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Why Do the States Not Spend?

This paper investigates the unusual phenomenon of state governments currently maintaining large cash balances even as many important sectors call for substantial outlays. Is it a governance issue, as the union finance ministry makes it out to be, or is it something more fundamental affecting the fiscal powers of state governments? We argue that the constraint on expenditure is imposed by the Fiscal Responsibility and Budgetary Management Acts passed by the centre and most state governments; the cash surplus phenomenon is a perverse outcome of such legislation. This essay also investigates the price paid by Kerala, an outlier where receipts do not keep pace with expenditure growth, because of the mechanical constraints imposed by the fiscal responsibility legislation.

Aspacts of Cantra-Stata Ralations

Why Do the States Not Spend?

An Exploration of the Phenomenon of Cash Surpluses and the FRBM Legislation

This paper investigates the unusual phenomenon of state governments currently maintaining large cash balances even as many important sectors call for substantial outlays. Is it a governance issue, as the union finance ministry makes it out to be, or is it something more fundamental affecting the fiscal powers of state governments? We argue that the constraint on expenditure is imposed by the Fiscal Responsibility and Budgetary Management Acts passed by the centre and most state governments; the cash surplus phenomenon is a perverse outcome of such legislation. This essay also investigates the price paid by Kerala, an outlier where receipts do not keep pace with expenditure growth, because of the mechanical constraints imposed by the fiscal responsibility legislation.


Shri P Chidambaram (finance minister): …the most importantthing is that the government must spend. Now, who is not spending? I am sorry to say that states are not spending. … (Interruptions)… As on day before yesterday, the state governments’ cashbalances were Rs 45,000 crore. The states are today cash rich.Every state has got a cash balance. There is no state with overdraft;there is no state with WMA as of today.… (Interruptions)

Md Salim (Calcutta – North-East): Most of them wait for March 31.

Shri P Chidambaram: No, they are not waiting. This is my worry…Every state is cash rich; every State must spend. One of the reasonswhy there is some tightening of liquidity is that states are unableto spend. The system does not have this absorptive capacity tospend in time and reach the target. I had appealed to the statefinance ministers; I had appealed to the state chief ministers. And I would, therefore, appeal to all sections of the House aboutthis…All states must spend the money. Unless money is spent,the targets will not be achieved. Unless money is spent, you willnot achieve your growth targets either…Therefore, Members musturge the state governments to spend more on primary education,to spend more on primary health, spend more on rural roads,drinking water, sanitation and so on. If the states also join andspend wisely and prudently and with proper monitoring, you willfind that the rate at which we achieve our target is accelerated.

– Excerpts from the combined discussion on the Budget for

2006-07, Supplementary Demands for Grants for 2005-06 andDemands for Excess Grants for 2003-04, XIV Lok Sabha.

his paper is an examination of the claim – made by the union finance ministry – that state governments in India are cash rich, but are not spending due to lack of “absorptive

capacity”. As on September 8, 2006, the state governments’

investment in the treasury bills (all denominations) of the Reserve

Bank of India (RBI) was Rs 66,659 crore. Even the so-called

BIMARU states, with a track record of abysmally low provision

of basic needs, have joined the rich states’ club with large amounts of surpluses. Against the background of widespread rural distress, the phenomenon of cash surpluses of states appears bizarre. This situation makes the question raised by the union finance ministry even more significant: why do the states not spend?

The focus of the present paper is on this issue: why are states not able to spend even with surplus cash balances? Is it really a governance issue, as the finance ministry would make it out to be, or something more fundamental affecting the fiscal powers of the state governments? We shall start with a brief analysis of the emergence of the phenomenon of cash surpluses in state government treasuries (Section I), and then go on to analyse the factors responsible for the phenomenon from the receipts side and the expenditure side. We argue that the limits to expenditure increases set through legislation are primarily responsible for the cash surplus phenomenon. The constraint on expenditure is imposed by the Fiscal Responsibility and Budgetary Management (FRBM) Acts passed by the centre and most state governments (Section II). As we argue, the cash surplus phenomenon is a perverse outcome of the FRBM Acts.

There have been some states, where expenditures continue to grow or receipts do not keep pace with expenditure rise, and therefore, continue to be on deficit in cash balance. Kerala is the most prominent case in this context. What is the price that Kerala has to pay for being an outlier? The mechanical constraints imposed by the FRBM Acts and their essential anti-democratic nature are brought out in our case study of Kerala (Section III).

I The Phenomenon of Cash Balance Surplus of States

When state governments’ day-to-day disbursement requirements are in excess of receipts, temporary accommodation is sought from the RBI in the form of Ways and Means Advances (WMA).

Figure 1: Investment Outstanding of State Governments in Intermediate Treasury Bills, Quarterly Estimates, 1998 to 2006

(Rs crore)

--l 70000 60000 50000 30000 20000 10000Investment outstanding (Rs crore) 14-day 91-day 182-day 364-day Total


Sept 1998Dec 1998Mar 1999Jun 1999Sept 1999Dec 1999Mar 2000Jun 2000Sept 2000Dec 2000Mar 2001Jun 2001Sept 2001Dec 2001Mar 2002Jun 2002Sept 2002Dec 2002Mar 2003Jun 2003Sept 2003Dec 2003Mar 2004Jun 2004Sept 2004Dec 2004Mar 2005Jun 2005Sept 2005Dec 2005Mar 2006Jun 2006Sept 2006

Source:Weekly Statistical Supplement, Reserve Bank of India, various issues.

Ceilings have been determined for each state and when the WMA exceeds the ceiling, the state gets into a position of overdraft (OD). The persistence of an OD beyond a specified period would result in temporary suspension of treasury operations by the RBI. State finances in India, from the latter half of the 1980s, were distinctly characterised by the persistence of cash balance deficits and consequent WMA and OD positions. However, from the early 2000s, the situation began to change; the extent to which state governments availed of WMA from the RBI declined sharply. As Table 1 shows, the number of non-special category states that availed normal WMA for 200 days or more declined from 14 to just one between 2000-01 and 2005-06. Out of the 17 states, 13 were not in WMA for even a day in 2005-06.

Surplus in cash balances, which was a relatively rare phenomenon in the 1990s, began to be a regular feature of the states’ treasuries in the 2000s. As on March 31, 2002, the treasury cash balance of all states in India was in deficit of Rs 7,873 crore. In two years, the deficit was gradually transformed into a surplus. As on March 31, 2006, treasury cash balance of all states was in a surplus of Rs 48,909 crore [Ministry of Finance 2006].

When there is a surplus balance in the treasury, the RBI invests the surplus in the intermediate treasury bills of the central government on behalf of the states. Figure 1 shows the quarterly trends in the growth of investments by states in the different treasury bills of the centre. The trends are easily discernible. Between 1998 and 2001, not only were the volumes of investment low, but were also declining. On December 28, 2001, the total investment by states in all denominations of treasury bills was only Rs 1,988 crore. Within this amount, the investments in longer duration treasury bills were almost negligible. However, from the beginning of 2002, these investments started rising slowly, reaching Rs 2,926 crore as on January 9, 2004. After January 2004, there was a phenomenal and continuous rise in the investment by states in the treasury bills. As on August 18, 2006, the total investment by states in all denominations of treasury bills was a whopping Rs 61,886 crore. The composition of securities within this investment also changed considerably between 2004 and 2006. States began to invest much more in longer duration


Table 1: Distribution of the States That Availed Normal WMA bythe Number of Days the State Government Availed WMA(2001-02 to 2004-05)

Number of days in WMA 2001-02 2002-03 2003-04 2004-05 2005-06

  • (a) Non-Special Category States: 0-99 3 5 5 10 (4) 16 (13) 100-199 0 1 320 200 and above 14 11 9 5 1
  • (b) Special Category states: 0-99 3 3 5 4 (1) 9 (1) 100-199 2 1 140 200 and above 4 5 3 1 0
  • Note: Figures in brackets show the number of states that had availed WMA for zero days. Source: RBI (2005b); RBI (2006).

    Table 2: Investment Outstanding in 14-Day Intermediate Treasury Bills, All-States, 2001-02 to 2005-06, as on End-March

    (Rs crore)

    States 2001-02 2002-03 2003-04 2004-05 2005-06
    Andhra Pradesh 139 190 1183 1701 253
    Assam 854
    Bihar 91 943 299 2845 3931
    Chhattisgarh 352 589 271 335 711
    Gujarat 747 289 227 3166
    Haryana 149 632 1571 3894
    Himachal Pradesh 317
    Jharkhand 1482 217 1259 1139 982
    Karnataka 1885 388 296 2033 971
    Kerala 343
    Madhya Pradesh 27 200 777
    Maharashtra 857 1021 1831 1095 2300
    Orissa 102 653 1080
    Punjab 911
    Rajastan 179 930 1051
    Tamil Nadu 5075
    Tripura 103 8 297 421
    Uttar Pradesh 407 240 3017
    Uttaranchal 311 77 307
    West Bengal 935 2408
    Other states 137 502 190 353 813
    All-states 4943 5594 6856 14314 33582

    Note: For 2005-06, the figures are as on January 18, 2006. Source: RBI (2005a: S99).

    Figure 2: Ratio of Different Components of Devolution of Resources from Centre to States to GDP

    (Per cent)


    5.0 4.0 3.0 2.0 1.0 0.0 Share in GDP (Per cent)




    2005-06 re

    Total central transfers (share in taxes and grants)

    Grants from centre

    Share in central taxes

    Source:Handbook of Statistics on the Indian Economy, Reserve Bank of India, various issues; RBI (2006).

    securities, such as the 91-day, 182-day and 364-day treasury bills. Around 9 per cent of the investment by states (about Rs 5,350 crore) were in 364-day treasury bills as on August 18, 2006.

    For the first time, RBI has published state-wise data on the investment outstanding in 14-day intermediate treasury bills in its report on state finances in 2005-06 [RBI 2005a]. Data show that in 2001-02, majority of the states did not have any outstanding investment in treasury bills (Table 2). By 2005-06, all state governments had significant investment outstanding in 14-day intermediate treasury bills. Tamil Nadu, with more than Rs 5,000 crore investment, was in the forefront. Interestingly, Bihar and Uttar Pradesh shared with Gujarat and Haryana the distinction of having investments of more than Rs 3,000 crore in treasury bills.

    The phenomenon of significant investment by states in treasury bills is worrisome for a number of reasons. First, the investments by states in the 14-day intermediate treasury bills of the centre earn them a return of 5 per cent per annum. However, as we shall see, the average cost of mobilisation of funds for the states is much higher. In 2005-06, the interest rate on borrowings of states against small savings was 9.5 per cent per annum (the costliest debt in the market) and the average interest rate on market borrowings was 7.4 per cent per annum. The total transfer of NSSF loans from the centre to states was Rs 90,000 crore in 2005-06. At the end of the same period, the total reverse investment by states in the treasury bills was Rs 61,886 crore, or about two-thirds of its NSSF borrowing! Even the RBI, in its recent study on state finances, has commented that this situation implies a “reverse transfer of resources from states to the centre” [RBI 2005a:52).1

    Secondly, the centre has also been recycling the cash surplus of states to itself at a very low rate of interest for treasury security operations. In 2005-06, the centre enjoyed a surplus cash balance for most months of the year. According to the RBI, “had it not been for the investments of States’ surplus cash balances in 14day Intermediate Treasury Bills, the Centre would have been in WMA” in 2005-06 [RBI 2005a: 52]. Also, the centre deploys its cash balances in securities held by the RBI (which fetches the centre a yield higher than the 5 per cent), thus saving on the interest to be paid on the dated securities held by the RBI (ibid). This has enabled the centre to make profits, through positive spreads, from the states’ cash surpluses.

    There is a growing resentment among states against this reverse flow of resources. Many states have openly stated that they do not want to borrow from the NSSF. The centre has responded to this criticism by forming a sub-committee of selected chief ministers and state finance ministers, which even after a year has not reached any concrete decision. Reading through the minutes of the deliberations of various official forums, one is amazed at the total absence of discussions on how the surplus cash balances can be fruitfully employed to meet the basic needs of the people. There is a peculiar myopia towards the expenditure side of the problem.

    No doubt, a discussion on the reasons behind the cash surplus phenomenon has to take into account both the receipts and expenditure sides of state finances. We shall first discuss the receipts side.

    Trends in States’ Receipts

    The sources of receipts of a state government can be broadly divided into central transfers (shareable taxes and grants), own revenue (own tax receipts and own non-tax receipts) and capital receipts (loans from the centre and other sources). Central transfers: The significant increase in transfers from the centre to the states has been cited as a prominent factor leading to the phenomenon of cash surpluses [RBI 2005a: 52]. Data show, first, that the ratio of central grants to GDP has tended to decline from around 2.4 per cent in the late-1980s to 1.7 per cent in the late-1990s (Figure 2). However, there was a significant rise in the ratio of grants to GDP between 2004-05 and 2005-06. Secondly, the ratio of central taxes to GDP was more or less stagnant till the mid-1990s, but fell between 1997-98 and 2002-03. After 2002-03, the ratio of central taxes to GDP increased, but in 200506 it was still below the corresponding ratio for 1997-98. Finally, the ratio of total central transfers (i e, share in central taxes plus grants) to GDP, after stagnating from the late-1980s at around 5 per cent, declined from 1997-98 and improved significantly between 2002-03 and 2005-06. In absolute terms, the total central transfers increased from Rs 1,00,008 crore in 2002-03 to Rs 1,82,796 crore in 2005-06: an increase of about 82 per cent over three years. Own revenue: The ratio of own revenue to GDP, particularly of owntax revenue, of state governments has increased the recent years (Table 3). The own tax revenue of states increased from

  • 5.2 per cent of GDP in 1999-2000 to 6.4 per cent of GDP in 2005-06. As a result, the total own receipts of states as a ratio to GDP also rose from 6.8 per cent in 1999-2000 to 7.7 per cent in 2005-06. Due to the rise in central transfers and own revenues, the ratio of total revenue receipts to GDP rose from 10.6 per cent in 1999-2000 to 12.9 per cent in 2005-06. Capital receipts: The ratio of capital receipts to the gross state domestic product rose sharply from 3.1 per cent in 1996-97 to
  • 6.7 per cent in 2004-05. Between 2004-05 and 2005-06, data show a fall in the ratio of capital receipts to GDP. Among capital receipts, high-cost loans from the NSSF rose significantly after 1999-2000. The ratio of NSSF loans to GDP rose from 1.3 per cent in 1999-2000 to 2.4 per cent in 2004-05 and 2.1 per cent in 2005-06 (Table 4). Also, the share of NSSF loans in total capital receipts of states rose from 26 per cent in 1999-2000 to 46 per cent in 2005-06. Till 1999-2000, loans from the NSSF were considered as loans from the centre; from 1999-2000, however, they were considered as internal debt and classified separately as “Special Securities Issued to NSSF.” Currently, the entire collection of NSSF in each state is returned to the respective state governments by the centre in the form of borrowings. Till 2004-05, the states had access to only 60 per cent of the net small savings collection, but from 2005-06 onwards, they are forced to borrow the entire small savings collections even if they do not require it. The interest rate on NSSF borrowings is 9.5 per cent per annum with the states bearing the additional burden of the special incentives that are provided under the small savings scheme.
  • In sum, the ratio to GDP of high-cost NSSF loans of states, own tax revenue of states and total central transfers to states have risen in the recent years. The total contribution of the three above components together, as a ratio to GDP, rose from 10.2 per cent in 1999-2000 to 13.1 per cent in 2004-05. Even if we grant that this extent of increase in receipts has made a significant difference to state finances, it still begs the question: how are the states using these increased receipts to meet the needs of people?

    Trends in States’ Revenue Expenditures2

    Coming to the expenditure side, a distinct feature of state finances in the 2000s has been the overall stagnation, if not decline, in revenue expenditures relative to the size of the economy. This stagnation in expenditures has taken place, as we have seen, in a period of increase in the ratio of revenue and capital receipts (especially NSSF borrowings) of states to GDP. This is evident from the data on trends in the ratio of revenue expenditure to GDP for all states, provided in Table 5. In fact, between 200001 and 2005-06, the ratio of revenue expenditure to GDP of states fell slightly from 13.8 per cent to 13.3 per cent. This slight fall in the ratio of revenue expenditure to GDP has been associated with a slight fall in the ratio of developmental revenue expenditure to GDP and a slight rise in the ratio of non-developmental revenue expenditure to GDP.

    On the other hand, the revenue deficit of states, expressed as ratio to GDP, sharply fell from 2.9 per cent in 1999-2000 to just

    0.5 per cent in 2005-06 (Figure 5). In other words, the decline in the revenue deficit has been achieved by the states by not spending the increasing revenue receipts and capital receipts. This conclusion becomes evident from the changes in the ratio of revenue expenditure to revenue receipts of states: this ratio fell continuously from 1.3 in 1999-2000 to 1.0 in 2005-06.

    Data at the state-level also show stagnation, if not a fall, in the size of revenue expenditure relative to the size of the economy (Table 6). In Table 6, we have plotted the change (in percentage points) in the ratio of revenue expenditure to GSDP (of the corresponding states) between 2004-05 and three earlier years

    Table 3: Selected Features of the Pattern of Revenue Receiptsof State Governments, 1990-91 to 2005-06

    (As percentage of GDP at current market prices)

    Year As a Ratio to GDP at Current Market Prices

    Total Revenue Total Own Own Tax Own Non-tax Receipts Receipts Receipts Receipts

    1990-91 11.6 6.9 5.3 1.6 1991-92 12.2 7.3 5.4 1.9 1992-93 12.0 7.0 5.3 1.7 1993-94 12.1 7.1 5.3 1.8 1994-95 11.9 7.6 5.4 2.1 1995-96 11.4 7.2 5.3 1.9 1996-97 11.0 6.8 5.1 1.7 1997-98 11.1 6.9 5.3 1.6 1998-99 10.0 6.4 5.1 1.4 1999-00 10.6 6.8 5.2 1.5 2000-01 11.3 7.1 5.6 1.5 2001-02 11.2 7.0 5.6 1.4 2002-03 11.4 7.3 5.8 1.5 2003-04 11.2 7.1 5.7 1.3 2004-05 11.9 7.6 6.1 1.5 2005-06 RE 12.9 7.7 6.4 1.3

    Source: Indian Public Finance Statistics, Ministry of Finance, various issues; State Finances: A Study of Budgets, various issues, RBI (2006).

    Table 4: Selected Features of the Pattern of Capital Receipts ofState Governments, 1990-91 to 2005-06

    (As a percentage of GDP at current market prices)

    Year As a Ratio to GDP at Current Market Prices

    Capital Receipts Special Securities Share of NSSF Issued to NSSF Loans in Capital Receipts

    1990-91 4.3 – – 1991-92 4.1 – – 1992-93 4.0 – – 1993-94 3.3 – – 1994-95 4.3 – – 1995-96 3.6 – – 1996-97 3.1 – – 1997-98 3.9 – – 1998-99 4.9 – – 1999-00 5.3 1.3 25.5 2000-01 5.3 1.5 29.2 2001-02 5.2 1.6 30.2 2002-03 5.9 2.1 36.1 2003-04 na 2.4 na 2004-05 6.7 2.4 39.3 2005-06 RE 4.6 2.1 45.6

    Source: Indian Public Finance Statistics, Ministry of Finance, various issues; State Finances: A Study of Budgets, various issues, RBI (2006).

    Figure 3: Average Rates of Interest on the Liabilities of the Centre and All States, 1980 to 2004

    (Per cent per annum) 12

    10 8 6 4 2 0 Rate of Interest (Per cent)




    Ch d kh dGh h(2005 )

    Source:Chandrasekhar and Ghosh (2005a).

    (2000-01, 2001-02 and 2002-03) for 19 states. What we see is a general decline in the ratio of revenue expenditure to GSDP in the states. In fact, between 2002-03 and 2004-05, there was a decline in the ratio of revenue expenditure to GSDP in 14 out of the 19 states considered.

    The overall stagnation, if not decline, in the ratio of revenue expenditure to GSDP of state governments cannot be the result of lack of “absorption capacity” of states, as the finance ministry has argued. states like Haryana, Karnataka, Gujarat and Tamil Nadu, which have been characterised by many as fiscally “better managed”, have also exhibited an overall falling trend. There are, of course, many state-specific factors that would have to be considered, but a factor common to almost all the state governments is the compulsion, set by the FRBM Acts, to eliminate revenue deficits by 2008-09. A discussion on the FRBM Acts and their implications for expenditure of states is attempted in the next section.

    II FRBM Acts and Expenditure Contraction

    State Finances: The Genesis of the Crisis

    The FRBM Acts were the neo-liberal response to the fiscal crisis of the state in the latter part of the 1990s. The roots of the crisis in state finances in India have to be traced to the postindependence evolution of centre-state economic relations. Nevertheless, the present deterioration in state finances began in the mid-1980s when states as a whole started recording revenue deficits. This period also marked the end of the era of low and administered interest rates. The interest rates sharply increased thereafter, but as Chaudhuri (2000) has pointed out, its impact was masked by the presence of pre-existing cheap debt that the states had availed. From the latter half of the 1990s, the high cost debts incurred since the mid-1980s took their toll on the interest burden of states and started a process of debt escalation. The earlier policy of the cancellation of part of states’ debts by finance commissions was given up by then. The severe imbalance

    Year Difference between states and centre

    in state finances in 1980s and 1990s has been the topic for many scholarly enquiries [Bagchi, Bajaj and Byrd 1992; Rao 1992; Kurian 1999; Chaudhuri 2000; Vithal and Sastry 2001; Rao 2002; EPWRF 2004].

    The role of the central government was critical in the process of deterioration of state finances. The rates of interest on borrowings of states were sharply increased after the mid-1980s, and especially so after 1990-91 (Table 7). The coupon rates of state government securities were raised sharply by the RBI from 1990-91 onwards. The weighted average of coupon rates, which was 11.5 per cent in 1990-91, reached its historic peak of 14 per cent in 1995-96. In the same period, the interest rates on small saving borrowings by states also increased from 13 per cent in 1990-91 to 14.5 per cent in 1992-93, and remained stable till 1997-98. These rates of interests that the states had to pay were

    Table 5: Selected Features of the Pattern of Revenue Expenditure of State Governments, 1990-91 to 2005-06

    (As percentage of GDP at current market prices)

    Year As a Ratio to GDP at Current Market Prices

    Revenue Develop-Within Developmental Non-Deve-Expenditure mental Expenditure lopmental Expenditure Social Economic Expenditure Services Services

    1990-91 12.5 8.5 4.9 3.6 3.8 1991-92 13.0 8.9 4.7 4.2 4.0 1992-93 12.7 8.4 4.6 3.8 4.2 1993-94 12.6 8.2 4.5 3.7 4.3 1994-95 12.5 7.7 4.4 3.3 4.7 1995-96 12.1 7.4 4.5 3.0 4.5 1996-97 12.2 7.7 4.4 3.3 4.4 1997-98 12.1 7.4 4.4 3.0 4.5 1998-99 12.5 7.5 4.7 2.8 4.8 1999-00 13.3 7.7 4.9 2.8 5.4 2000-01 13.8 8.0 5.0 3.0 5.6 2001-02 13.8 7.6 4.7 2.9 6.0 2002-03 13.7 7.4 4.6 2.8 6.1 2003-04 13.4 7.4 4.3 3.1 6.0 2004-05 13.1 7.4 4.5 2.9 6.0 2005-06 RE 13.3 na na na na

    Source: Indian Public Finance Statistics, Ministry of Finance, various issues; State Finances: A Study of Budgets, various issues, RBI (2006).

    clearly usurious, much higher than the growth rate of the GDP and thus, a sure recipe for financial disaster. Even though the interest rates started falling thereafter, the financial burden that these periods of high rates of interest placed on state finances was significant. The interest payments of states increased from Rs 8,655 crore in 1990-91 to Rs 21,932 crore in 1995-96 and Rs 62,489 crore in 2001-02. As a percentage of total revenue receipts, these interest payments amounted to 13 per cent in 1990-91, 16 per cent in 1995-96 and 24 per cent in 2001-02.

    In the period in which the centre was raising the rates of interest on states’ borrowings, the rates of interest on the centre’s borrowings were not only lower in levels, but were also rising at a much slower rate (Figure 3). The result was that the differential between the rates of interest faced by the centre and the states widened significantly in the 1990s, which has continued into the 2000s [Chandrasekhar and Ghosh 2005a; EPWRF 2004]. In fact, the differential in every year in the 2000s was higher than the differential for any year between 1980 and 2000. The average rate of interest of states’ borrowings was above 10 per cent even in 2004, while that of the centre had dipped below 7 per cent.

    In 1997-98, there was another shock to state finances when the recommendations of the Fifth Pay Commission were implemented. This measure sharply raised the levels of revenue deficit of states from 1997-98 onwards. In just one year, the revenue deficit of states more than doubled – from 1.1 per cent in 199798 to 2.5 per cent in 1998-99. While we do not wish to neglect other factors, the rise in interest burden and higher salary payments constitute the two most prominent factors responsible for the deterioration of state finances. The outcome of these two factors was a sharp rise in the debt burden of states. As a percentage of GDP, the total debt outstanding of states increased from 21 per cent in March 1997 to 26.1 per cent in March 2000 and 33.1 per cent in March 2006 (Figure 4).

    These changes are clearly visible when we analyse the long term trends in the levels of revenue deficit and fiscal deficit of all states (Figure 5). Through the 1970s, states as a whole were enjoying a revenue surplus. It was only by the late 1980s that the revenue account of states fell into deficit. The revenue deficit increased gradually between 1986-87 and 1997-98, and thereafter increased sharply till 1999-2000. Interestingly, the fiscal deficit of all states was rarely above 3 per cent till 1997-98. However, driven by the rise in the revenue deficit, the fiscal deficit of states rose sharply after 1997-98.

    Introduction of FRBM Acts

    It was in this context that the FRBM Bill was introduced in the Parliament in 2000. The task force appointed by the government on the FRBM Act noted that

    The gravity of the situation, and the multi-year process of debateand discussion, led to a far-sighted response. All political partiesvoted in favour of the Fiscal Responsibility and BudgetaryManagement Act 2003…It is the deeply held view of the TaskForce that their implementation will reshape our destiny, and takeIndia to a commanding position in the world economy [GoI2004:13].

    It was thus firmly believed in the neo-liberal circles, exemplified by the report of the task force, that “there is an innate synergy between acceleration of GDP growth and fiscal consolidation” (ibid). As the first step, the government appointed the E A S Sarma Committee to prepare a draft of the legislation; this committee submitted its report in July 2000. The FRBM Act was passed by the Lok Sabha on May 7, 2003 and by the Rajya Sabha on July 29, 2003. The bill was passed by a voice vote, and not unanimously, as the task force erroneously claimed. Members from the Left parties had raised their serious objections to the provisions in the Bill (see report in the People’s Democracy, 10 August 2003). The Bill was notified as an Act on August 26, 2003. In this version of the Act, the government had to eliminate the revenue deficit to zero by 2005-06. In July 2004, the Act was amended to postpone the year of elimination of revenue deficit to 2008-09. In February 2004, a task force was appointed by the government to “draw up the medium term framework for

    Table 6: Changes in the Ratio of Revenue Expenditure to GSDP of States between 2004-05 and 2000-01, 2001-02 and 2002-03, 19 Indian States

    (Percentage points)

    State Difference in Revenue Expenditure/ GSDP Ratio between 2004-05 and

    2000-01 2001-02 2002-03

    Andhra Pradesh 0.01 0.13 -0.3 Bihar -0.5 3.7 4.2 Chhattisgarh -7.8 -19.5 -24.1 Gujarat -8.7 -6.7 -4.1 Haryana 0.9 -0.5 -1.2 Himachal Pradesh -4.7 -2.9 -7.6 Jharkhand 22.7 0.6 -2.5 Karnataka 0.9 -0.6 -0.6 Kerala 2.5 3.1 3.0 Madhya Pradesh -2.4 1.5 -1.1 Maharashtra -1.9 -0.4 0.2 Orissa 0.1 -0.8 -2.4 Punjab 3.2 2.9 -0.5 Rajastan -1.1 0.0 -3.4 Tamil Nadu -0.1 0.2 -2.2 Tripura -5.0 -32.6 -2.8 Uttar Pradesh 1.6 2.0 0.8 Uttaranchal 25.6 9.5 2.2 West Bengal -1.7 -1.1 -1.1 Number of states with a fall in ratio 10/19 9/19 14/19

    Note: The last year of analysis is 2004-05, because 2004-05 was the latest year for which NSDP data were available.

    Source: Indian Public Finance Statistics, Ministry of Finance, various issues; State Finances: A Study of Budgets, various issues, RBI (2006).

    Table 7: Key Interest Rates on State Government Borrowingsfrom the Centre and the Market, 1990-91 to 2005-06

    (Per cent per annum)

    Year Coupon rates on State Interest rates on Interest Rates on Government Securities Small Savings Plan and Non-Plan (Weighted Average) Borrowings by Loans from the States Centre

    1990-91 11.5 13.0 10.3 1991-92 11.8 13.5 10.8 1992-93 13.0 14.5 11.8 1993-94 13.5 14.5 12.0 1994-95 12.5 14.5 12.0 1995-96 14.0 14.5 13.0 1996-97 13.8 14.5 13.0 1997-98 12.8 14.5 13.0 1998-99 12.4 14.0 12.5 1999-2000 11.9 13.5 – 2000-01 11.0 12.5 – 2001-02 9.2 11.0 – 2002-03 7.5 10.5 – 2003-04 6.1 9.5 – 2004-05 6.4 9.5 – 2005-06 7.6 9.5 – 2006-07 (till Oct) 8.1 9.5 –

    Source: EPWRF (2004), RBI (2005c); RBI (2005d); RBI (2006).

    Figure 4: Total Outstanding Liabilities of All-Indian States, 1991 to 2006, as on End March

    (as per cent of GDP)

    Share in GDP (Per cent)

    40 35 30 25 20 15 10 5 0

    2 2 .5 2 2 .5 2 2 .5 21 . 9 21 .4 21 .1 21 .0 22 . 1 22 . 8 26 . 1 28 . 4 30 . 2 32 . 4 33 .4 33 .5 33 . 1 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Year

    Source:RBI Bulletin; State Finances: A Study of State Budgets, RBI, various issues.

    fiscal policies to achieve the FRBM objectives”, and “also formulate the annual targets indicating the path of adjustment and required policy measures” [GoI 2004: 201]. Introducing its projections on fiscal consolidation, the task force noted that “States finances would obtain an enormous boost under the proposals of this report” (ibid: 11).

    Concurrently, the centre was also forcing the hands of the states to pass similar acts in their state assemblies. The finance commissions chose to have a narrow definition of “constitutional transfers” to mean only the divisible pool. The other grants and benefits were held to be over and above the “constitutional transfers” and thus could be tied to specific conditions. For the first time, the Eleventh Finance Commission started the process of linking resource transfers and other benefits from the centre to fiscal consolidation by states. The passage of the FRBM Acts at the state-level became an indicator of the progress achieved by states in fiscal consolidation. States were asked to model their legislations on the legislation prepared by the centre. Karnataka was the first to pass an FRBM Act in August 2002. Kerala, Tamil Nadu and Punjab followed suit in 2003. Uttar Pradesh passed its legislation in 2004. The other state governments, with the exception of a few, passed their FRBM Acts in 2005 and 2006. As on August 2006, 23 states had passed FRBM Acts [Ministry of Finance 2006].

    The hurried passage of these legislations in 2005 and 2006 by many states had to do with the conditionalities put forward by the Twelfth Finance Commission (TFC). States had to pass the FRBM Act in 2005 itself to take advantage of the debt waiver scheme offered by the TFC. The main elements of the FRBM acts passed by the states were the following:

  • (a) 2 to 3 per cent target for fiscal deficit to be achieved by 2005-06 to 2010-11; (b) elimination of revenue deficit by around the same time; (c) limits to state government guarantees on debt;
  • (d) limits to overall liabilities that could be incurred; (e) formulation of a medium-term fiscal plan to reach these targets; and
  • (f) institution of a complaint redressal mechanism.
  • The specific point of our interest in this paper is the targets for revenue deficit, which are summarised in Table 8. The surprising rapidity with which FRBM Acts were passed by the states is an issue that requires some examination by political scientists. Vouching from the personal experience of one of the authors of this paper, most legislators in states knew pretty nothing about what they were passing. The legislature in Kerala, in a fit of reform fury, determined a 2 per cent ceiling for fiscal deficit by 2006-07. This was later de facto amended, but the fact that any political leadership could even propose a 2 per cent ceiling for fiscal deficit is indeed intriguing. The key players in this process were the bureaucracy of the state governments, who

    Table 8: Year of Passing of State FRBM Acts and the Proposed Year of Elimination of Revenue Deficits

    Year of Passage Proposed Year of Elimination of RD Other/Special of FRBM Act 2006 2007 2008 2009 2010 Cases

    2002 Karnataka

    2003 Kerala Tamil Nadu Punjab

    2004 Uttar Pradesh

    2005 Gujarat Orissa, Maharashtra, Assam Himachal Pradesh, Rajasthan, Haryana, Tripura Chhattisgarh, Madhya Pradesh, Andhra Pradesh

    Note: Eight states passed their FRBM Acts in 2006, which are not shown in this table. Source: RBI (2005a).

    Economic and Political Weekly December 2, 2006

    Figure 5: Revenue Deficit and Fiscal Deficit of States, 1970-71 to 2005-06

    (as per cent of GDP)



    Deficit as share of GDP (per cent)





    0.0 –1.0 –2.0

    1970-711971-721972-731973-741974-751975-761976-771977-781978-791979-801980-811981-821982-831983-841984-851985-861986-871987-881988-891989-901990-911991-921992-931993-941994-951995-961996-971997-981998-991999-20002000-012001-022002-032003-042004-052005-06 re

    Revenue deficit

    Source:Ministry of Finance (2006); RBI (2006).

    had so totally internalised the neoliberal reform rhetoric. How else could one explain the proposal of a 2 per cent ceiling for fiscal deficit?

    The Role of Finance Commissions

    There have been a number of criticisms of the Twelfth Finance Commission (TFC) exceeding its constitutional brief in proposing conditionalities on central transfers. The Constitution has defined the role of the finance commissions as to make recommendations on “the distribution between the union 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 commissions were supposed to act as a neutral umpire to fix the levels of transfer of resources from the centre to states as well as the distribution of these transferred resources across states.

    However, in recent years, extra-constitutional powers have been given to the finance commissions through the issue of additional terms of reference by the central government. These powers were provided to the commission in order to tune their reports to dovetail the policies of the central government. For instance, the terms of reference of the Eleventh Finance Commission (EFC) included the mandate to “draw a monitorable fiscal reforms programme aimed at reduction of revenue deficit of the states and recommend the manner in which grants to states…may be linked to progress in implementing this programme”. In fact, under Article 275 of the Constitution, the finance commissions have no powers to impose conditionalities on resource transfers to states. According to the report of the EFC, 15 per cent of the revenue deficit grants were explicitly linked to the progress achieved in the implementation of the fiscal reforms programme (that even included a forced reduction of subsidies and privatisation of the power sector).

    The TFC had similar terms of reference, including the mandate to “review the state of the finances of the Union and the States and suggest a plan by which the governments, collectively and severally, may bring about a restructuring of the public finances


    Fiscal deficit

    [by] restoring budgetary balance [and] achieving macro-economic stability and debt reduction along with equitable growth.” The TFC was also given powers to “review the Fiscal Reform Facility introduced by the Central Government on the basis of the recommendations of the Eleventh Finance Commission, and suggest measures for effective achievement of its objectives.”

    The TFC recommended a fiscal restructuring plan in its report, according to which (a) the revenue deficit had to be eliminated by 2008-09; (b) the fiscal deficit had to be brought down to 3 per cent in 2008-09; and (c) annual targets were set for the reduction of revenue deficit and fiscal deficit (0.4 percentage points for the revenue deficit and 0.3 percentage points for the fiscal deficit for all states put together). Each state had to enact a fiscal responsibility legislation to this effect. The TFC, in order to address the rising debt burden of states, also recommended a general scheme of debt relief and a loan write-off scheme. As per the general scheme, all loans from the centre (excluding the high-cost loans under NSSF) were to be consolidated and a uniform interest of 7.5 per cent charged on them. Under the loan write-off scheme, repayments on loans from the centre between 2005-06 and 2009-10 were to be written-off, with the quantum of write-off linked to the absolute amount of reduction of revenue deficit of the state in each successive year as well as the containment of the fiscal deficit at the level of 2004-05. The benefits of both these schemes were to be made available to only those states that had passed fiscal responsibility legislations.

    Such has been the environment generated by the neoliberal reformers that few states are willing to break the rules. The West Bengal government has refused to pass an FRBM Act. The present government in Kerala, in its revised budget for 2006-07, has declared that its FRBM Act would be amended. Nevertheless, as can be seen from Figure 5, state governments on the whole have been moving fast to meet the targets set by FRBM Acts and the TFC. The revenue deficit for all states has declined from

    2.9 per cent of the GDP in 1999-2000 to 0.7 per cent of the GDP in 2005-06. As we have seen already, this contraction has been achieved mainly by cutting important social sector expenditures. The states are thus set to reach the target of elimination of revenue deficit by 2009. Same is the case with respect to the fiscal deficit; it declined from 4.7 per cent of the GDP in 1999-2000 to 3.2 per cent in 2005-06 (Figure 5).

    Economists from the Left have been the most consistent critics of the central policies of framing legislations to cap revenue and fiscal deficits [Patnaik 2000, 2001; Chandrasekhar and Ghosh 2000, 2001, 2005a, b]. More recently, the Planning Commission also seems to have understood the implications of continuing with the FRBM Acts to any strategy to development that would involve acceleration of revenue expenditure. The Planning Commission, in its attempt to have “faster” but “more inclusive” growth in the Eleventh Five-Year Plan, has outlined a strategy that includes a number of new initiatives, such as the expansion of school education, programmes for provision of healthcare, drinking water, rural infrastructure and schemes for “bridging the divides”. All these ambitious programmes belong essentially to the revenuedevelopment expenditure category and cannot be implemented if the FRBM/TFC targets of elimination of revenue deficit are achieved. The entire strategy of the Eleventh Plan would collapse if revenue deficit is eliminated by 2008 or 2009.

    The Planning Commission is draft approach paper also discusses the issue of fiscal deficit targets in the FRBM Acts. It says that important Plan expenditures, such as in infrastructure, may have to be postponed if the targets of fiscal deficit are adhered to. Such postponement, the paper argues, “could jeopardise growth” and could reduce the space available for “countercyclical fiscal measures” in times of economic slowdown. Again, as the approach paper reminds us, the state governments would have no option but to postpone capital investments as they have a double bind – apart from being forced by the FRBM Acts to cut fiscal deficits, they are also bound by the much stiffer targets set by the TFC that has linked such adjustments to resource transfers. As the centre is not bound by the TFC, it may avoid this situation either by postponing the achievement of targets or by modifying the central FRBM Act to remove the targets set.

    International Experience

    It may be useful here to look at the experience of countries that have passed and implemented fiscal responsibility legislations. In the US, the ‘Gramm-Rudman-Hollings Act’ of 1985 and 1987 has been amended many times to incorporate clauses that allow the government to raise deficits. In the European Union, the ‘Growth and Stability Pact’ was adopted to enforce budgetary discipline among all countries using the Euro. Germany was the main mover behind the introduction of the pact. The irrationality of the pact was soon understood by Germany itself, when Germany and France went through a major economic recession in the early 2000s. For four years in succession from 2002, Germany broke the ceiling of 3 per cent set by the pact for budget deficits. As on 2005, six of the 12 Euro-area countries were facing procedural action under Article 104 of the EC Treaty for excessive deficits [Zeitler 2005]. In seven countries, the consolidated gross debt ratio in 2004 was above the 60 per cent reference value for debts (ibid). There has been a spate of election defeats in Europe, reflecting public anger against for governments that have tried to cut social sector spending to respect the deficit ceilings set by the pact.

    In this context, it would be interesting to examine the case of Kerala. The state was one of the first to pass the FRBM Act, and that too with much more stringent clauses than most states. However, unlike most of other states, Kerala is characterised by a very vibrant political society that refuses to accept the implications of externally set targets for elimination of revenue deficits. We wish to emphasise here that this is not an outcome of the ideological predilections of the present Left Democratic Front government in office. Even the previous Congress-led United Democratic Front government that initiated the fiscal reform programme had to admit the infeasibility of the time-phasing of the programme. The case of Kerala brings out sharply the implications of the issues that we have so far discussed.

    III The Case of Kerala

    Kerala is one of the states that is characterised by severe fiscal imbalance: its revenue deficit, fiscal deficit and public debt, as ratios to GSDP, have been significantly higher than the average for all Indian states. On the one hand, its expenditure pattern is characterised by a heavy commitment to recurring social services expenditure, as high priority has been accorded to social infrastructure historically. While social sector investment in Kerala has led to better health and longevity to its people, it has also resulted in a high burden of pension payments on the exchequer. In 2005-06, pension payments in Kerala constituted about 51 per cent of the total salary expenditure.

    On the other hand, Kerala’s revenue potential is circumscribed by the relatively high ratio of exports among the taxable commodities and the domination of services in the GSDP. Further, the inappropriateness of the Finance Commission criteria for devolution, weightage and its indicators, have been responsible for the fall in the share of central taxes to the state over the years. The share of Kerala among all states in the central taxes declined from 3.9 per cent in the Tenth Finance Commission period to

    3.1 per cent in the Eleventh Finance Commission period and to

    2.7 per cent in the Twelfth Finance Commission [George et al 2006]. The widening non-plan revenue gap of the state has also not been addressed by the successive finance commissions. The relatively improved social indicators and the lower headcount ratio of poverty have reduced the state’s share in central sector schemes (CSS) to less than 1 per cent in 2005-06. Finally, the rise in the high-cost debt burden has resulted in the escalation of the interest charges in the disbursements of the state.

    We do not wish to go into a more detailed analysis of the factors responsible for the fiscal imbalance of Kerala’s finances beyond the above summary [George 1999; George and Krishnakumar 2003; Kannan and Mohan 2003; Mohan and Shyjan 2005]. As can be seen from the data in Table 9, similar to the experience of most Indian states, the latter half of the 1990s saw a significant increase in the revenue deficit, fiscal deficit and the debt burden of the state. This trend assumed crisis proportions in 2000-01 when the revenue deficit increased to 4.5 per cent and the fiscal deficit increased to 5.6 per cent of the GSDP. The severe agrarian crisis that engulfed the state’s economy at the end of the 1990s (due to the sharp downturn in the prices of commercial crops) took a heavy toll on the state’s tax collection. The own tax GSDP ratio, which averaged 8.6 per cent in the second half of the 1990s declined to 8.4 per cent in 2000-01. It can also be seen that there was a sharp decline in the share of central transfers in the total revenue of the state from 32 per cent in the first half of the 1990s to 28.1 per cent in the second half of the 1990s and further to

    25.2 in 2000-01. The unexpected decline in the central devolution, primarily as a result of the lower share in the central transfers awarded by the Eleventh Finance Commission, left a gap of more than Rs 500 crore in the budget of 2000-01. As a result, the total revenue receipts, as a share of GSDP, declined to 12.5 per cent in 2000-01 from 13.4 per cent in the period 1995-96 to 1999-2000.

    On the expenditure side, the implementation of the Pay Equalisation Committee recommendations increased the salary payments by over Rs 1,000 crore per annum. There occurred a very severe crisis of Overdraft in 2001, and even the closure of the treasury. The substantial devolution of funds to the local selfgovernments and the consequent spurt in the number of treasury cheques in circulation issued by the LSGIs to thousands of beneficiaries made the crisis highly visible and vulnerable. This fiscal crisis was an important factor, among others, that contributed to the defeat of the LDF in the 2001 assembly elections.

    The UDF government that came to power in 2001 brought out a white paper that sought a dramatic exaggeration of the fiscal crisis of the state government so as to prepare ground for a drastic fiscal adjustment programme [GoK 2001]. The remedial measures to deal with the so-called impending disaster included expenditure compression (such as curtailment of benefits to employees and reduction in social subsidies, including welfare pensions), closure of sick public sector undertakings and all-round increases in user charges. These prescriptions became the conditionalities in the semi-structural adjustment loan that the state government took from the Asian Development Bank (ADB). These were further reinforced by the Fiscal Responsibility Act 2003, which set the goal to wipe out the revenue deficit and reduce the fiscal deficit to 2 per cent of the GSDP by 2006-07. The government guarantees for liabilities were capped at an absolute figure of Rs 14,000 crore. Meeting the above targets would have required draconian measures, which even the UDF government found politically and socially difficult to carry out. The move to curtail government employees’ benefits and rights met with stiff resistance including a month-long strike. A major “Save-PSU” movement emerged and numerous agitations by the workers in the traditional sector took place. There was also a mass movement against privatisation policies in the educational and health sectors.

    Between 2000-01 and 2001-02, the revenue expenditure of the state declined sharply from 17 per cent to 16.1 per cent of the GSDP and the revenue deficit of the state declined from 4.5 per cent to 3.6 per cent of the GSDP (Table 9). The fiscal deficit of the state also declined from 5.6 per cent to 4.5 per cent of the GSDP between 2000-01 and 2001-02. However, the ratios were reversed in the very next year. The state government, in its memorandum to the TFC in 2003, admitted that the “shortterm measures, such as expenditure compression and postponement of liabilities, are bound to show up as expenditure in the following years” [GoK 2003: 14]. But the government hoped that “the medium-term measures are expected to bring in the fiscal sustainability” (ibid).

    However, the confidence of the UDF government in the success of the fiscal adjustment programme was already shaken with no concomitant increase in the central devolution. The state’s memorandum to the TFC openly stated that it would be impossible to realise the fiscal targets of the Medium-Term Fiscal Restructuring Programme (MTFRP) that had been drawn up following the recommendations of the EFC. The UDF government made the following judgment on the MTFRP:

    In the present situation, we believe that it would be futile to have a target of reducing fiscal deficit without first attempting to tackle the core issue of non-plan revenue deficit and plan revenue deficit…As a basic pre-requisite of the fiscal reform programme, the revenue deficit should have been taken care of. In the absence of this requirement being met, the fiscal reforms programme was ab initio faulty. Therefore, in spite of our continued commitment to fiscal correction, we would not meet the targets of MTFRP. We would urge that any fiscal correction programme be based on realistic and not merely prescriptive parameters to break the vicious circle of rising revenue deficit, increasing borrowing and deepening fiscal crisis [GoK 2003: 16].

    The achievement of the fiscal targets by 2006-07 required an annual reduction in revenue deficit from 5.1 per cent of the GSDP in 2002-03 at 1.3 per cent per annum, if the annual fiscal correction was prorated [Rajaraman and Kurian 2006]. The revenue deficit tended to move in the right direction of correction in 2003-04 and 2004-05, but at around half the targeted pace. The revenue deficit declined from 5.1 per cent of the GSDP to

    3.7 per cent of the GSDP between 2002-03 and 2004-05.

    The required annual rate of reduction of fiscal deficit from the pre-FRA level of 5.8 per cent in 2002-03 to reach the target of 2 per cent in 2006-07 worked out to be 0.88 percentage points (ibid). Data presented in Table 9 show that the fiscal deficit declined from 6.2 per cent in 2002-03 to 6.1 per cent of the GSDP in 2003-04. It declined to 4.4 per cent of the GSDP in 2004-05.

    However, the TFC recommendations for interest rate concession and debt consolidation raised the optimum fiscal deficit ceiling to 3 per cent of GSDP, and extended the date for attaining fiscal

    Table 9: Indicators of State Finances, Kerala State, 1980-81 to 2006-07

    (in per cent)

    Item 1980-81 to 1985-86 to 1990-91 to 1995-96 to 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 1984-85 1989-90 1994-95 1999-00 RE) (BE)

    Own tax-SDP ratio 7.0 8.4 8.3 8.6 8.4 8.2 9.0 9.0 8.9 8.6 9.2 Own non-tax SDP ratio 2.3 1.5 1.2 1.1 0.9 0.8 0.8 0.9 0.8 0.8 0.9 Share of central transfers

    in total revenue 32.0 33.2 32.0 28.1 25.2 28.6 24.9 24.7 27.5 29.8 33.3 Revenue expenditure

    as ratio to SDP 13.4 16.3 16.0 16.2 17.0 16.1 18.3 17.2 17.1 16.6 19.5 Capital expenditure

    as ratio to SDP 5.0 5.0 4.0 3.0 1.2 0.8 0.9 0.7 0.7 0.9 1.8 Revenue receipts as ratio to SDP 13.6 14.9 14.3 13.4 12.5 12.5 13.2 13.1 13.4 13.7 15.2 Capital receipts as ratio to SDP ----5.6 4.6 5.9 6.1 4.7 4.3 6.0 Revenue deficit as ratio to SDP 0.6 1.4 1.7 2.8 4.5 3.6 5.1 4.1 3.7 4.0 4.3 Fiscal deficit as ratio to SDP 2.7 3.9 3.7 4.8 5.6 4.5 6.2 6.1 4.4 5.3 6.0 Revenue deficit as ratio

    to fiscal deficit -27.3 36.4 44.0 53.3 81.2 79.7 82.5 66.4 82.4 76.6 71.9 Debt stock as ratio to SDP 26.9 29.8 28.8 29.8 36.0 39.4 41.3 43.1 43.9 44.4 -

    Source:Computed from different official sources.

    deficit targets and eliminating the revenue deficit to 2008-09. This was more lenient than the fiscal correction as originally envisaged in Kerala’s Fiscal Responsibility Bill of 2003. Consequently the reduction required in the revenue deficit declined to 0.85 percentage points per annum and in the fiscal deficit by

    0.42 percentage points per annum [Rajaraman and Kurian 2006]. The Public Expenditure Review Committee (PERC), constituted under the FRA 2003, concluded that

    Aggregating across the first two years of the FRA, therefore, the FD correction remains in conformity with the (amended) correction requirement…[However,] the actual decline in the RD of 1.01 percentage points in 2003-04, and 0.43 percentage points in 2004-05, falls short of the combined requirement over two years, by 0.26 per cent of GSDP [Rajaraman and Kurian 2006: 20-21].

    The PERC also drew attention to the fact that the major proportion of the grants given to LSGIs is capital outlay. If a realistic modification is made in the accounts to take care of the above fact, the revenue deficit of the state would sharply decline.

    Starting from an RD, so adjusted [for the capital outlays involved in the grants to local bodies and PWD expenditure on maintenance], of 3.88 per cent of GSDP in 2002-03, the yearly required reduction in the adjusted RD is 0.68 per cent of GSDP. The achieved reduction over two years is 1.42 per cent, higher than the 1.30 per cent required (ibid: 21).

    Rebuffed by the electoral setbacks in the successive assembly by-elections, Lok Sabha elections and the elections to the LSGIs, the UDF government tried to reverse some of its draconian measures and distanced itself from the fiscal adjustment programme. As per the revised budget estimate for 2005-06, the revenue deficit was 4 per cent of the GSDP and the fiscal deficit was 5.3 per cent of the GSDP (Table 9). However, according to the supplementary figures of the CAG, which are not yet published, the revenue deficit has declined further in 2005-06 to 2.83 per cent of the GSDP and the fiscal deficit to 3.77 per cent of the GSDP. We may have to wait for some more time before conclusive figures are arrived at. Nevertheless, there has been a reduction in the ratio of revenue expenditure to GSDP from 17.1 per cent in 2004-05 to 16.6 per cent in 2005-06. This has been achieved largely by postponement of payments of some of the current liabilities like dues to contractors (Rs 950 crore), welfare pension liabilities (Rs 250 crore), and food subsidy (Rs 21 crore). There was also a significant increase in central transfers (that included VAT compensation), which increased from 24.7 per cent in 2003-04 to 29.8 per cent in 2005-06. Even then, the popular discontent was too severe and conclusive; the UDF government was voted out and the LDF government came to power with an overwhelming majority.

    Any illusion on the success of the fiscal adjustment programme has been removed with the implementation of the report of the Pay Commission of the state, the order for which was passed on the eve of the assembly elections. This report was to be implemented from the financial year 2006-07. The additional commitment to the state government on this account was Rs 2,922 crore. Even after freezing a part of the arrears in the provident fund, the net requirement of funds in the budget for 2006-07 was Rs 2,017 crore. Even without providing fully for the arrears due to contractors and welfare funds, it is seen from Table 9 that the ratio of revenue expenditure to GSDP increased sharply from

    16.6 per cent in 2005-06 to 19.5 per cent in 2006-07. Despite a higher ratio of revenue receipts to GSDP assumed (15.2 per cent in 2006-07 as compared to 13.7 per cent in 2005-06), the revenue deficit in the budget of 2006-07 increased to 4.3 per cent of the GSDP and the fiscal deficit to 6 per cent of the GSDP. It is likely that the year 2006-07 would end at a much higher level of revenue deficit.

    The budget for 2006-07, with a total expenditure of Rs 26,768 crore and a Planning Commission-approved plan outlay of Rs 6,210 crore, was drawn up on the assumption of a fiscal deficit of Rs 7,535 crore, and a borrowing limit of Rs 7,200 crore. As we have seen, there was an increase of nearly 70 per cent in the fiscal deficit between 2005-06 and 2006-07. This increase was a major deviation from the fiscal correction path envisaged. As the union finance ministry pointed out to the state, according to the fiscal correction path drawn up, the borrowing ceiling in 2006-07 should have been Rs 4,672 crore.

    The implications of the reduction of borrowing ceiling to Rs 4,672 crore in 2006-07 in order to stick to the fiscal correction path would have been calamitous to the state government. It would have meant a drastic reduction in the plan outlay and a severe cut in social sector and welfare expenditures. It would have also meant total disruption of the devolution of funds from the state government to the LSGIs, consisting of plan grants of Rs 1,400 crore and maintenance and general purpose grants of around Rs 650 crore.

    After much pressure, the union finance ministry agreed to raise the borrowing limit of the state to the original level. But there was a condition. The state would have to forego the TFCrecommended incentive of debt-waiver and would not be permitted to raise additional loans from other sources for the shortfall in the small savings collection (which was expected to be at least Rs 1,200 crore lower than the budgeted amount of Rs 2,950 crore). It is to be remembered that the central government that swears by the TFC has neither constituted the Inter-State Loan Council that it recommended nor discussed the issue in the subcommittee of chief ministers formed by the NDC to discuss the debt burden of states. The unilateral stand adopted by the central government is a serious challenge to the spirit of fiscal federalism in India.

    It is very evident that a mechanical implementation of the fiscal adjustment programme would result in severe compression of social and developmental expenditure in Kerala and derail the democratic decentralisation process in the state. In the revised budget for 2006-07 presented by the LDF government, an alternative adjustment programme that postponed the revenue deficit target to 2009, with no drastic expenditure compression measures and focus on raising the tax-GSDP ratio, has been mooted. With this objective in mind, a number of measures for increasing the tax revenues, primarily to check evasion, and also an increase in the VAT rates on non-necessities were introduced. The average sales tax rate on such items in the pre-budget period was about 22 per cent in Kerala. It has been conclusively shown that, as far as Kerala was concerned, the revenue neutral VAT rate was not 12.5 per cent but above 18 per cent. Therefore, a position was adopted that the VAT rates must be conceived of as floor rates and not as uniform rates.

    Further, whether the revenue deficit of the state is reduced as per the revised budget for 2006-07 would be conditional on greater devolution from the centre. With revenue deficit under strict control, the alternative adjustment programme does not see any particular merit in mechanically adhering to a ceiling for the fiscal deficit. This position has been made amply clear in the response note of the Kerala State Planning Board to the Eleventh Plan Approach Paper of the Planning Commission [State Planning Board 2006].

    IV Summing Up

    Public expenditure by states on social and economic services, a crucial necessity for fulfilling the basic needs of people, is low in India by any standard and needs urgent enhancement. However, in the 1990s and 2000s, the ratio of revenue expenditure by all states to the GDP has stagnated, if not declined. At the same time, all states together have an investment outstanding of over Rs 64,000 crore in the treasury bills of the centre. Then why do the states not spend this money? The union finance minister has concurred in the Parliament that much more needs to be invested in education, health care, the mid-day meal scheme, rural roads and urban development. The problem, according to him, is that states are “unable to spend” because they do not have the “absorptive capacity”. Our position in this paper has been that this is a false and misleading argument.

    States do not spend because there are legal constraints on spending. The finance ministry and the successive finance commissions have forced the states to pass fiscal responsibility legislations in their assemblies. As per these legislations, states have to eliminate the revenue deficit and reduce the fiscal deficit to 3 per cent of the GSDP by 2008-09. In line with these targets, the revenue deficit and fiscal deficit of states declined sharply in the 2000s. This decline in revenue deficit was achieved by keeping the revenue expenditure to GDP ratio stagnant, even while there was an increase in revenue receipts to GDP ratio of states. The states could have raised revenue expenditures by making use of the increased receipts, and still kept the revenue deficit constant. This, however, would have been contrary to the targets set for the elimination of revenue deficit by 2008-09. Even the increased capital receipts – in the form of NSSF borrowings

    – were not routed to revenue expenditures because of the fear of rising revenue deficit. The cash surplus phenomenon, thus, is a perverse outcome of the FRBM Acts.

    The case study of Kerala in this paper sharply brings out the adverse implications of mechanically designed fiscal adjustment programmes in the context of long-term commitments to social spending and exogenous changes like pay revisions. Going by the provisions of the FRBM Act, Kerala would have to sharply cut plan expenditures, reduce social spending and curtail devolution to local self-governments.

    The Planning Commission has already taken a position against the lack of flexibility in the FRBM Act provisions. Demands for more flexibility are also fully endorsed by international experiences with fiscal responsibility legislations. As we have argued, the FRBM Act has to go off the rule book or drastically amended. This demand is today in the centre stage of centre-state relations in India.




    [For helpful comments and discussions on an earlier draft, we thank Amiya Kumar Bagchi, Prabhat Patnaik, S L Shetty, Pallavi Chavan and Jose Cyriac.] 1 One argument has been that it is the centre that provides tax incentives to investors in small saving accounts. However, this is argument not

    tenable, as the loss to the centre due to tax incentives affects the receipts of states as well through the lower share in taxes devolved.

    2 In this paper, we have not undertaken an analysis of capital expenditures of states.


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