Implementation of Rajan panel's report on states will be suicidal for UPA

ByParanjoy Guha Thakurta

Opposition to the recommendations of the committee for “evolving a composite development index of states”, better known as the Raghuram Rajan committee, is mounting by the day. Not only is it being argued that the recommendations were tailored to suit the requirement of one state, Bihar, and its chief minister Nitish Kumar, independent economists maintain that if the government accepts the committee’s suggestions, it would exacerbate regional inequalities and could lead to widespread unrest in regions like the north-eastern part of India.

What is worse, the committee’s critics argue, is that its recommendations go against the federal spirit of the country’s Constitution, penalise states that perform well and could create more problems than resolving them. In short, the committee’s recommendations need to be junked.

On 26 September, Finance Minister Palaniappan Chidambaram stated that the Rajan committee had come up with a multi-dimensional index and made two important recommendations, the first of which was that a basic allocation of 0.3 percent of overall central funds would go to each state. The second important suggestion was that states that score 0.6 and above according to the index would henceforth be categorised as “least developed states”.

[caption id=“attachment_1199267” align=“alignleft” width=“380”] The Rajan committee has not addressed the issue of the second kind of transfer, the horizontal transfer of funds across states. PTI[/caption]

Chidambaram added that these two recommendations, along with the new allocation methodology proposed, would effectively subsume what are now described as “special category” states, as per the committee’s report which was submitted to the Ministry of Finance on 2 September after seven meetings.

According to the committee’s classification, the 10 “least developed” states identified are Arunachal Pradesh, Assam, Bihar, Chhattisgarh, Jharkhand, Madhya Pradesh, Meghalaya, Odisha, Rajasthan and Uttar Pradesh.

The Finance Minister said the Prime Minister had “directed” that the recommendations of the committee be “examined” and “necessary action” be taken.

The preface to the 58-page report points out that the “level of development of a state is likely to be the consequence of a complex set of historical, cultural, and sociological factors”. “An explicit government objective was to have a more egalitarian society, coupled with balanced development of different regions. Despite taking a number of steps to reduce the regional disparities, substantial differences in development still exist between states.”

In order to address this issue, in May 2013, the government constituted an expert committee headed by Dr Raghuram G. Rajan, who was then the Chief Economic Adviser to the government of India in the Finance Ministry (and is now the Governor of the Reserve Bank of India), “to consider backwardness of the states for evolving a composite development index…”

The members of the committee included Dr Shaibal Gupta, a social scientist based in Patna, who presented a sharp note of dissent to the committee’s report despite being perceived by some to be close to the Bihar chief minister.Other members were Dr Niraja Gopal Jayal, professor at the Centre for the Study of Law and Governance at Jawaharlal Nehru University, Dr Bharat Ramswami, professor of economics at the Indian Statistical Institute and Tuhin Pandey, a 1987 batch officer of the Indian Administrative Service belonging to the Orissa cadre who is with the Planning Commission. (After he took over as Lieutenant Governor of Delhi, former vice chancellor of Jamia Millia Islamia, Najeeb Jung ceased being a member of the committee.)

Given the eminence of the members of the committee, many are surprised at the highly contentious nature of the panel’s recommendations.

The terms of reference of the committee were:

(a) to suggest methods for identifying backward states on the basis of measures such as the distance of the state from the national average on a variety of criteria such as per capita income and other indicators of human development;

(b) to suggest any other method or criteria to determine the backwardness of states;

(c) to suggest the weightage to be given to each criterion;

(d) to recommend how the suggested criteria may be reflected in future planning and devolution of funds from the central government to the states; and

(e) to suggest ways in which the absorptive capacity of states for funds and their ability to use the funds to improve well-being can be assessed and used to influence devolution to incentivise performance.

One of the most articulate critics of the Rajan committee’s recommendations is Dr R. Ramakumar, associate professor at the Tata Institute of Social Sciences, Mumbai, who is an economist by training having completed his PhD from the Indian Statistical Institute, Kolkata. Here are excerpts from a conversation he had with Paranjoy Guha Thakurta.

Q: What according to you are the main limitations of the Raghuram Rajan committee report?

Let us first understand that the appointment of the committee was itself a political decision. It had to do with the demand of the Bihar government led by Chief Minister Nitish Kumar to give the state a ‘special category’ status. On 11 May, Chidambaram went to Patna where he stated that in order to study the backwardness of Bihar and to prepare a comprehensive index of economic backwardness, an expert committee will be appointed. He also said on that occasion that whatever criteria the committee adopted, he was sure that Bihar would become eligible for a special status. This is the political background.

The Raghuram Rajan committee has given a report which uses a set of indicators and develops a composite index for the backwardness of states which is a multi-dimensional index, which is also called a underdevelopment index. The committee classifies the states of India into three categories based on this index, ’least developed’, ’less developed’ and ‘relatively developed’. What the committee has done is to first allocate a share of 0.3 percent of the total funds available for the states to all states. Over and above 0.3 percent, what will be allocated to states will be determined by two indicators. The first is the current status with respect to the underdevelopment index. And secondly, the performance with respect to the underdevelopment index.

These two indicators will determine what a particular state will get over and above the 0.3 percent. Now, 0.3 percent multiplied by the 28 states in the country gives 8.4 percent of total funds. That is the fixed allocation for all states. The remaining funds will be determined by the formula. Now, this composite index developed by the Rajan Committee, if you look at it statistically, there is nothing in it which makes it superior to another composite index.

A composite index is nothing but bringing together a large number of variables, in this case ten variables. So if the index is very poor in terms of one variable, it can catch up in terms of other variables and the composite index at the end can be completely different.

I wish to make three points. First, the composite index is deeply sensitive to the choice and number of variables. What variables you choose and how many variables you choose will have an impact on what the index will ultimately be.

Second, the index is also deeply sensitive to the way the variables are defined. For instance, suppose you want to have an index on education. Now, whether you choose the literacy rate or the enrolment rate or the dropout rate will determine the index. You can argue that all three rates are important. But the choice of one over the other will completely change the index.

The third point is that a composite index is also sensitive to the weights given to each variable. A composite index typically gives equal weight to all variables. But, in order to define the underdevelopment index, you may still want to give particular weightage to particular indicators.

Q: In this case, all indicators have been given equal weightage.

But in this case, for instance, you have one indicator which is the number of households with a bank account which has been given an equal weight to the infant mortality rate.

Let us deal with each of these criteria one at a time. On October 8, in a letter to Finance Minister Chidambaram, Bihar Chief Minister Nitish Kumar said the proportional share between the centre and the state in centrally sponsored schemes should be changed for the ’least developed’ states like the one existing for ‘special category’ states at present. As per existing norms, special category states at present pay only 10 per cent share in the centrally sponsored schemes and the remaining 90 per cent is borne by the Union government. Also, the funds under the schemes do not lapse in the case of special category states.

Q: Nitish Kumar also asked the Finance Minister to allocate additional gross budgetary support to the Planning Commission for accommodating the financial requirement. He also sought the evolution of a fiscal regime of tax breaks and concessions for incentivizing private investments in the least developed states on the lines of the treatment currently given to special category states. And the CM, who has made a strong case for according special category status for Bihar, said it should be done within the next six weeks.

Despite that, Nitish Kumar said that he had doubts about the choice of variables and he has been consistent about this. From Day One, he has been saying that the criterion should have been per capita income instead of per capita consumption. While he has welcomed the report, he has also said that it would have been more rational and appropriate if per capita income, per capita consumption of electricity and the credit-deposit ratio had been included as variables while evolving a composite development index.

I would also like to add some of the points that have been made by Dr. Shaibal Gupta in his dissent note. He says that merely because you have the data on per capita monthly expenditure, you should not use it because it is not good enough. You should use the income indicator like per capita gross state domestic product (or per capita income).

Gupta argues that using monthly expenditure overestimates the well-being of the poorest states (like Bihar) and underestimates the well-being of the richest states (like Gujarat). That is primarily because an income indicator would also account for savings, which expenditure does not. So Orissa, which is the most backward state in India according to Rajan’s estimates, actually has twice the per capita income of Bihar. In per capita income terms, Orissa is far richer than Uttar Pradesh, Jharkhand and Assam among others.

There is a significant churn in the rankings, even in the bottom one-third of the least developed states, if per capita income is used as a primary indicator.

I have two sets of questions for you now. One is relating to the use of per capita income rather than per capita expenditure and the second is Nitish Kumar’s demand for changing the way of allocation of funds for the centrally sponsored schemes.

This is essentially the point I made earlier. It is very difficult to arrive at a widely acceptable set of indicators to create a composite development index. The use of consumption expenditure and the use of per capita income may have its merits and demerits. Per capita income and population are being used to define the different formulas that are available to decide the allocation to different states.

It might be true that per capita income might have certain superior features as compared to per capita consumption expenditure figure. But I don’t think that would change the numbers drastically. Bihar is still the second-most underdeveloped state in India after Odisha even after per capita consumption expenditure is used. So, I don’t think Nitish Kumar has much to complain about the choice of variables that the Raghuram Rajan committee has adopted. I don’t think that is quite the significant issue here.

I think the point that is important here is that any composite index is deeply sensitive to even small changes in the way variables are defined. So even small changes can actually lead to significant changes in the index and that is not something that is superior in one choice as compared to another. You can see that one index is slightly better but you cannot say that it is scientifically superior. Remember that in India, per capital income is largely calculated on the basis of date for per capita state domestic product. In India, household data on income is unavailable. So in that sense, per capita income is not quite equivalent to household per capita income.

Q: And the figures on expenditures are based on data from the National Sample Survey Organization…

I can actually turn the argument around and tell you that the per capita consumption expenditure data of the NSSO which is collected from households can be much more reliable than the per capita income figures, the use of which some are advocating.

[caption id=“attachment_1222939” align=“alignleft” width=“399”] Dr R. Ramakumar, associate professor at the Tata Institute of Social Sciences, Mumbai,[/caption]

Q: The state domestic product figures are calculated by the Central Statistical Office…

Each indicator has its merits and demerits. There is nothing inherently superior in one choice of variables as compared to another choice of variables. Both can be equally justified. That’s the problem with the composite index itself. I am not saying that there should not be a composite index. What I am saying is that there is nothing superior in the Raghuram Rajan committee’s index in comparison with any other index.

Q: My next point that logically follows is that Dr Shaibal Gupta has been particularly critical of variable number seven or the percentage of the population of scheduled caste/scheduled tribes in the total population and variable number nine which is financial inclusion. As far as the SC/ST population is concerned, Dr Gupta argues that this is not an ‘outcome’ variable like others and is in any case adequately captured in the remaining variables. He also argues that since other variables which also indicated ’non-outcome’ disadvantages faced by states, like left-wing extremism and proneness to floods, were not included, there was no reason to include the percentage of SCs/STs in the total population as a variable.

On financial inclusion, he opposed the committee’s choice of using ‘household banking facility’ as an exclusive indicator which is already incorporated under variable four which is ‘household amenities’. Dr Gupta says that the index should have incorporated different variables like credit per capita and credit-deposit ratio. What is your opinion?

I largely agree with the point that once you have an under development index, you cannot automatically choose a non-outcome variable in the composite index that you are trying to calculate. But I would like to make a larger point. Many of the variables that have been chosen to create this composite index are highly correlated with each other. For example, you are calculating the per capita consumption expenditure and you are also calculating the poverty rate. When you compute poverty, you use the per capita consumption index itself. So, these two are highly correlated with each other. Indeed, these two are highly correlated with each other if you look at one of the tables in the report itself. So there is double counting, as some economists are saying, in computing the per capita consumption expenditure and the poverty rate in the same composite index. The general point is that if many of the variables that have been chosen to create this composite index are highly correlated, this is bound to have an impact on the results that you will get using the final composite index.

Q: Dr Gupta also questions the credentials of the committee headed by Dr Rajan, a quantitative economist, which has given equal weightage to all ten variables in the construction of the index. He says that the majority of the members on the committee said that it made life simple for them. Or was it because this was a simple way of doing it?

Dr Gupta says that if you need an index which is accurate, it need not be simple. It has to be complex, it has to be nuanced. For instance, he wonders why the percentage of SC/ST population in a state should have the same weightage as female literacy? Why should per capita expenditure not have a greater weightage than household amenities given that household amenities would follow from per capita expenditure? According to him, this whole notion of equal weightage of disparate variables makes no sense at all.

That’s what I have also been saying about the weightage system. How you decide the weights has a serious bearing on the index itself. For me, the argument of convenience in terms of incorporating the index does not in any way justify ignoring the more serious aspects of backwardness in each state. I think variables like infant mortality rate and literacy rate are much more fundamental to people’s livelihoods and the requirements of states for central funds instead of variables like household bank accounts. By giving them equal weights to create a composite index seriously compromises the ability of states to attack the most important aspects of backwardness in people’s lives.

Q: The Congress led UDF government in Kerala has asked Prime Minister Manmohan Singh to reject the Raghuram Rajan panel report evolving a new formula for devolution of funds to states. In a letter to Dr Singh, Kerala Chief Minister Oommen Chandy urged the Centre not to accept the recommendations of the panel holding that the ’new method would be totally against the provisions of the constitution and the concept of fiscal federalism’.

He says that in order to make a case for ending ‘special category’ criteria to provide additional assistance to poorer states, the committee ranks Goa and Kerala as the most advanced states and Odisha and Bihar the least advanced. The Kerala CM says that this multi dimensional index ‘would be totally against the provisions of the Constitution, the concept of fiscal federalism and the existing scheme of devolution of development funds by the Planning Commission’.

He feels the methodology adopted by the committee is ‘seriously flawed’ as it does not include major economic factors. Chandy pointed out that the committee had consulted states and other stakeholders. Expressing serious concern over the recommendations, he also pointed out that the report has been prepared on a very short time of four months. According to him, distribution of resources as recommended by the panel would only help to ‘aggravate existing imbalances’. This is the view of a Congress chief minister. What are your reactions?

It’s not just Oomen Chandy of Kerala who should have reasons to complain but also Prithviraj Chavan of Maharashtra. The share of central funds to his state would come down considerably if the committee’s recommendations are accepted. The Maharashtra chief minister has not responded to the committee’s report but I think many Congress governments are likely to respond. I would like to mention that chief ministers like J. Jayalalitha of Tamil Nadu…

Let me read out Jayalalitha’s statement. She says: “The background to the constitution of the committee was the repeated demand of the government of Bihar to confer special category status on it to enable greater fund flow to the state to address its developmental deficit.”

She added: “The completely skewed allocation formula which the committee has recommended severely penalizes states which have consistently worked towards national goals of development and welfare. It pushes resource allocation to populous states which have historically underperformed.”

The Tamil Nadu CM has alleged that this “is a thinly disguised attempt to provide an intellectual justification to deliver resources to a potential political ally”. She said that smaller states, regardless of their status of development, were protected because of the fixed 0.3 percent share recommended for all states, regardless of their size. Then she says that this report is also an attempt at meeting the “political objective of the mentor of the report”.

She says that states that suffer most in the proposed formula were the relatively large ones which over the last several decades had consistently performed well due to their own efforts. She felt that this is “regressive, unfair and (a) completely perverse outcome”. The bulk of transfer of funds from the Centre to states needs to take place based on recommendations of the Finance Commission which is constituted every five years. Describing the recommendations of the Raghuram Rajan committee as “highly unfair”, Jayalalitha severely lambasts the suggestions saying that by “using mathematical jugglery to disproportionately increase resource allocation to a selected group of states is invidious and an attempt to rob Peter to pay Paul.”

She has all reasons to be upset with the outcome of the report. Let me make three points here. The first is the Constitutional point. The 14th Finance Commission that has been constituted under the leadership of Dr Y V Reddy (former RBI Governor) is presently preparing its report. Under the Indian Constitution, the mandate of the Finance Commission is to make recommendations on the distribution between the Centre and the states of the net proceeds of taxes and set principles which should govern the grants-in-aid of the revenues of the states out of the Consolidated Fund of India. In other words, the Finance Commissions is Constitutionally supposed to act as a neutral umpire to fix the level of transfer of resources from the centre to the states as well as distribution across states. This is the power given to the Finance Commission by the country’s Constitution.

Q: The Finance Commission is a Constitutional authority…

What the Raghuram Rajan committee has done is to bypass a Constitutional body like the Finance Commission and provide its own politically coloured recommendations to share revenues between the Centre and the states. It’s an unconstitutional and a highly regressive step. It’s correct that in a federal system, the states have come out very strongly against such steps particularly when they have not been consulted at all, even through letters leave alone face-to-face meetings with the members of the Rajan committee.

The second point is that one of the biggest losers would be the north-eastern states of India if the Rajan committee’s recommendations are implemented. Let me explain that there are three forms of financial transfers that take place between the Centre and the states today. The first is the Finance Commission’s transfers to the states which are grants as well as a particular share in collections of central taxes. The second is the normal assistance from the Centre to states which is decided as per the Gadgil-Mukherjee formula as of now.

(The Gadgil Mukherjee formula to decide Plan transfers among the states from the Centre owes its origins to an initial formula devised and put in place by social scientist and former Deputy Chairman of the Planning Commission Dr D R Gadgill in 1969 for transfer of funds in the Fourth Five Year Plan. Some changes were made in 1990 to the original Gadgil formula by the then National Development Council comprising all the country’s chief ministers and was subsequently co-named after current President of India and the former Deputy Chairman of the Planning Commission in 1990 Pranab Mukherjee.

Under this formula, the following criteria, along with weights, are used to decide the allocation and transfer of Central funds to states:

a) population (55 percent);

b) per capita income (25 percent);

c) fiscal management (5 percent);

d) special problems (15 percent), which include heads like coastal areas, floods and drought prone areas, special environmental issues, desert problems, slums in urban areas, exceptionally sparse and densely populated areas and special problems in achieving a minimum reasonable Plan size.

In 2000, the Gadgil-Mukherjee formula was reviewed and the component of ‘performance’ by the respective states was adopted. The allocation accruing to the states under this head was 7.5 percent, within which 2.5 percent of the allocation was based on tax efforts of the states, 2 percent for fiscal management at the state level and 1 percent for undertaking population control measures. Special attention was also paid to the sluggish improvements in female literacy and 1 percent allocation was set aside taking female literacy into account. Timely completion of externally funded projects and land reforms undertaken accounted for the remainder of the 7.5 percent figure.)

The third form of financial transfer is the total central assistance to states’ Plans and centrally sponsored schemes from the Centre to the states. With respect to all these three, there are well accepted formulae in implementation. If you look at the transfers that currently take place under the centrally sponsored schemes, the normal central assistance and the Finance Commission transfers, on all three grounds, the biggest loser of the Rajan committee’s recommendations are accepted would be the north-eastern region. Finance Minister Chidambaram has said the recommendations of the committee, along with the new methodology, essentially subsumes what is called the special category among states.

Q: What do you make of the FM’s statements?

He said the Prime Minister has directed that the proposals be examined and necessary action be taken. The Ministry of Finance has been asked to take the necessary action but it is unclear how the Finance Commission will actually respond to this committee’s report. Let me return to a point I have made. If you compare the share that the north-eastern region will get as a result of the implementation of the Rajan committee’s formula with the three central transfers that are currently taking place. According to the Finance Commission’s formulae, this region is supposed to get 7.6 percent of the total transfers. This proportion would fall to 6.85 percent of total transfers of the Rajan committee’s recommendations are followed.

If you take the Gadgil Mukherjee formula, a little over 34 percent of central funds at present go to the north-eastern region. This proportion would fall dramatically by more than 27 percent to a bit under 7 percent. If the north-eastern region loses out such a lot because of the Rajan committee’s recommendations, I think that this can become a politically volatile and highly sensitive issue. It would seriously undermine the very roots of Indian federal system. Personally, I think it would be suicidal for the government to go ahead and accept the suggestions, made by the Raghuram Rajan committee. The consequences would be frightening.

Q: You are arguing that if the Rajan committee’s recommendations are implemented, then that would result in a substantial curtailment of the flow of funds from the Union government to the nine states of north-eastern India which, in turn, could lead to social unrest in an already economically backward and politically disturbed part of the country. Is that what you are suggesting?

If you take the three states of Assam, Meghalaya and Arunachal Pradesh which are classified as least developed according to the Rajan committee’s composite index, and if you look at the change in the share of funds that will go to these three states in spite of their least developed status, they will actually see a fall in their share both under the Gadgil Mukherjee formula as well as under the states’ Plans and the centrally sponsored schemes. It’s a bizarre situation and I’m surprised that the north-eastern states have so far not come out openly against the committee’s recommendations.

Q: Would you not go further to say that it’s not just bizarre but regressive and that the potential for disrupting peace in the northeastern part of India is huge?

It’s bizarre with respect to the statistical nature of the index. It’s indeed disruptive and indeed regressive with respect to the Indian federal structure. It’s bizarre in terms of the nature of the index which classifies three states as least developed and ends up cutting their funding. I have a last point to add. I said earlier that I had three main points of criticism. The first related to the bypassing the Finance Commission, the second to the decline of funds to the north-east and the third relates to penalizing performers, which is where Jayalalitha and Oomen Chandy come in.

Let me consider four states which have performed rather well with respect to the social sector over the last 10-15 years, namely, Himachal Pradesh, Tamil Nadu, Kerala and Tripura. With respect to every indicator chosen – whether it be total central assistance to states’ Plans, the normal central assistance as per the Gadgil Mukherjee formula or the Finance Commission’s grants - these four states are going to see a sharp fall in their share of funding if the Rajan committee’s suggestions are accepted.

According to the Finance Commission’s grants, Kerala is supposed to get 2.45 percent of total transfers. According to the Rajan committee’s formula, Kerala will only get 0.38 percent or a fall of 2.07 percentage points. According to the Finance Commission’s recommendations, Tamil Nadu is supposed to get 5.01 percent of the total transfers which would fall by half to 2.51 percent.

This is going to be a huge disadvantage for these states in terms of maintaining their achievements. It’s one thing to reach a peak in terms of an indicator. It’s quite another to remain there. You constantly need money to maintain the social and physical infrastructure in order to keep your achievements at a high level. The Raghuram Rajan committee does not take this into consideration at all and as a result, the performers are being penalised. So, there is an incentive not to achieve a particular indicator.

Q: This is perverse…

Well, this will actually happen if the government accepts the Rajan committee’s formula. In fact, the committee was supposed to overcome such a problem but its suggestions, if implemented, would actually exacerbate the problem.

Q: So you think the recommendations of this committee need to be scrapped…

I don’t think the Congress-led UPA government will have the political capability to take it up for discussion in any public forum. I think it is just a gimmick to keep one particular chief minister happy. It’ll also come in handy for the Congress party when elections take place in Uttar Pradesh because the flow of funds to the largest state is likely to rise.

Q: But the Uttar Pradesh elections are still some time away. We have the state assembly elections this year in five states, Delhi, Rajasthan, Madhya Pradesh, Chhattisgarh and Mizoram. And then, we have the general elections that would start in April next year…

This committee’s report might come in handy for the government in a few states but I don’t think it has either the courage or the capability to take it up for discussion in the states, leave alone creating a consensus for its acceptance. So, I don’t think this report is to be taken seriously. But let me make a larger point here. Nobody is against more funds being provided to backward states like UP, Bihar and Rajasthan, which are all in dire need of more Central funds to implement social sector schemes.

The problem with the Rajan committee report is that it looks at only one type of transfer and completely ignores another type of transfer. There are two broad types of transfers that need to be distinguished: one that takes place between the Centre and the states which is the vertical kind of transfer; and the other is the transfer which takes place across states. Let me illustrate my point with a simple example.

If out of Rs 100, Rs 60 belongs to the Centre and Rs 40 belongs to the states, the second kind of transfer relates to how much states would get out of Rs 40. The problem in India, however, relates to the first kind of transfer of funds. In other words, if the Centre continues to hold on to Rs 60 out of Rs 100 and not reduce this amount, the states will never have enough money no matter what kind of formula you use.

The Rajan committee has not addressed the issue of the second kind of transfer, the horizontal transfer of funds across states. But then this was not in his committee’s terms of reference and so I don’t blame him. The real problem with state finances in India relates to how much the central government is willing to give. If the amount that is to be transferred from the Centre to the states increases, then it becomes easy to give more money to states like UP, Bihar and Rajasthan without reducing the money that is given to Kerala and Tamil Nadu etc. That is the kind of reforms in state finances that you require.

Q: What you are essentially arguing is that the central government needs to loosen its purse strings…

What the central government needs to appreciate is that India is a federal country, that the principles of federalism are deeply embedded in the Indian Constitution. If the total quantum of money allocated to all states goes up it becomes possible to give more funds to the few backward states without penalising the performers.