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Twelfth Finance Commission and Backward States

The recommendations of the Twelfth Finance Commission particularly for backward states - allowing them to directly access the market, placing borrowing limits consistent with fiscal responsibility legislation and transferring external assistance to states on a back-to-back basis - have far-reaching implications. Fixing borrowing limits based on capacity to service debts and uniform targets for fiscal deficit reduction will further accentuate regional imbalances. Debt-stressed and backward states may find it difficult to raise loans from the market because of their lower creditworthiness and higher risk perception among lending agencies. The scheme of debt write-off linked to revenue deficit reduction recommended by the commission favours states with a low base year revenue deficit. A more realistic approach would be to allow a relatively longer timeframe for backward states to effect fiscal correction, while ensuring that states as a whole bring down their fiscal deficit to 3 per cent of GDP by 2009-10.

Special articles

Twelfth Finance Commission and Backward States

The recommendations of the Twelfth Finance Commission particularly for backward states – allowing them to directly access the market, placing borrowing limits consistent with fiscal responsibility legislation and transferring external assistance to states on a back-to-back basis – have far-reaching implications. Fixing borrowing limits based on capacity to service debts and uniform targets for fiscal deficit reduction will further accentuate regional imbalances. Debt-stressed and backward states may find it difficult to raise loans from the market because of their lower creditworthiness and higher risk perception among lending agencies. The scheme of debt write-off linked to revenue deficit reduction recommended by the commission favours states with a low base year revenue deficit. A more realistic approach would be to allow a relatively longer timeframe for backward states to effect fiscal correction, while ensuring that states as a whole bring down their fiscal deficit to 3 per cent of GDP by 2009-10.


I Introduction

he Twelfth Finance Commission (TFC) made its recommendations against the backdrop of failure of earlier attempts at fiscal consolidation and renewed attempts by the centre and a few states by enacting fiscal responsibility legislations. The widening of regional disparities and the growing fiscal stress of both the centre and the states, particularly of the backward states has added a further dimension to the federal fiscal relations. The TFC has indicated that its scheme of transfer provides for larger transfers to correct the fall in the volume of transfers relative to gross domestic product (GDP) in recent years and ensures minimum vertical transfers, while correcting a larger horizontal imbalance [TFC Report 2004]. The TFC’s scheme of transfers and its recommendations mark a distinct departure from those of the previous finance commissions in a number of respects. Though the previous finance commissions have also been following the normative approach for assessing the revenue and expenditure of states, the norms adopted by the TFC are stiffer. The TFC increased the share of grants in total transfers to address the growing horizontal imbalances across states. The TFC’s scheme of debt relief linked to revenue deficit reduction and enactment of fiscal responsibility legislations comes with numerous conditionalities, which many states may find difficult to adhere to. There are a few other important recommendations with far-reaching implications for states, more particularly of the backward category. These recommendations relate to dispensing with loan component of central assistance for state plans, disintermediation in borrowings by allowing states to directly access the market, placing limits on borrowings by states and passing on assistance for externally aided projects on a backto-back basis. The main objective of this paper is to analyse the implications of the recommendations of the TFC for backward states after briefly examining the equity aspects of overall transfers recommended by it. The paper is organised into six sections. Section II looks at the equity aspects of overall transfers. Section III examines the norms adopted by TFC, while making its assessment of revenue and expenditure of states. Section IV contains an analysis of the scheme of debt relief to states. Section V analyses the implications of allowing states to directly access the market and transferring assistance in respect of externally aided projects on a back-to-back basis. Section VI contains a few concluding observations on the recommendations of the TFC.

II Equity Aspects of TFC Transfers

The TFC has estimated the coefficient of correlation between comparable per capita gross state domestic product (GSDP) and the recommended per capita total transfers for the general category states, excluding Goa at –0.89. The commission stated that this is indicative of the redistributive character of its transfers. A distinguishing feature of the transfer system recommended by the TFC is the substantial increase in the share of grants in total transfers. In the total transfers recommended by the TFC, the share of grants is 18.87 per cent as compared with shares of 13.47 per cent and 8.96 per cent recommended by the Eleventh Finance Commission (EFC) and the Tenth Finance Commission, respectively. The increase in the share of grants is on account of specific grants for the maintenance of roads and buildings, grants for the preservation of forests and grants to education and health sectors to certain states, whose per capita expenditure on the provision of these services is lower. Normally, non-plan revenue deficit grants account for a predominant share in the total grants recommended by the finance commissions. In the case of the EFC, the share of non-plan revenue deficit grants was 60.4 per cent. In contrast, non-plan revenue deficit grants constitute only 39.9 per cent of total grants recommended by the TFC. (a)Grants: The TFC recommended grants amounting to Rs 20,000 crore or 14.0 per cent of total grants for the maintenance of roads and bridges (Rs 15,000 crore) and buildings (Rs 5,000 crore). As this is the first time that such grants are recommended by a finance commission, the implications of these grants are taken up first for discussion. Grants amounting to Rs 1,000 crore for the maintenance of forests are similar to those recommended for roads and buildings. But the TFC categorised them as additional grants to states. As the amount recommended for forests is not sizeable, the analysis is, therefore, restricted to maintenance grants recommended for roads and buildings. In recommending these grants, the TFC has departed from the practice followed by the previous commissions. The normal practice is to normatively assess the requirements for maintenance and subsume these requirements in the overall forecast of revenue expenditure on non-plan account for the award period. Any post-tax devolution deficit in the non-plan revenue account is met through revenue deficit grants. In addition to subsuming the existing levels of maintenance expenditure and their growth in the overall forecast of non-plan revenue account, the TFC recommended additional grants for the maintenance of roads and buildings based on norms, length of roads and plinth area of public buildings in different states. If the TFC had subsumed these norm-based requirements also in the overall forecast of non-plan revenue expenditure and provided for these expenditures through non-plan revenue deficit grants, most of the states would not have got any additional funding. This is because of the fact that most of the states are assessed to have post-tax devolution surplus on their revenue accounts, making them ineligible for gap grants. It would be interesting to see how different states stand to gain or lose in the new dispensation.

Among the 17 general category states, four states – Kerala, Orissa, Punjab and West Bengal – were assessed by the TFC as having post-tax devolution deficits in their non-plan revenue accounts. While Kerala and Orissa were assessed having posttax devolution deficits in the first year of the forecast, Punjab was assessed to have such deficits in the first three years of the forecast and West Bengal in the first two years of the forecast period (2005-10). In contrast, all the special category states were assessed as having deficits in their non-plan revenue accounts in all the years of the forecast, with the exception of Assam which was assessed having non-plan revenue deficit in the first year of the forecast. Even when the norm-based expenditures on maintenance are added to the overall non-plan revenue forecast, all the post-tax devolution revenue account surplus states will continue to remain in surplus and will not to be entitled to any gap grants. Therefore, specific maintenance grants recommended by the TFC are an addtionality for these states. The post-tax devolution revenue deficit general category states also stand to gain in the new dispensation, as the amount of specific grants they would be getting (Rs 3,777 crore) is higher than the amount of additional gap grants they would have got (Rs 1,277 crore). Special category states, with the exception of Assam, neither gain nor lose under the new dispensation. Assam gains by Rs 450 crore. Thus, the benefit of specific purpose grants for roads and buildings has mostly gone to revenue surplus states. The position is summarised in Table 1.

The TFC has indicated that it has preferred specific maintenance grants, as states have been neglecting maintenance of roads and buildings. Another reason for greater importance to grants is that these can be better targeted and can better take into account cost disabilities and redistributive considerations, which cannot adequately be captured in any tax devolution formula. From the analysis presented in the previous paragraph, it is clear that these objectives have not been met fully by specific maintenance grants. While specific grants may ensure adequate provisions for maintenance of roads and buildings, these grants may not serve any redistributive purpose. As these grants are based on the existing length of roads and plinth area of buildings, developed states are the major beneficiaries in terms of higher allocations. Grants based more or less on similar maintenance norms may not serve adequately the redistributive purpose.

If lack of interest on the part of states to provide for maintenance of capital assets is the justification for recommending specific maintenance grants, then there does not seem to be much justification for leaving out the irrigation sector, where inadequate maintenance continues to remain a major problem. The TFC has not given any reasons for leaving out this sector from the purview of specific maintenance grants.

Another major departure made by the TFC is in relation to education and health sectors. The TFC recommended grants to education sector for eight states and grants to health sector for seven states. Among these, six states, viz, Assam, Bihar, Jharkhand, Madhya Pradesh, Orissa and Uttar Pradesh have been recommended grants both under education and health sectors. States receiving one of the two sectoral grants are West Bengal (education) and Uttaranchal (health). These grants are based on normatively adjusted existing levels of per capita expenditure on these sectors. States, whose per capita expenditure is lower than their respective group averages, have been selected for these grants. The beneficiaries of these grants are poorer states, except West Bengal, which is a middle-income state.

States, in their memoranda to successive finance commissions have been favouring a higher share of tax devolution in total transfers on the ground that the tax revenue tends to be buoyant,

Table 1: Specific Maintenance Grants and States

(Rs crore)

States Post-tax Devolution Estimated Non-Plan Revenue Additional Deficit/Surplus G a p (2000-05) Grants As Asse-As Ressed by adjusted TFC Specific Grants for Roads a n d Buildings Gain(+)/ Loss (-)(Col 5-Col 4)
1 2 3 4 5 6

General category Revenue surplus 417356.00 403540.04 NIL 13815.96 +13815.96 Revenue deficit -7135.80 -8413.23 1277.43 3776.95 +2499.52 1 Kerala -470.37 -593.06 122.69 745.82 +623.13 2 Orissa -488.04 -1207.87 719.83 1864.22 +1144.39 3 Punjab -3132.67 -3419.05 286.38 572.76 +286.38 4 West Bengal -3044.72 -3193.25 148.53 594.15 +445.62

Special category 1 Assam -305.67 -416.03 110.36 560.76 +450.40 2 Others -49412.98 -51259.31 1846.33 1846.33 NIL

whereas grants are fixed. Another reason for even poorer states pitching for a higher share of tax devolution in total transfers is that the former tended to be more equitable than the latter. Because of the predominance of non-plan gap grants in total grants, the grants tended to be less equitable than tax devolution [Rao 2000]. The stand of the states favouring a higher share of tax devolution seems to have proved disadvantageous in the postreforms period, which witnessed a decline in the tax-GDP ratio following trade reforms. As a result of the decline in the tax-GDP ratio, tax devolution to states, commencing from the award of the Tenth Finance Commission, was lower than that estimated by the finance commissions. Table 2 illustrates the point.

In a scenario of declining or constant tax-GDP ratios, states would be better off with a higher share of grants in total transfers. Going by the trends observed in the post-reforms period, the higher share of grants in total transfers recommended by the TFC looks advantageous to states. However, this may not hold true in the long run, with the centre committing itself to increasing its revenue through widening tax net and introducing new taxes.

(b) Tax devolution: One of the criticisms against the formula for allocation of shares in central taxes across states recommended by the TFC is the lower weightage assigned to redistributive factors [Rajaraman 2005]. The TFC has doubled the combined weight of equity neutral factors of population and area to 35 per cent (population 25 per cent and area 10 per cent) compared with the weight of 17.5 per cent (population 10.0 per cent and area

7.5 per cent) assigned by the EFC. In contrast, the TFC assigned a lower weight of 50 per cent to equity promoting factor of distance from the highest per capita income compared with the combined weight of 70 per cent assigned to per capita income distance and infrastructure by the EFC. Transfers recommended by the TFC are presented in Table 3.

Per capita tax devolution as well as per capita grants are the highest for special category states, followed by low-income, middle income and high-income states, indicating the progressiveness of transfers recommended by the TFC. Among the total transfers, grants are found to be less progressive as between high income states and middle-income states. This is entirely on account of higher non-plan gap grants amounting to Rs 3,133 crore recommended by the TFC to Punjab. Punjab being a high income state, gap grants amounting to this magnitude may not be justified. Excluding Punjab and Goa, per capita transfers to high-income states will be much lower, improving the progressitivity of overall transfers. Among the middle-income states, West Bengal has received higher per capita grants because of higher non-plan gap grants and specific grants to the education sector.

Excluding Goa and Punjab, the correlation coefficient between per capita grants and per capita GSDP works out to –0.6618 and that between per capita tax devolution and per capita GSDP to –0.9429. Despite the progressiveness of TFC transfers, post-tax devolution non-plan revenue account surplus is much higher for the high and middle income states than the low income states. This will enable the better-off states to have higher plan outlays.

III Forecast of Revenue Receipts and Expenditure

The TFC too adopted a normative approach for projecting the revenue and expenditure of states on non-plan account. For the purpose of forecasting tax revenue, the TFC adopted a two-step process. In the first step, the TFC worked out the trend growth rate (TGR) of own tax revenue for each state for the period 1993-2003 and then applied it to 2002-03 actual own tax revenue (OTR) to arrive at the base year estimate for 2004-05. Thereafter, the TGR-based estimate for 2004-05 was compared with budget estimates and the higher of the two was adopted as the initial estimate for 2004-05. Then the initial estimates were converted into tax-GSDP ratios. The tax-GSDP ratios thus estimated were adjusted upwards by 30 per cent of their distance from the respective group averages of the special and general category states. This resulted in an average tax-GDP ratio of 5.9 per cent for all states. The TFC incorporated an increase of little less than 0.9 percentage points in the tax-GDP ratio to 6.75 per cent over the forecast period. For realising this improvement, the TFC assigned prescriptive buoyancies ranging from 1.1 to

1.35 to individual states. The assignment of buoyancies was based on three factors, viz, average OTR/GSDP ratio achieved in 2000-03, improvement in OTR/GSDP ratio in 2000-03 over

Table 2: Tax Devolution to States

(Rs crore)

Finance Commission Tax Devolution Actual Tax as Assessed Devolution

Seventh (1979-84) 20,407 21,356 Eighth (1984-89) 37,374 42,009 Ninth (1989-95) 1,06,638 1,12,569 Tenth (1995-2000) 2,13,926 1,82,925 Eleventh (2000-05) 3,76,318 3,05,035

Source: Reports of the finance commissions and central budgets.

Table 3: Transfers Recommended by the TFC

(Per Capita in Rs)

States Tax Grants Total Non-Plan Revenue Devolution Transfers Surplus

General category 5941 878 6820 5465 states (6003) (848) (6851) (5187) High-income 4076 801 4877 6602

(4111) (687) (4798) (6978) Goa 12224 1041 13266 27281 Punjab 3267 2014 5281 1442 Maharashtra 3164 571 3735 6554 Haryana 3126 685 3812 12714 Kerala 5143 1023 6166 2245 Gujarat 4320 731 5051 7760 Tamil Nadu 5217 663 5880 7475 Middle income 5533 805 6338 5893 Karnataka 5172 766 5939 11903 Andhra Pradesh 5924 684 6608 5642 West Bengal 5399 944 6344 2167 Low income 7327 962 8288 4538 Rajasthan 6092 822 6914 2901 Chhattisgarh 7830 956 8785 8135 Madhya Pradesh 6829 853 7682 6479 Jharkhand 7667 1127 8794 6890 Orissa 8606 1433 10039 2134 Uttar Pradesh 7112 918 8031 4587 Bihar 8153 961 9114 3546 Spl category states 7790 9318 17108 1854 All states 6058 1409 7467 5238 (6119) (1395) (7514) (5303)

Notes: 1 The general category states have been classified under three income groups based on the average comparable per capita GSDP for the years 1999-2000 to 2001-02. States having 25 per cent or more than the all-states average per capita GSDP are classified as high income. States with per capita GSDP exceeding the all states average by less than 25 per cent are classified as middle income. States having below average per capita income are classified as low income. 2 Figures in brackets are exclusive of Goa and Punjab.

1993-96 and average per capita GSDP for 1999-2002. Higher buoyancy was adopted if a state’s OTR/GSDP ratio as well as its improvement over time was relatively lower but its per capita income was relatively higher. Then in the second stage, the TFC assigned nominal GSDP growth rates of 11.0 per cent, 12.0 per cent and 12.8 per cent to different states. The growth rate of 11 per cent and higher assumed for some of the backward and special category states seems high going by the current trends. The average growth in states like Bihar, Jharkhand, Chhattisgarh, Uttar Pradesh and a number of special category states was much lower than 10 per cent during 2001-02 to 2003-04. Similarly, the tax buoyancy of 1.20 assumed for a number of backward and special category states does not look realistic.

The method adopted by the TFC while forecasting revenue expenditure also discriminates the backward states. The TFC normatively assessed the interest payments of states for the base year 2004-05 based on the actuals for 2002-03. The TFC worked out interest payments/total revenue ratios (IP/TRR) for each state for 2002-03. These ratios have been averaged for each group of states, namely, general category and special category. For states with ratios higher than the group average, only 80 per cent of the excess was allowed. After this adjustment, 10 per cent growth was adopted to arrive at the base year estimate for 2004-05. For the forecast period, the TFC pegged the overall growth of interest payments at 7.5 per cent per annum. Within this prescriptive limit, differential growth rates of 6.5 per cent, 7.5 per cent and 8.5 per cent were assigned to states within the general category, depending on the ratio of IP/TRR. States with a IP/TRR ratio above 30 per cent were assigned a growth of 6.5 per cent, those with a ratio between 23 and 30 per cent, a growth of 7.5 per cent and those with IP/TRR ratio below 23 per cent were assigned a growth of 8.5 per cent. If the purpose were to reduce the interest burden, then a lower growth for interest liability on fresh borrowings in the forecast period would be justifiable. By not taking into account the actual commitment in the base year and its likely growth, the fiscally stressed states would be subjected to further stress.

IV Debt Relief to States

The TFC recommended debt relief to states in two parts, general debt relief through consolidation of outstanding central loans and debt write-off linked to revenue deficit reduction. General debt relief and debt write-off recommended by the TFC constitute 9.3 per cent and 25.0 per cent, respectively of outstanding balances of central loans granted up to March 31, 2004 and outstanding as on March 31, 2005. For availing the facility of general debt relief, all that the states are required to do is to enact fiscal responsibility legislations. Debt relief consists of reschedulement and lowering of interest rate to 7.5 per cent. These benefits will be available from the year states enact fiscal responsibility legislation.

(a) General debt relief: The TFC recommended consolidation of central loans to states contracted till March 31, 2004 and outstanding on March 31, 2005 and their reschedulement for a fresh term of 20 years at an interest rate of 7.5 per cent. The debt swap scheme for states introduced in 2002-03 resulted in substitution of high cost central government loans by market borrowings and loans from the National Small Savings Fund (NSSF). As a result of the debt swap scheme, the amount of outstanding loans from the central government to states (excluding Delhi) has come down even in absolute terms from Rs 2,30,735 crore at the end of 2002-03 to Rs 2,05,253 crore at the end of 2004-05. Thus, the debt swap scheme has somewhat minimised the benefit of debt consolidation to states. Over the years, the share of loans from the central government has come down considerably. At the end of March 1991, the share of central loans in total outstanding debt of states was over 68 per cent, with the remaining shares accounted for by market loans (17 per cent) and provident funds and others (15 per cent). The share of central loans in total outstanding debt of states has come down to 26.4 per cent at the end of March 2004, with market loans

(32.5 per cent), loans from NSSF (25.8 per cent) and provident funds (15.3 per cent) emerging as the major sources for states’ borrowings. Till 1998-99, loans against small savings collections were classified as loans from the central government. With the transfer of small savings collections to the NSSF and substitution of high cost central loans by market borrowings, the benefit of consolidation of outstanding central loans is much lower.

The aggregate benefit as a result of consolidation of loans is estimated at Rs 11,929 crore in terms of deferred repayments over the award period of the TFC. Debt relief as a percentage of total consolidated outstanding debt is the highest for low income states, followed by special category states, middle income states and high-income states, in that order. However, differences in the ratios of debt relief to outstanding debt are insignificant across states. The benefit of consolidation depends on the maturity pattern of outstanding loans and the share of loans from the centre in the total outstanding debt [Kurian 2005]. Low income and special category states are the most stressed states in terms of their debt-GSDP ratios. The benefit of debt relief

Table 4: Debt Relief Recommended by the TFC

States Debt/GSDP Share of Debt Interest Relief
Ratio Central Relief as to States as
2002-03 Loans in Per Cent of Per Cent of
Total Total Total Interest
Outstanding Outstanding Liability
Debt 2003-04 Debt 2003-04 2005-10
Gen category
states 33.54 24.12 1.52 4.38
High income 29.10 19.86 1.35 3.25
G o a 28.15 25.02 1.67 4.17
Punjab 48.41 13.18 0.86 2.38
Maharashtra 21.56 21.64 1.52 2.26
Kerala 36.34 14.99 1.03 3.23
Haryana 27.85 17.41 1.24 2.70
Gujarat 33.93 26.08 1.58 4.94
Tamil Nadu 26.80 20.37 1.53 3.72
Middle income 32.53 27.67 1.36 4.69
Karnataka 25.12 28.86 1.18 5.97
Andhra Pradesh 28.85 32.92 1.31 5.79
West Bengal 41.15 23.49 1.46 3.05
Low income 41.08 26.15 1.81 5.47
Rajastan 45.38 19.53 1.80 3.16
Chhattisgarh 25.46 29.45 1.56 6.25
Madhya Pradesh 32.28 25.25 1.73 6.93
Jharkhand 24.28 31.01 2.08 8.47
Orissa 62.93 27.75 2.70 4.96
Uttar Pradesh 39.08 27.57 1.56 6.05
Bihar 55.33 28.56 1.74 5.56
Spl category
st a t e s 44.29 16.80 1.53 2.61
All states 34.21 23.52 1.52 4.24

Source: Outstanding debt at the end of 2003-04 is based on the figures given in the RBI study on state budgets 2004-05.

is found to be lower for some of the most debt-stressed states like West Bengal, Uttar Pradesh and Bihar. The interest saving as a result of consolidation and reschedulement of debt is estimated at Rs 21,276 crore for all the states. The interest saving as per cent of interest liability in the forecast period as assessed by the TFC is found to be favourable to low income states within the category of general category states but most unfavourable to special category states. When the benefit of debt consolidation is examined in the context of the debt-stressed states, and the greater fiscal consolidation that is required to be done by these states, the relief does not seem to be adequate. The benefit of debt relief to states is summarised in Table 4.

For obvious reasons, the debt relief recommended by the TFC is restricted to loans from the central government. These loans include additional central assistance (ACA) for externally aided projects. The ACA for externally aided projects has mostly gone to a handful of states. During the period 1991-92 to 1994-95, seven states, viz, Andhra Pradesh, Maharashtra, Uttar Pradesh, Tamil Nadu, Gujarat, West Bengal and Karnataka received nearly 82 per cent of the total ACA. This predominance continued during 1996-97 to 1999-2000, with these states accounting for over 74 per cent of the ACA. During the latter period, there was a drastic reduction in the share of Uttar Pradesh from over 19 per cent of the total to 10 per cent. By and large, relatively better-off and industrialised states received higher external assistance as compared with backward states [Planning Commission 2000]. To be even handed, the additional loans for externally aided projects should have been netted from the total outstanding central debt. In addition, debt-stressed states could have been given an additional benefit in the form of a longer repayment period or moratorium in the initial years. The Eighth Finance Commission followed this kind of an approach and recommended varying repayment periods for states, depending on debt-GSDP ratios [Report of the Eighth Finance Commission 1984]. With the TFC recommendations restricting central assistance for state plans to just grants component and allowing states to directly access the market for financing the loan component, having been accepted by the government, central loans to states will come down drastically in coming years and so will the scope for future consolidation of outstanding central loans to states. Keeping this in view, the TFC could have been more liberal to debt-stressed states in its scheme of debt relief.

(b) Debt write-off : The TFC recommended write-off of repayments of central loans due from 2005-10, after consolidation and reschedulement. The write-off is linked to revenue deficit reduction and subject to a state fulfilling a number of conditionalities. Since the repayment period of the consolidated central loans is 20 years, repayments due in the period 2005-10 constitute 25 per cent of the outstanding central loans at the end of 2004-05. Thus, the percentage of loan that can be written off is uniform for all the states at 25 per cent of the outstanding central debt. The quantum of write-off is linked to the absolute amount by which the revenue deficit of a state is reduced in each year of the award period, over the immediately preceding year. The scale of write-off is determined by the ratio of repayments due in 2005-10 to the base year revenue deficit of a state. The base year deficit figure as worked out by the TFC is the average of the revenue deficit for three years, viz, 2001-02, 2002-03 and 2003-04 (RE). The actual write-off will be worked out by multiplying the ratio of repayments due in 2005-10 to the base year revenue deficit, with the actual revenue deficit reduction in a year. The ratio varies from 0.17 for Uttaranchal to 2.69 for Jharkhand. The scale of debt write-off will be generally lower for fiscally stressed states, because of their higher base year revenue deficit. Therefore, fiscally stressed states need to effect much higher reduction in their revenue deficits relative to less fiscally stressed states. For example, Andhra Pradesh, with a ratio of total repayments due in 2005-10 to average revenue deficit of 1.30, will have the benefit of Rs 1.30 of its loan written-off for every Re 1 of revenue deficit reduction. In contrast, West Bengal with a higher level of revenue deficit will get only Re 0.27 of its loan written-off for every Re 1 reduction in its revenue deficit. The total amount of write-off in a year is restricted to the repayments due in that year, after loan consolidation and reschedulement. For a state to become eligible for loan write-off in a year, cumulative reduction in revenue deficit relative to the base year figure should be at least equal or higher than the cumulative interest relief obtained by the state as a result of loan consolidation and interest rate reduction. The write-off is subject to the further stipulation of a state containing its fiscal deficit at the level of 2004-05. If in any year, the fiscal deficit exceeds the 2004-05 level, the benefit of write-off would not be available, even when all other requirements are met. A zero revenue deficit by 2008-09 will entitle the state to a full write-off of all repayments due from 2005-06 on central loans contracted up to March 31, 2004 and consolidated by the TFC.

As per the recommendations of the TFC, the states which were in revenue surplus in the base year should continue to maintain a surplus at least equivalent to the absolute amount of the surplus in the base year, till the end of the award period to get the benefit of loan write-off. No write-off is permissible in the years the revenue surplus is lower than the base year figure.

Some of the conditions laid down above do not seem to be consistent. Restricting the debt write-off facility to only those states that do not exceed their fiscal deficit level of 2004-05 goes against fiscally prudent states. There is some ambiguity whether maintaining the level of fiscal deficit at 2004-05 is in absolute terms or as a percentage of GSDP. Most likely, the TFC’s intention was to maintain it at its absolute level. In either case, this goes against the interests of fiscally prudent states. For example, in 2004-05, the fiscal deficit of Haryana was Rs 1,747 crore or 1.2 per cent of GDSP. Why should its fiscal deficit be restricted at this lower level, while other states can have much higher fiscal deficit levels?

The condition that reduction in revenue deficit should at least be equal to reduction in interest liability on account of debt reschedulement is inequitable to those states, whose interest saving is higher than revenue deficit. These states need to eliminate the revenue deficit to be able to derive the benefit of debt relief. In this category fall states like Bihar, Jharkhand, Arunachal Pradesh, Meghalaya and Tripura. Of these, Jharkhand, Arunachal Pradesh and Tripura will have to eliminate their revenue deficits, even before the target year of 2008-09. For states like Andhra Pradesh, Chhattisgarh and Karnataka, interest savings are quite substantial in relation to the base year revenue deficit.

The problem of revenue deficit reduction cannot be addressed effectively without addressing the problem of revenue deficit on the plan account. Gap grants recommended by a finance commission only meet the deficit on the non-plan revenue account as normatively assessed. Even this would depend on states augmenting their revenue and containing their expenditure, as normatively assessed by a finance commission. Past experience shows that actual performance by states was much below the assessment made by the finance commissions. Assuming that post-tax devolution non-plan revenue deficit states would do all that was expected of them by a finance commission, these states would at best succeed in eliminating deficit on their non-plan revenue accounts. These states cannot be expected to eliminate their entire revenue account deficits unless the revenue component of their plan is fully met by plan grants. In the budget estimates for states for the year 2004-05, revenue plan expenditure amounted to Rs 66,318 crore and plan grants from the centre amounted to Rs 47,644 crore. In this scenario, fiscally stressed states would be denied the benefit of debt write-offs. On the whole, the package of general debt relief and debt write-off does not address the problems of severely indebted states.

V Borrowings by States

The TFC made two important recommendations with regard to the future loan contracting by states. The first one is that the centre should restrict its assistance for state plans to only grants and allow freedom to states to access markets for the loan component of the plan. In the present dispensation, where plan size determines the borrowings of states, debt has become explosive [Bagchi 2003]. Plan size is determined more by developmental considerations rather than by the ability of a state to service the debt. The TFC recommended a body like the Australian Loan Council (ALC) to fix the borrowing limits for states. The government of India accepted this recommendation and indicated that this would be implemented in a phased manner [GoI 2005]. There is no indication about the role of the Planning Commission in the changed scenario. It seems Planning Commission’s role would be restricted to determining plan grants to states, while the proposed Loan Council would determine loan component of state plans. While better-off states would be able to access the market at reasonable terms, backward states would be worse off. They may have to pay a premium over that paid by other states, as their creditworthiness would be lower and risk perception higher among lending agencies. Weaknesses in the finances of some state governments manifested in the widening of the spread and undersubscription of their market borrowings in 2004-05 [RBI 2005]. Another major issue, which has not received much attention, is the maturity pattern of market loans vis-à-vis central government loans. The central government loans to states are given for a period of 25 years with a moratorium of five years. In contrast, market loans normally have a maturity period of 10 years with bullet repayment at the end of the maturity period. As part of the debt swap scheme, a number of states swapped their high cost central government debt with market loans, for which the states were allotted higher market borrowings. These market borrowings will mature in the next six to seven years. This together with the proposed shift to market-based borrowings will make it difficult for states to carry forward their fiscal reforms. Table 5 indicates the maturity pattern of market borrowings of states.

Nearly 60 per cent of the market loans are in the maturity period of 6-10 years. There is bunching of repayments during the four-year period starting from 2011-12. Some of the worst affected are the special category states like Himachal Pradesh and Uttaranchal, where over 70 per cent of the outstanding market loans will become due for repayments in the next six to 10 years.

Another area of concern is the possibility of lower borrowing limits being fixed for poorer states depending on their servicing capacity. These are the states, which need public investment more. The plan size is currently skewed in favour of high-income and middle-income states. Approved plan outlays for 2003-04 indicate that with the exception of Chhattisgarh and Jharkhand, the newly created states, per capita plan outlays of all low- income states are below the average for general category states. The per capita plan outlays for 2003-04 in respect of Uttar Pradesh (Rs 465) and Bihar (Rs 400), the poorest among the general category states are not even half of the average of 17 general category states (Rs 1,723). With the fixing of ceilings on borrowings, plan outlays in backward states will be much lower than their present levels, affecting capacity and infrastructure building in these states.

Liquidity in the market is crucial for backward states to directly access the market. Till recently, there was adequate liquidity in the system and banks were generally investing more than the stipulated minimum of their net demand and time liabilities (NDTL) in government securities. The investments by scheduled commercial banks (SCBs) in government securities amounted to nearly 40 per cent of their NDTL at the end of March 2005, much higher than the stipulated minimum of 25 per cent [RBI 2005]. With the pick up in non-food credit since 2004-05, incremental investments by commercial banks and cooperative banks in government paper have come down to Rs 12, 617 crore

Table 5: Maturity of Market Loans of States

States Percentage to Total Amount Outstanding 0-5 Years 6-10 Years Above 10 Years

General category states 27.5 59.3 13.2 High-income states 25.0 61.1 13.9 Goa 27.1 59.2 13.6 Punjab 23.4 62.0 14.6 Maharashtra 21.3 57.8 20.9 Kerala 33.0 56.1 11.0 Haryana 26.3 62.1 11.6 Gujarat 22.4 65.3 12.3 Tamil Nadu 26.8 64.3 8.9 Middle-income states 25.3 62.1 12.6 Karnataka 23.8 62.8 13.4 Andhra Pradesh 29.7 64.9 5.4 West Bengal 21.5 58.7 19.8 Low-income states 31.2 55.8 12.9 Rajasthan 29.0 60.7 10.3 Chhattisgarh – 72.1 27.9 Madhya Pradesh 32.3 54.4 13.3 Jharkhand – 86.9 13.1 Orissa 34.0 50.0 16.1 Uttar Pradesh 34.9 52.7 12.4 Bihar 32.2 55.4 12.3 Special category states 21.8 62.8 15.5 Arunachal Pradesh 15.0 48.1 36.9 Assam 30.7 59.1 10.3 Himachal Pradesh 15.2 72.8 12.0 Jammu and Kashmir 21.4 66.5 12.1 Manipur 27.8 47.3 24.9 Meghalaya 33.3 46.7 20.0 Mizoram 24.9 51.7 23.3 Nagaland 32.5 54.9 12.6 Sikkim 50.0 28.9 21.1 Tripura 26.8 44.1 29.1 Uttaranchal – 78.6 21.4 All states 27.0 59.6 13.4

Source: Reserve Bank of India, Annual Report, 2004-05.

in 2005-06 (up to September 30, 2005), which is less than onethird of their incremental investments in the corresponding period of the previous year. As a result, commercial banks’ holdings of government paper declined to 36 per cent of their NDTL. The present trends indicate that commercial banks may further bring down their exposure to government paper, if the pick up in nonfood credit continues.

The recommendation of the TFC allowing states to directly access the market will benefit the centre in reducing its fiscal deficit. The central budget for 2005-06 has not made any provision for plan loans to states. The provision made for such loans in the revised estimates for 2004-05 was Rs 24,247 crore. Thus, the centre was able to show a reduction in its fiscal deficit by 0.7 percentage points of GDP in the budget estimates of 2005-06, by this accounting change.

For regulating borrowings by the states, the TFC recommended setting up of a body on the lines of ALC. The Commonwealth and the states formed ALC on a voluntary basis in 1923 to resolve the competing demands for funds. The ALC was formalised in 1928 with the enactment of the financial agreement act. The financial agreement provided for the ALC to regulate borrowings by the Commonwealth and states, the Commonwealth to borrow on behalf of states and to impose limits on states’ borrowings. The financial agreement had undergone a number of changes taking into account emerging developments. Currently the ALC operates under a new arrangement, which came into existence in 1993-94. Under the new arrangement, loans are allocated having regard to each jurisdiction’s fiscal position and reasonable infrastructure needs as well as the macroeconomic implications of total borrowings. The new arrangement removed the requirement for Commonwealth and state borrowings to be approved and the Commonwealth’s power to borrow on states’ behalf. Now the arrangement is more in the nature of emphasising transparency through financial market scrutiny. Allocation across states is based on fiscal position [Grewal 2000].

In the Indian context, constitution of Loan Council will necessitate a paradigm shift, the way plan size is determined. At present, plan size does not bear any relationship with the size of the owned funds or the capacity of states to service debts. In India, the Loan Council cannot work on a voluntary basis without the enforcement of borrowing limits, given the tendency of states to be profligate. With all the states having enacted or in the process of enacting fiscal responsibility legislations, borrowing limits will have to take into account the fiscal deficit targets prescribed in these legislations. Adherence to fiscal responsibility targets may drastically curtail the plan size of backward states, unless matched by a commensurate increase in grants, through a revision of the Gadgil formula, which currently governs the allocation of plan assistance to states. Apart from the allocation of normal plan assistance and market borrowings, overall borrowings of states also depend on net small savings collections and the size of the externally aided projects. These components will make the task of fixing borrowing limits for states, related to their fiscal capacities, a complicated affair.

The question of setting up of a body on the lines of ALC as recommended by the TFC needs to be examined thoroughly. There are a number of differences between the Australian and Indian federations. Most states in Australia are budget surplus. The proportion of population concentrated in low fiscal capacity states is smaller, making redistribution easier. In India, there is a greater concentration of population in low fiscal capacity states.

Regional imbalances in Australia are not as acute as in India. In Australia, the ratio of highest per capita income to lowest per capita income among states is 1.5. In contrast, the ratio is over

8.6 in India. The Australian Commonwealth Grants Commission (CGC) follows the principle of equalisation which aims at enabling states to receive transfers such that, if each state made the same effort to raise revenue from its own sources and operated at the same level of efficiency, each would have the capacity to provide services at the same standards. The CGC considers the state budgets comprehensively and takes into account both current and capital expenditure. In contrast, the approach in India is fragmented with expenditure divided into current and capital and further into plan and non-plan and Finance Commission and Planning Commission considering different segments of expenditure [Rangarajan and Srivastava 2004].

The TFC recommended that each state should enact fiscal responsibility legislation providing for elimination of revenue deficit by 2008-09 and reduction of fiscal deficit to 3 per cent of GSDP. The TFC set the target for fiscal deficit reduction at 3 per cent of GDP for states as a whole. Though the TFC did not recommend application of the fiscal deficit reduction target uniformly across all states, a number of states, including backward states like Assam have already enacted fiscal responsibility legislations. These legislations are based on the model legislation prepared and circulated by the RBI. All these legislations prescribe 2009-10 as the target year for the reduction of fiscal deficit to 3 per cent of GSDP. The TFC observed that annual borrowing programme of a state should be decided within the framework of its fiscal responsibility legislation. A uniform fiscal deficit reduction target will go against the interests of backward states and balanced regional development.

The second recommendation relating to contracting of loans by states made by the TFC relates to passing on external assistance to states on a back-to-back basis, i e, on the same conditions at which the external agency lends to the central government. At present external assistance is passed on to states as ACA in full in the form of 30 per cent grant and 70 per cent loan for general category states and 90 per cent grant and 10 per cent loan for special category states. As is the case with normal plan assistance, the ACA has a maturity period of 25 years. The external loans from multilateral agencies like the World Bank and the Asian Development Bank have a maturity period ranging from 15 to 40 years. Under the new dispensation recommended by the TFC, states are likely to benefit by way of an elongation of the repayment period. Over the years, grant component of external assistance has improved considerably. This also helps the states, when external assistance is passed on to them on a back-to-back basis. But states will have to take the exchange rate risk. Till recently such risk was considerable as the rupee witnessed substantial depreciation in its value. Between 1980-81 and 2002-03, rupee vis-à-vis US dollar continuously depreciated from Rs 7.91 to Rs 48.39. The entire exchange rate risk is currently being borne by the government of India. In recent years, rupee has remained stable and somewhat gained in its value. The rupeedollar exchange rate in recent months is about Rs 43. With prospects of Indian economy gaining strength, rupee may remain stable or even appreciate. In either case, states stand to gain by the dispensation recommended by the TFC. The TFC recommended that the external assistance pass through should be managed through a separate fund in the public account. This looked like a win-win situation for both the centre and the states.

However, the centre may not be in a position to reduce its fiscal deficit, because of the compulsion to route external assistance through the consolidated fund of India on account of contractual and legal obligations [GoI 2005]. At present, the special category states are not getting much ACA. As the external assistance flows to these states, its transfer on a back-to-back basis may be somewhat disadvantageous, depending on whether the external assistance is in the form of grant or loan. If it is in the form of a loan, the special category states will have to take full liability for these loans in sharp contrast to the present dispensation, which allows them to get external loans in the form of 90 per cent grant and 10 per cent loan.

VI Concluding Observations

The main concern that seemed to have guided the TFC was greater degree of equalisation. With this objective in view, the commission recommended an increase in the share of grants in total transfers. Besides, another concern was to use grants as an instrument for state-specific and purpose-specific targeting. While the latter objective has been met to a large extent, the objective of greater equalisation has not been met. The benefit of sizeable specific maintenance grants for roads and buildings has mostly gone to better-off states. The scheme of debt write-off recommended by the TFC was guided more by the need for fiscal consolidation rather than providing relief to debt-stressed states. The relief package is unfavourable to debt-stressed and poorer states. In the process, the scheme of debt write-off may fail to provide much needed relief to debt-stressed states and may in turn derail the process of fiscal consolidation.

The TFC has broken new ground by recommending delinking of plan grants from loans and disintermediation in loans to states. These recommendations, though sound in principle, have ignored the growing regional imbalances and the specific problems of backward states.

Now that the recommendations of the TFC have been accepted, the government of India needs to put in place a mechanism, which ensures augmentation of plan grants to backward states. Besides, these states may be given a slightly longer time frame to bring down their fiscal deficits to the desired level of 3 per cent of GSDP, while ensuring that states as a whole bring down their fiscal deficit to such a level by 2009-10.



[The author is grateful to C H Hanumantha Rao and Mahendra Dev of the Centre for Economic and Social Studies, Hyderabad for very useful comments and suggestions. The author alone is responsible for errors and omissions

that still remain.]


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