Will Reddy follow the Raghuram Rajan lead?

The RBI Governor has,however,created a difficult choice for the Centre to solve.

In the run up to the elections,the recommendations made last week by the panel led by Raghuram Rajan on state finances is possibly the most important piece of financial news. The composite development index for states rewrites everything that has been held sacrosanct in Centre-state relations for the past few decades. All terms like Gadgil-Mukherjee formula,the concept of core plan,tied aid and of course special category states will now pass into history.

The Rajan index is an average of ten measures of under-development that ranks states and more important the efforts they are making to improve their performance,within the plan funds provided them. This is important for the states not only to draw Central plan allocation but also for their rating by the financial sector,since they borrow heavily from the markets now. It is about Rs 1,50,000 crore in FY13. Banks have till now rated states on an equal platform since their papers are stamped as statutory liquidity ratio SLR status.

But as the SLR requirements get clipped as Rajan has himself suggested,the ranks of the states will tell the banks the price they should now demand for those papers.

The RBI Governor has,however,created a difficult choice for the Centre to solve. In about a year the 14th Finance Commission under YV Reddy is expected to publish the results of a similar exercise. The Commission has a similar remit,viz on what basis should states get a share of the tax revenue pool. One part of the pool is assigned on the basis of share of tax receipts but the rest is assigned on a set of indicators which measure how far the states are located from the national mean on fiscal performance,poverty and pressure of population.

All of these figure in the Rajan index too. In addition it has also built an incentive structure for fiscal marksmanship,poverty reduction and others. At present it will cover 25 per cent of the allocation,but as his report says it has room for expansion. The better performing states will support the expansion as it will benefit them.

Should the Finance Commission then come up with an alternative formula that ranks states separately,the Centre will find it impossible to argue how the two can co-exist. A state doing better on the Rajan index will be surprised if the Reddy index penalises it. Also do remember,the 14th Finance Commission will partially decide how compensation will be paid under the Goods and Services Tax to states so they will be watching its award even more carefully. Again,one of the basis of Rajan index is per capita monthly consumption; what if the Reddy formula uses the alternative per capita income? Does it make sense now for the governments to instead move towards one overriding index for allocation of funds?

Subhomoy is a Deputy Editor based in New Delhi.

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