Fourteenth Finance Commission is asked to insulate the economy from politics

It is no secret that the state of the Indian economy has Prime Minister Manmohan Singh and his team deeply worried. The UPA government wants to take urgent steps to revive it - in particular, address the deteriorating fiscal situation. To achieve this, it is now seeking outside help in the form of the Fourteenth Finance Commission (FFC), which has been given an unusual mandate.

In early January, former Reserve Bank of India governor Y.V. Reddy was asked to head the FFC. The government decides the scope, or terms of reference, of a finance commission's work, which usually relates to "contemporary issues important to public finance," points out a former finance commission head, who did not want to be quoted.

However, the FFC's terms of reference this time reveal an intriguing concern. While making its recommendations, the FFC has been asked to keep in mind "the need for insulating the pricing of public utility services like drinking water, irrigation, power and public transport from policy fluctuations, through statutory provisions".

D.K. Srivastava, who was a member of the Twelfth Finance Commission and is currently Chief Policy Advisor at Ernst & Young, interprets this as a move to partially ring-fence public finance from politics. "Definitely there is a move to insulate public finance from political economy considerations," he says. "It's a positive move."

The development is important because of the reach of the FFC. Its recommendations will apply to state governments too, making this a move that might well herald the transition to a more rules-based regime in pricing public utility services. Today, this depends on the whim of governments, thereby destabilising public finances.

A Finance Commission is arguably the most important constitutionally mandated economic body. Unlike the Planning Commission, which was set up by a government resolution in 1950 to push the economic agenda of the party in power, finance commissions draw their power directly from the constitution. Their recommendations, while not binding, are generally accepted. The government has to inform Parliament on what it plans to do about the commission's recommendations.

There are two important reasons for the constitution of finance commissions. Taxation rights favour the Centre over states even though the latter provide most of the services used by people. Then, poorer states require additional help for rapid economic growth.

Finance commissions are seen as institutional mechanism for transferring resources from the Centre to states.

The FFC will wind up in October 2014 and its recommendations will cover the period between April 2015 and March 2020. And pricing of public utility services is not the only sensitive issue before it. The FFC has also been asked to estimate the quantum of subsidies needed without jeopardising economic growth, as well as suggest ways to make public sector enterprises more competitive and market oriented.

There is reason for the anxiety over growing subsidies, since they impact the fiscal deficit. For a year, Prime Minister has been signalling, through speeches and interventions in Parliament, that the economy is being dragged down by loose fiscal policies. In fact, soon after taking over in August, Finance Minister P. Chidambaram asked Vijay Kelkar, Chairman of the Thirteenth Finance Commission, to file a report on the fiscal problem.

Kelkar's report, which came a month later, warned that India was grappling with its own fiscal cliff. "The Indian economy is presently poised on the edge of a fiscal precipice," it said.

In the absence of immediate steps, the fiscal deficit for 2012/13 will overshoot its budget target of 5.1 per cent of gross domestic product (GDP) by a full percentage point, according to Kelkar. Chidambaram has promised to restrict the slippage to 5.3 per cent of GDP. Fiscal deficit represents the excess of government expenditure over revenue and is bridged through loans.

The size of subsidies is critical to what happens to the fiscal deficit. "Subsidies connote an economic benefit provided by a government to reduce market price of an item below its cost of production," says the Comptroller and Auditor General's report on Union government finances for 2010/11.

According to Srivastava, now "there is a general thrust to look at non-tax revenues," to pare the deficit, which explains the emphasis on insulating pricing of public utility services from politics.

The ball is now in Reddy's court. Indeed, the FFC has a chance to make history and pull the economy back from the edge of the fiscal precipice.