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Subnational Fiscal Sustainability Analysis: What Can We Learn from Tamil Nadu?

This paper presents a framework for subnational fiscal sustainability analysis and emphasises the differences between fiscal adjustment at the national and subnational levels. Using the case of Tamil Nadu that experienced an unprecedented fiscal deterioration - a part of the widespread fiscal stress in Indian states in the late 1990s - the analysis attempts to take into account uncertainty and discusses the key components of the state's fiscal accounts and how they respond to reforms and shocks. It illustrates that risks to the state's fiscal outlook include interest rate shocks, pressures on the primary balance, and contingent liabilities, reflecting the interplay of subnational and national policies. The analysis is relevant for other Indian states and countries.

We thank Craig Burnside, Vikram Nehru, Dana Weist, Brian Pinto, Sona Varma, James Hanson, and an anonymous referee for their useful comments. The substance of the paper also beneted from extensive discussions with the government of Tamil Nadu. The ndings and conclusions expressed herein are those of the authors and do not reect the views of the World Bank group. december 29, 2007 112Sage AD Fiscal Deficit Revenue Deficit Primary Deficit SPECIAL ARTICLEdecember 29, 2007 114Table 1: Debt Dynamics Tamil Nadus Case (% ofGSDP) 1994199519961997199819992000200120022003Stock of debt (b) 16.6 16.4 16.3 16.3 17.3 20.5 22.2 24.9 28.0 27.8(A) Actual change in debt (db) -0.2 -0.1 0.0 1.1 3.2 1.7 2.6 3.2 -0.3Decomposition of change in debt (1) Interest payments (i) 1.8 1.8 1.7 1.8 2.1 2.2 2.4 2.7 2.8(2) Primary balance (x) 0.2 -1.0 -0.6 -2.3 -2.5 -1.8 -1.1 -1.9 0.3(3) Growth effect (gb/Z) -0.5 -0.7 -1.2 -0.7 -1.0 -1.4 0.5 -0.6 -1.4(4) Inflation component (b/) -1.5 -1.3 -1.1 -1.3 -0.1 -0.7 -0.8 -1.2 -1.2(P) Predicted change in debt* -0.4 0.7 0.0 2.1 3.5 1.8 3.2 2.7 -0.2(A)-(P) Residual term 0.2 -0.8 0.0 -1.1 -0.3 -0.2 -0.6 0.5 -0.1Effective interest cost (per cent of GSDP) 0.2 0.5 0.6 0.5 2.0 1.5 1.6 1.5 1.5As a percentage of debt 1.4 2.8 3.7 2.8 11.7 7.1 7.3 6.1 5.4The years shown in this and subsequent tables and graphs denote fiscal years, e g, 1994 stands for fiscal year 1994-95. * Predicted change in debt is computed by the authors following equation (2) as (1)-(2)+(3)+(4). state revenue in Mexico. The predictability and size of transfers depend on the transfer system. In India, the constitutionally mandated Finance Commission (FC) convenes every ve years to determine revenue sharing between the centre and states based on a formula using non-constant weights for various relevant fac-tors such as population, income disparity, area, tax effort and s-cal discipline. Sixth, the central government can affect the scal sustain-ability of subnationals through policies, which impact subnational scal balances and economic growth. Examples include the cen-tral governments policies on wages and pensions in Brazil and India, and the ceilings on debt services and debt stock set by the central government in Colombia, Peru, Russia and Mexico. In In-dia, many projects and policies that affect the growth potential of the subnational economy, such as investment in major infrastruc-ture, investment and labour policies and regulation, are largely or exclusively within the purview of the central government.Expected bailouts by the central government inuence sub-national debt dynamics. Market participants may tolerate un-sustainable subnational scal policy if past history backs their perception that the central government implicitly guarantees the debt service of the subnational government. Central govern-ments implicit guarantees for local government bailouts contri-buted to the widespread subnational defaults in Russia in the late 1990s and in Mexico in the mid-1990s. Finally and not least importantly, scal risks are associ-ated with the borrowing regime. In India, a number of policy loopholes have softened state budget constraints [Rajaraman, Bhide and Pattnaik 2005].6 Although subnational borrowing is subordinated to prior approval by the centre, the states negoti-ate bilaterally with the centre the size of plan spending. The por-tion uncovered by central loan/grant assistance and by the states own resources is therefore left for states to cover through loans from other sources,7 but no sustainability analysis is carried out before the negotiated limits for additional borrowing by each state are approved, and no systematic procedures are in place to ensure that the limits are not exceeded. There has also been an automatic entitlement of states to loans against small savings collections within the jurisdiction of each state.8 Furthermore, many states circumvented the borrowing limits by accumulating arrears or issuing guarantees to support the market borrowing of SOEs or special purpose vehicles. Progress has been made in addressing the borrowing regime particularly with the Twelfth FC whose recommendations include mandatory scal responsi-bility legislation by states and central incentives for states scal adjustment.92 Fiscal Crisis and Reforms in Tamil NaduAt the end of the 1990s, Tamil Nadus scal decits grew rapidly,10 and so did its debt and contingent liabilities (Figures 1 and 2). The quality of scal spending deteriorated. A high and growing portion of net borrowing nanced wages, pensions, subsidies and interest payments, while capital expenditure remained low. The latter was a special concern. Since the 1990s, Tamil Nadus capital-outlay-to-GSDP ratio has been on average 1.6 per cent and much lower than the 2 to 3 per cent in comparable states. The traditional measure of the scal decit did not capture the quasi-scal activities, and therefore masked the depth of the s-cal decline. Specically, the budget did not capture the nanc-ing gaps of SOEs. MostSOEs in Indian states were not creditworthy,11 hence their borrow-ings were backed by government guarantees. The nancial losses of the state electric-ity boards posed the most signicant scal threat [World Bank 2005b]. Although efcient compared to the elec-tricity boards of many other Indian states, the Tamil Nadus Electricity Board(TNEB) had nancial losses that rose steadily beginning in the late 1990s, owing to increasing subsi-dies to agriculture and domestic consumers and rising supply costs. To capture the im-pact of these losses, theTNEBs accounts were consolidated with the states scal accounts. The impact of the power sector on the budget was signicant. In 1999-2000, the consolidated decit, dened as the sum of the non-power scal decit of the govern-ment and TNEBs total nancing requirements, was 6.7 per cent of GSDP compared with the traditional measure of scal decit 4.6 per cent ofGSDP.12Tamil Nadus scal deterioration was not an isolated pheno-menon. The combined scal decit of the Indian states rose from 2.9 per cent of GSDP in 1997-98 to 4.3 per cent of GSDP in 2003-04, with states accounting for about one-half of Indias general scal decit. This decit gure would have been higher if it included off-budget liabilities and arrears not reected in ofcial statistics. The pattern of scal deterioration rising revenue decits, gov-ernment guarantees, and signicant off-budget activities was similar across Indian states. In relative terms, Tamil Nadus scal performance was better than that of most other states. While the debt-to-GSDP ratios of Indian states were not high (average was 25 per cent of GSDP in 2001-02) compared to that of the national government (65 per cent of GDP in 2001-02), Tamil Nadus ability to meet debt service obligations was eroding. Inter-est payments as a share of revenue rose to about 20 per cent in 2003-04, reaching a threshold of debt distress as dened by the central government.The rapid scal deterioration was attributed to a number of reasons, common to all states with varying degrees. Expendi-tures on salaries, retirement benets, and pensions grew rapidly SPECIAL ARTICLE december 29, 2007115Table 2: Baseline Simulation as Proposed in Tamil Nadus MTFPAssumptions 2003 20042005 2006200720082009 20102011 2012 20132014Real interest rate (r) 5.5 5.5 5.5 5.5 5.0 5.0 5.0 5.0 5.0 5.0 5.0Real growth rate (g) 8.5 6.5 6.0 6.0 6.0 6.0 6.0 6.0 6.0 5.8 5.7Primary surplus (x) -0.3 -0.5 -0.1 0.5 0.8 0.5 0.5 0.5 0.5 0.5 0.5Debtdynamics Debt (% of GSDP) (b) 27.8 27.3 27.5 27.5 26.9 25.8 25.1 24.4 23.7 23.0 22.3 21.7 2015 20162017 2018201920202021 20222023202420252026Realinterestrate(r) 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0Real growth rate (g) 5.5 5.3 5.2 5.0 4.8 4.7 4.5 4.5 4.5 4.5 4.5 4.5Primarysurplus(x) 0.5 0.5 0.5 0.50.50.50.5 0.50.5 0.5 0.5 0.5Debtdynamics Debt (% of GSDP) (b) 21.1 20.5 20.0 19.5 19.0 18.6 18.2 17.8 17.4 17.0 16.6 16.2Source: Authors simulation based on equation (3).following the implementation of the pay commission award.13 Subsidies grew rapidly. Tamil Nadus share in central tax devo-lution declined further following the EleventhFCs award. New borrowing to support the growing revenue decit added to the debt and interest burden. Finally, growth in contingent liabilities associated with scal support to the public sector units, coopera-tives, and statutory boards exacerbated the scal risks.14 Based on equation (2) in Section 2, Table 1 (p 114) identies the key determinants of Tamil Nadus state debt. Growth in state liabilities reected both growth in scal decits and accumula-tion of interest payments on outstanding debt, while growth and ination were offsetting factors.In response to the scal crisis, scal reforms were undertak-en by Tamil Nadu from 2001-02 to 2003-04 to control recurrent expenditures, improve the efciency of the tax system, restruc-tureSOEs, and improve scal transparency.15 Tamil Nadus Fiscal Responsibility Act, which laid down the principles of scal adjustment, became opera-tional in May 2003. One of the commitments un-der the act was a medium-term scal plan(MTFP) stating how the targets under the act were going to be achieved. The MTFP was presented to the state legislature in February 2004. The scal adjustment aimed to achieve a primary balance, eliminate the revenue decit and reduce the consolidated scal decit to 2 per cent of GSDP. While reducing the consolidated scal decit, the scal reform expect-ed re-orientation of expenditure from salaries, pensions, and sub-sidies to non-wage operation and maintenance (O&M) and capital investments and deepening of tax reform.Tamil Nadus multiyear adjustment framework explicitly in-corporated important off-budget and contingent liabilities. Off-budget borrowing serviced by the state government was inte-grated with the states public debt.16 Capital works executed in the public account but nanced by off-budget borrowings de-posited in the public account were fully integrated within the scal framework. Comprehensive estimation of accrued pension liabilities and cash ow needs based on the inherent demograph-ics of the workforce replaced the incremental cash budgeting. As mentioned earlier, the accounts of the TNEB were consolidated with the scal account.On the expenditure side, reform efforts were made at control-ling the growth of pensions and wages, reducing major subsidy programmes and improving their targeting. These efforts resulted in a slowdown of growth in pensions, subsidy, salaries and inter-est expenditure whereas expenditure on non-wage operations and maintenance expenditure and transfers grew because the state could better utilise resources under central schemes. On the revenue side, a major tax reform effort, including the preparation for the introduction of a value added tax (VAT), was aimed at improving the efciency of the sales tax system, which suffered from multiple layers of taxes and a complex rate struc-ture, cascading, frequent and ad hoc changes, and extensive ex-emptions. The state reformed its stamp duty system, lowered the tax rate on property transactions and improved its administra-tion in an effort to reduce tax evasion. On the non-tax side, the governments efforts to increase cost recovery had some success but was limited due to political considerations.As a result of these reforms, a large portion of arrears (2 per cent ofGSDP) was cleared in 2002-03. Furthermore, the consolidated scal decit was reduced from the peak of 6.7 per cent ofGSDP in 1999-2000 to 3.3 per cent in 2003-04.17 The scal adjustment was largely attributed to an increase in the ratioofthestates own tax revenue to GSDP (from 8.6 per cent in 1999-2000 to 9.4 per cent in 2003-04) and a reduction in the ratio of salaries to GSDP (from 6.5 per cent in 1999-2000 to 4.7 per cent in 2003-04). Unfortunately, capital outlays and net lending suffered a reduction of 0.4 per cent of GSDP due largely to lack of nancing.The nancial performance of the TNEB also improved mainly due to improvements in operational efciency, bill collection, and anti-theft measures. The net loss before subsidy decreased from Rs 18.54 billion in 2001-02 to Rs 3.90 billion in 2003-04. The net losses of the state transport units were reduced by 98.6 per cent between 1999-2000 and 2002-03. Outstanding guarantees fell from 7.5 of GSDP in 1999-2000 to6.4 per cent in 2003-04, when they were lower than those of many Indian states.Since April 2004, some critical reforms have been rolled back.18 Strong revenue growth enabled the state to absorb the current expenditure impact of the reform reversals momentar-ily. The revenue growth was driven by stronger than anticipat-ed growth in states own tax revenue, due to a strong upturn in the states economy, and much more robust devolution from the centre. On the expenditure side, higher than projected subsidies and transfers due to the reform rollbacks were more than com-pensated by lower than projected outlays on salaries and pen-sions as the government withheld ination-indexed salary and pension increases.3 Subnational Fiscal Sustainability Analysis We start by assessing Tamil Nadus scal sustainability in a base-line covering the period 2003-04 to 2026-27 and in the context of Indias macroeconomic policies and intergovernmental revenue-sharing system. Given the long-run nature of scal sustainability analysis we look at outcomes over a period of 23 years. Recognis-ing the uncertainty associated with the projected values of key variables in the model we supplement the analysis with sensitiv-ity tests that examine the impact of adverse shocks on deviations from the baseline. We also explore whether there is scal space for infrastructure investment. Baseline Capital expenditure increase

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