems to be the best solution. Revenue generation may take a hit if, and only if, the assumption of an increased tax base is not fulfilled. However, given the experience of expansion in direct tax base after demonetization (an additional 9.1 million people filing returns) and the first-quarter tax collections in FY18, one can be confident that the multi-tier GST will be the Pareto-optimal solution going forward.

Another risk, of the spate of farm loan waivers being announced by states, which the report highlighted , is coming to fruition. After Uttar Pradesh, several states have now announced a complete waiver for farmers. Already in FY16 , according to revised estimates, the GFD/GDP (gross fiscal deficit to gross domestic product ratio) breached the threshold of 3% for the first time since FY05.

The report also objectively discusses the impact of the Ujwal DISCOM Assurance Yojana on state finances. As the issuer of state government bonds, the RBI is not in a position to endorse or criticize states, yet the data and guarded inferences in the report (if one is reading between the lines) provide ample thought for analysts and rating agencies to gauge the viability of state public finances.

The analysis on Central levies also shows that despite the increase in transfer of resources to states by 10 percentage points (from 32 to 42%), the actual transfers turn out to be much lower due to the shrinking of the divisible pool of resources.

To sum up, as a research document, the report makes a mark by introducing sophisticated state-of-the-art techniques such as stochastic frontier and panel co-integration techniques, which are usually used in research papers. On a lighter note, the market now hopes that the RBI will also give due importance to ratcheting up macro-forecasting (inflation, in particular) techniques within the organization.

Soumya Kanti Ghosh is group chief economic adviser, State Bank of India. Views are personal.

Shambhavi Sharma contributed to the piece.

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