1 Agenda for Fiscal Reforms

T

The global financial crisis which began with the bursting of the housing bubble in the United States and aggravated by the collapse of several international financial institutions beginning with Lehman Brothers swiftly had an impact on the real sectors and has caused a recessionary environment in the US, Japan and European countries. Although, initially, the emerging market economies including India felt that they could decouple themselves from the global financial meltdown, it was soon recognised that this was simply not possible. Thus, the adverse impact of the recession in the countries of the Organisation for Economic Cooperation and Development (OECD) on India was much more than that was initially envisaged. Reviving the economy required strong stimuli from both fiscal and monetary policy instruments, but it was soon realised that the headroom for providing fiscal stimulus side was very limited.

The central government put forward three fiscal stimulus packages in 2008-09, but the fiscal contents of these packages were not very significant mainly because there was hardly any headroom. Of course, there were tax cuts of 6 percentage points in union excise duties and 4 percentage points in service tax. Another important component of the package was allowing an additional half a percentage of the gross state domestic product (GSDP) borrowing to the states. Not surprisingly, the economy has continued to slow down and clear signs of revival are yet to emerge though the GDP estimate of the last quarter at 5.8% is marginally higher than the previous quarter’s at 5.3%. In this situation, there will be considerable pressure on the new government to provide additional stimulus packages to revive the economy, but the package of measures will be constrained by the lack of fiscal space and limited policy manoeuvrability.

In order to understand how much additional fiscal stimulus can be given, it is important to understand the nature of the fiscal imbalance in the country. In other words, it is necessary to analyse how much of the deficit is structural and how much of it is cyclical. While the cyclical component of the deficit is not a serious cause for concern, the structural component needs to be attended to. This will also help in identifying the policy measures to be implemented in the short and medium term to nurse the fiscal situation back to health. The country will have to live with high deficits in 2009-10 for any attempt to make a significant adjustment will have a severe impact on the growth of the economy. This, however, does not mean that important reform cannot or should not be undertaken in the current year. Some of the reforms could actually help to release larger resources for providing the stimulus and some reform measures could help to create a better environment for the revival of private sector sentiment.

This paper attempts to make an assessment of the fiscal situation in the country. It will analyse the trends in fiscal imbalances and examine the efforts at fiscal consolidation since the enactment of Fiscal Responsibility and Budget Management Act (FRBMA) at the centre and Fiscal Responsibility Acts (FRA) in the states. It will address the question on the efficacy of FRBMA and its shortcomings in achieving fiscal consolidation and the lack of counter-cyclical element in the fiscal restructuring plan adopted by the central and state governments as recommended by the Twelfth Finance Commission (TFC). The paper will also examine the adequacy of fiscal stimulus packages implemented so far and analyse the fiscal space available for further stimulus by the new government at the centre. The paper discusses also the immediate reform measures to provide the stimulus while containing the fiscal deficit in the short term and achieving fiscal correction in the medium and long term. It also discusses the next stage of fiscal consolidation and the design of the new fiscal responsibility legislation to avoid the shortcomings of the last FRBMA.

2 Fiscal Consolidation in India since 2001-02

The latter part of the 1990s saw a sharp deterioration in the fiscal situation at both central and state levels. Most analysts attribute the problem to significant pay and pension revision, but there are other important factors contributed to the deterioration. These include a sharp decline in the central revenues from customs and excise duties, an increase in the interest burden due to both increasing volume of indebtedness and higher interest rates and continued proliferation of subsidies and transfers. The gross tax revenue of the centre relative to GDP declined from 10.2% in 1991-92 to 8.2% in 2001-02 and this was due to 2 percentage point decline in customs duties, 1 percentage point decline in union excise duties, which was offset by a 1 percentage point increase in direct taxes. Interest payments as a ratio of central revenues increased from 40.3% in 1991-92 to 53.4% in 2001-02. Even as revenue receipts relative to GDP showed a declining trend, the revenue expenditures as a ratio of GDP increased from 6.8% in 1991-92 to 14.1% in 2001-02. All these factors culminated in creating the worst fiscal imbalance scenario possible in 2001-02

78 with the revenue and fiscal deficits as ratios of GDP at 7% and 10.3%, respectively (Table 1, Figure 1).

Since 2001-02, however, there has been an appreciable turnaround – up to 2007-08. The consolidated fiscal deficit declined relative to GDP from 9.9% in 2001-02 to 5% in 2007-08 (Table 1). The revenue deficit declined by 6.4 percentage points from over Table 1: Fiscal Indicators of the Central and State Governments (% of GDP)

* The estimate for the central government are actuals and for the states, revised estimates. ** The estimate for the central government is revised estimates and for the states, budget estimates. The 2006-07 figures are actual for the central government and revised estimates for states. Source: Budget Documents, Government of India, and Finance Accounts, State Governments

7% in 2001-02 to just about 0.6% in 2007-08. The aggregate fiscal deficit in 2007-08 is estimated at about 5%. Furthermore, improvements were seen at both the central and state levels (Figure 1). In fact, the reduction in fiscal deficit exceeded the targets set under the fiscal responsibility legislation though the performance of the centre in reducing the revenue deficit has lagged behind the plan. Notably, according to the fiscal restructuring plan recommended by the TFC, the central and state governments taken together were required to phase out the revenue deficits and bring down the consolidated fiscal deficit to 6% of GDP. The plan envisaged the central government compressing the deficit to 3% of GDP and the consolidated deficit of the states to be reduced to 3%.

Figure 1: Trends in Fiscal Imbalances in India

7 – 6 – 5 – 4 – 3 – 2 – 1 – 0 – -1 – 1996-97 1998-99 2000-01 2002-03 2004-05 2006-07 2007- 2008- | | | | | | | | | Centre fiscal deficit State fiscal deficit Centre rev deficit State rev deficit

08(RE) 09(BE)

In 2008-09, however, there was a sharp reversal of the trend. Although the consolidated revenue deficit for the central and state governments was budgeted at 0.5% and the consolidated fiscal deficit was budgeted at 4.5%, the revised estimates place the revenue deficit at 4.4% and fiscal deficit at 6%. When the impact of the tax cuts and slow growth of tax revenues due to economic slowdown is taken into account, the revenue and fiscal deficits as

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ratios of GDP could increase to 5% and 6.5%, respectively. In the case of states, the available information for 14 of the 28 states shows that the aggregate revenue surplus which was estimated at over 0.6% of GSDP in the budget estimate would be reduced to 0.4% and fiscal deficit as a ratio of GDP shows an increase from 2.8% to 3.4%. Assuming that the situation in other states is similar, we can expect the aggregate fiscal deficit to be about 3% of GDP which implies that the consolidated fiscal deficit for 2008-09 could be as high as 9.5%. In addition, there are off-budget liabilities amounting to Rs 96,000 crore by way of bonds issued to oil companies (Rs 75,942 crore), fertiliser companies (Rs 20,000 crore) and this works out to about 2% of GDP. Thus, the consolidated liabilities of the central and state governments including offbudget liabilities add up to over 11.5% of GDP in 2008-09. This magnitude of the fiscal deficit is unprecedented and has even surpassed the highest level of deficit incurred in 2001-02 (10.3%).

It must be noted that the sudden deterioration in the fiscal situation is neither sudden nor is it due mainly to the economic slowdown in the country. It was not sudden because a substantial proportion of the deficit in the year was due to the non-payment of subsidies that accrued in the previous year, but the payment was simply postponed to 2008-09. However, a substantial proportion of the deficit was due to budgeting of expenditures for pay revision, loan waiver and additional expenditure provision for implementation of the National Rural Employment Guarantee Act which was extended to 250 districts from the 100 districts in the previous year, but was not budgeted.

There are three important questions from the viewpoint of policy. First, is the improvement in the fiscal situation until 2007-08 attributable to fiscal responsibility legislations? Second, is the sharp deterioration in the fiscal situation in 2008-09 due to the fiscal stimulus packages announced by the government to combat the economic slowdown? Finally, a related question: how much of the fiscal imbalance in the country seen in 2008-09 is cyclical and how much of it is structural? Before answering these questions, it is important to analyse the fiscal trends at the central and state levels separately.

3 Trends in Central Government Finances

Both the central and state governments contributed to the progress in fiscal consolidation until 2007-08 broadly in equal measure, although, the improvement in the state finances itself was, to a considerable extent, due to higher tax devolution and grants from the central government. Analysis shows that during the past decade the fiscal deficit of the central government was the highest in 2001-02 at 6.2%. Similarly, the revenue deficit of the central government was the highest in 2001-02 at 4% of GDP. In subsequent years, there was a steady reduction in both revenue and fiscal deficits and the reduction was sharper after the FRBMA was passed in August 2003. The fiscal deficit relative to GDP declined from 6.2% in 2001-02 to 4.5% in 2003-04 and further to 2.7% in 2007-08. Similarly, the revenue deficit was reduced from 4.4% in 2001-02 to 3.6% in 2003-04 and further to 1.1% in 2007-08.

The sharp improvement in the fiscal situation after passing the FRBMA has led to the impression that (i) the improvements in the fiscal situation were mainly attributable to the legislation; (ii) the

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large fiscal deficit that exists today is cyclical and not structural and therefore, is not a major cause of worry; and (iii) since the deficit is cyclical, there is still considerable scope for the new government to introduce further stimulus packages for combating the economic slowdown. Surely, the new government at the centre will be under considerable pressure to follow an expansionary policy to increase spending on food subsidy, loan waiver and other populist schemes.

The important question is: if indeed there has been a structural improvement in the fiscal health over the years until 2007-08, how could it turn so bad within a year? Although the budget estimate for 2008-09 shows that the revenue and fiscal deficits relative to GDP would be contained at 1% and 2.5%, respectively, the revised estimates for the year show that the revenue deficits would increase to 4.4% and fiscal deficit would increase to 6%. The indications are that the revenue receipts would be even lower than shown in the revised estimates by a further half a per cent of GDP. In addition, there are off-budget liabilities amounting to about 2% of GDP making increase in aggregate central liabilities to 8.5% of GDP. Not just that these are much higher than the targets set in the FRBMA, but these are the highest – higher than the deficit even in 2001-02.

A close analysis shows that although some part of the deficit is attributable to cyclical factors, the deficit is largely structural. Notably, the reduction in taxes consequent to the stimulus packages and lower revenue collections due to the slowdown in the economy can at best account for 1.2% of GDP. While the budget estimate of gross tax revenue as a ratio of GDP for 2008-09 is close to 13%, the revised estimate is placed at 11.8%. As regards expenditures are concerned, the increase from the budget estimate of 13.8% of GDP to 16.6% of GDP in the revised estimate is not due to any stimulus package but only to adequately fund the commitments made in the budget speech. The structural weaknesses in the budget can be brought out by a more detailed analysis of fiscal situation.

Thus, both revenue and fiscal deficits of the central government as ratios of GDP declined steadily from 2001-02, and the decline was much sharper since 2003-04, which gives an impression that the improvement was due to the fiscal discipline imbibed by the FRBMA. However, a careful analysis shows that according to the FRBMA implementation task force’s restructuring plan, while the revenue deficit was expected to be reduced to 0.3% of GDP in 2007-08 and eliminated by 2008-09, it was 1.1% in 2007-08 and is estimated at 4.5% in 2008-09. As regards the fiscal deficit, until 2007-08 the adjustment was broadly according to plan which implies that a substantial portion of the adjustment was achieved by compressing capital expenditures from almost 4% of GDP in 2003-04 to 2.5% in 2007-08.

Notably, it was the sharp increase in the tax revenues, particularly in direct taxes, that led to the appreciable reduction in the revenue deficit. In fact, the centre’s gross tax revenues as a ratio of GDP increased by 4.4 percentage points between 2001-02 and 2007-08 of which a 3.4 percentage points increase was since 2003-04 (Table 2, p 80). During the period 2003-08, revenue from direct taxes increased at a compound rate of 30.7% per year with corporation tax increasing at 31.3% a year and personal income tax revenue increasing at 30% a year. The nominal increase in GDP during this period was 14.3% and given the buoyancy coefficient of 1.1, we can explain a growth rate of 15.7% to the increase in GDP, which implies another 15 percentage point increase must

Table 2: Trends in Central Finances

% of GDP Percentage Points 2001-02 2003-04 2007-08 2008-09 Imporve-Imporve-Deteriora(RE) ment in ment in tion in 2007-08 2007-08 2008-09 over over over 2001-02 2003-04 2007-08

Source: Budget documents of the central government for various years.

be attributed to other factors. The main factor that has contributed to the growth of direct taxes was the institution of the Tax Information Network (TIN) in 2003-04 and entrusting this task to the National Security Depository Ltd (NSDL). The important lesson from this is that the government can mobilise substantial additional revenues if only it strengthens the information system of union excise and customs duties, entrusting the task to a competent information technology company rather than continuing with the depleted National Informatics Centre (NIC) which does not have the capacity to institute the information system required for the effective enforcement of these taxes.

It must be noted that the task force on the implementation of FRBMA had worked out the plan for achieving the targets envisaging both increase in revenues and compression of expenditures. However, while the increase in revenues conformed, the government failed to compress expenditures according to the plan (Rao, Sen and Jena 2008). According to the plan, the revenue expenditures as a ratio of GDP were to be compressed from 13.1% in 2003-04 to 11.3% in 2007-08 and further to 11% in 2008-09. As against the planned decline of almost 1 percentage point, the revenue expenditure actually declined by just about

0.5 percentage points, to 12.7% in 2007-08, but increased sharply to 14.8% in 2008-09 (RE). In fact, during this period, spending on debt servicing declined by almost 1 percentage point as the interest rates declined and the government swapped debt with high interest rates with lower interest rates. This implies that the noninterest expenditure as a ratio of GDP actually increased from 8.6% in 2003-04 to 9.1% in 2007-08. Thus, the structural problems on the expenditure side of proliferation of subsidies and untargeted transfers were not simply addressed in the implementation of FRBMA.

Is the deterioration in the fiscal health in 2008-09 due to the fiscal stimulus given to combat the economic slowdown? A closer examination shows that the revision was mainly because there was significant under-provision of expenditures in the 2008-09 budget estimates and during the course of the year expenditures had to be provided to fund the commitments made in the budget. The detailed analysis of the Supplementary Demands (Table 3) shows provision for additional cash expenditures amounting to almost 2.8% of GDP. This includes provision for pay revision, additional funds for food and fertiliser subsidies, funding of the loan waiver scheme and additional allocation to various flagship programmes including the National Rural Employment Guarantee. Thus, in order to show that the government was adhering to the FRBMA, the expenditures were simply under-budgeted. Thus, the deterioration in the fiscal situation was not due to any stimulus package, though, these expenditure certainly provide additional stimulus to the economy. However, under-provision in the budget estimates results in poor planning and implementation of expenditures and contributes to low productivity of public spending.

The above analysis indicates that the government failed to achieve the adjustment as envisaged in the FRBMA, particularly in containing the expenditures and protecting capital expenditures. Whatever adjustment was achieved was attributable mainly to the increase in tax revenues arising mainly from improvement in computerised information system and to some extent, reduction in the interest rates. The analysis also shows that overwhelming proportion of the deficit continues to be structural and not cyclical. Furthermore, the increase in the expenditures was not due to fiscal stimulus packages but to adequately fund

Table 3: Supplementary Demand for Grants of the Central Government

Ministry of Finance, Government of India.

the commitments made in the budget itself. Inadequate funding of the programmes in the budget only creates inefficiency in expenditure implementation.

Thus, even as it passed the FRBMA, the government missed the opportunity to adhere to the set targets by weeding out

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unproductive expenditures. In particular, the proliferation of explicit and implicit subsidies has long been a concern not only because to the large and growing magnitude but also its poor targeting and fiscal responsibility legislation provided a good opportunity to rationalise them. Successive governments were concerned about the increasing burden and in 2004 the government had placed a White Paper on the subject in Parliament. Yet, there was very little progress on this front in reducing or rationalising the subsidies. The new government will have to address this issue not only to create additional fiscal space for combating the economic slowdown, improving productivity in public spending and revert to the fiscal correction path.

4 Trends in State Government Finances

The deterioration in the fiscal health of the states in the latter part of the 1990s following significant increases in pay and pensions of government officials, declining tax devolution from the centre and increasing burden of debt servicing caused a steady deterioration in the fiscal health of the states in the latter part of the 1990s. The Eleventh Finance Commission was asked to recommend an incentive linked fiscal restructuring plan to achieve correction. However, the incentive linked grants by the commission had serious design shortcomings (Rao 2003) and the situation did not show much improvement until 2003-04. Therefore, the TFC was mandated to draw up a fiscal restructuring plan to restore the balance. According to its recommendation, each of the states was required to phase out its revenue deficit and contain the fiscal deficit at 3% of GSDP. The commission recommended debt restructuring and a write off scheme to the states linked to passing of fiscal responsibility legislation and compression of revenue and fiscal deficits. All the states except Sikkim and West Bengal have passed the fiscal responsibility legislations after 2005-06.

However, since 2003-04, the fiscal health of the states has shown a steady improvement until 2007-08 (RE). The aggregate revenue deficits of the states as a ratio of GSDP declined from 2.3% in 2003-04 to a surplus of about 0.5% in 2007-08. This 2.8 percentage point improvement in the revenue deficit helped to reduce the fiscal deficit by 2.1 percentage points and increase the capital outlay by about 0.9 percentage point (Table 4). Thus, the states in the aggregate were able to generate revenue surplus of about half a per cent and reduced their fiscal deficit to a little over 2% of GDP which is 1 percentage point more than that was recommended in the fiscal restructuring plan of the TFC. In addition, they could increase the capital outlay by about 1 percentage point of GDP. Surely, fiscal consolidation in the states until 2007-08 has helped them to cope better with the economic slowdown.

Table 4 presents the analysis of the sources of improvement in state finances. As already mentioned above, between 2003-04 and 2007-08, there was a 2.8 percentage point improvement (relative to GDP) in the revenue deficit position and this has helped to reduce the fiscal deficit by 2.1 percentage points. It is also seen that the improvement in the revenue deficit due to larger revenue collections was 2.1 percentage points or about 78% and the expenditure reduction was only due to lower interest payments. Of the 2.1 percentage point improvement in revenues, the contribution

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of own tax revenues was 0.7 percentage point and tax devolution and grants from the centre contributed to 1.4 percentage point improvement. Again, the higher transfers were mainly attributable to the increased buoyancy of central tax revenues during this period. With the reduction in the union excise duties as a part of the fiscal stimulus packages and slowing down of the economy, there would be a significant deceleration in central tax revenues and this could adversely affect state finances in the next two years.

Own tax revenues of the state governments increased by 0.7 percentage point during the period and a close examination shows that much of the increase is attributable to the introduction of value added tax (VAT) to replace the cascading type sales tax in April 2005. Of course, buoyant economy, rationalisation of stamp duties and a boom in the real estate market also resulted in a significant increase in stamp duties and state excise duties as well. The economic slowdown and the reduction in excise duties is likely to shrink the VAT base of the states and with the housing market under severe strain, there could be a significant deceleration in the states’ own revenues after 2008-09.

On the expenditure side, the adjustment was only 0.6 percentage point and this is almost entirely due to lower interest payments. Besides lowering of interest rates due to the debt swap scheme adopted in 2004-05, lower volume of borrowings from the National Small Savings Fund and to some extent, the writeoff of debt repayment as per the recommendation of the TFC have contributed to the improvement.

Surely, the economic slowdown in 2008-09 has adversely affected state finances significantly. Available information on the revised estimates for 14 states for 2008-09 shows that the position has deteriorated since due to the slowdown in the economy and declining tax devolution and the revenue surplus is likely to

Table 4: Trends in State Finances

Source: NIPFP Data Base.

be reduced by about 0.2% of GDP and the fiscal deficit may increase by about 0.7 percentage point. Most of the states for which information is available are yet to undertake the pay revisions and when the fiscal position in other states is also considered, the states taken together may not generate any revenue surplus and may end up with the fiscal deficit of about 3.5% of GSDP, which is equivalent to 3% of GDP. While these targets conform to those set by the TFC in the fiscal restructuring plan, the situation is far from being comfortable. This is because, in the next year (2009-10), when the impact of pay revision in all the states are effected and the impact of the economic slowdown on the states’ own tax revenues and tax devolution are taken account of, a substantial revenue deficit is likely to re-emerge and the fiscal deficit may increase substantially.

Finances of Individual States

Almost all states have shown significant improvements in their fiscal health in 2008-09 as compared to 2001-02 (Table 5). Interestingly, on an average, the improvement in the fiscal health of the states in low income states was much more than that of high income states in both revenue deficits, fiscal deficits as well as in capital expenditures. Similarly, improvement in the fiscal health of special category states was better than that of general category states.

Fiscal Deficit Revenue Deficit Capital Outlay*

2001-02 2008-09 (BE) Improve-2001-02 2008-09 (BE) Improve-2001-02 2008-09 (BE) Improve

ment (2-3) ment (5-6) ment (9-8)

1 2 3 4 5 6 7 8 9 10

I General category states Orissa’s performance has been the best

Andhra Pradesh 4.28 2.92 1.36 1.83 -0.21 2.05 2.44 6.76 4.31

Goa 5.82 4.50 1.31 3.22 -1.26 4.48 2.60 5.76 3.16

Gujarat 5.27 2.40 2.87 5.45 -0.02 5.46 -0.18 2.42 2.59

Haryana 4.32 1.23 3.09 1.66 -0.86 2.53 2.65 2.09 -0.56 Karnataka 5.39 2.99 2.40 3.01 -1.28 4.30 2.37 4.36 1.98substantial part of the reduction is by

Kerala 4.22 3.46 0.77 3.37 2.07 1.30 0.86 1.39 0.53compressing capital expenditures. In

Maharashtra 4.02 2.19 1.82 3.02 -0.16 3.18 1.00 2.35 1.35terms of improving capital outlay, Bihar’s

Punjab 6.22 3.22 3.00 4.74 0.69 4.06 1.48 2.53 1.06performance was the best. Tamil Nadu 3.18 3.34 -0.16 1.84 -0.03 1.87 1.34 3.37 2.03

West Bengal 7.51 3.56 3.95 5.64 2.32 3.32 1.88 1.25 -0.63

Average 4.85 2.77 2.07 3.38 0.21 3.17 1.47 3.04 1.57

Bihar 4.47 2.98 1.49 2.28 -4.13 6.42 2.19 7.11 4.93

Chhattisgarh 3.60 2.45 1.15 1.88 -2.28 4.16 1.73 4.73 3.00 Jharkhand 3.89 2.52 1.38 0.87 -2.42 3.29 3.02 4.94 1.91more particularly due to higher central

Madhya Pradesh 4.20 3.14 1.05 3.64 -1.88 5.52 0.56 5.02 4.47transfers. There was hardly any com

Orissa 8.45 2.17 6.28 6.04 -0.48 6.52 2.42 2.65 0.24pression of revenue expenditures even

Rajasthan 6.28 2.98 3.30 4.14 -0.69 4.83 2.13 3.67 1.53as the ratio of interest payments to GSDP Uttar Pradesh 5.21 3.12 2.09 3.25 -2.93 6.18 1.95 6.04 4.09

Average 5.25 2.89 2.37 3.37 -2.21 5.58 1.88 5.09 3.21

category states 4.97 2.81 2.17 3.38 -0.51 3.89 1.60 3.65 2.05

Arunachal Pradesh 11.70 -15.44 27.14 -2.62 -23.14 20.52 14.32 7.70 -6.62off recommended by the TFC.

Assam 3.79 2.13 1.66 2.30 -2.74 5.04 1.48 4.87 3.39The pattern of fiscal adjustment since

Himachal Pradesh 8.81 5.63 3.19 5.02 -0.20 5.22 3.80 5.83 2.03 2001-02, however, shows significant Jammu and Kashmir 8.17 6.61 1.57 1.85 -9.15 11.00 6.32 16.28 9.96

Manipur 10.22 1.67 8.55 4.84 -13.92 18.76 5.38 15.59 10.21

Meghalaya 4.79 1.48 3.31 0.73 -6.15 6.88 4.06 7.63 3.57

Mizoram 21.70 3.68 18.02 13.38 -5.18 18.56 8.32 8.85 0.54

Nagaland 8.09 3.08 5.01 2.46 -7.28 9.74 5.63 10.36 4.73

Sikkim 5.88 14.56 -8.68 -12.58 -17.57 4.99 18.47 32.13 13.66

Tripura 8.45 6.56 1.89 -0.86 -6.37 5.51 9.30 12.93 3.63

Uttarakhand 3.83 3.05 0.78 2.06 -4.74 6.80 1.77 7.79 6.02 Average 6.38 3.55 2.83 2.40 -5.08 7.47 3.99 8.71 4.72 points improvement in the revenue

Average of all states 5.06 2.85 2.21 3.32 -0.78 4.10 1.74 3.95 2.21 deficit, higher tax effort contributed

GSDP figures are projected using trend growth rate on last two available years; * Capital outlay includes net lending.

Source: Finance accounts and budget documents of state governments. to the introduction of VAT. However,

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own non-tax revenues declined by 0.23 percentage point. The tax devolution and grants together increased by 1.07 percentage points during the period. These states could compress their revenue expenditures by 0.6 percentage point of which, almost 0.3 percentage point was due to lower interest payments. The increase in own tax effort was more than 3 percentage points in Andhra Pradesh, more than 2.5 percentage points in Punjab and Tamil Nadu and more than 2 percentage points in Karnataka. Except Goa and Gujarat every state improved its tax effort. In the case of Kerala too, the tax-GSDP ratio increased by

1.7 percentage points and central transfers increased by over 1 percentage point, but as revenue expenditures increased by over three points, the revenue deficit actually increased by 0.2 percentage point.

Table 6: Fiscal Consolidation from 2001-02 to 2008-09 (BE) (% of GSDP)

States	Reduction		Increase in		Change (+/-) in
	in Revenue				Interest Payments
Deficit	Own	Own	Share in	Grants	Revenue	Interest
	Taxes	Non-taxes	Central		Expenditure	Payments
		Taxes
I	General category states
High income states
Andhra Pradesh 2.05	4.09	0.82	1.22	1.39	5.48	-0.20
Goa	4.48	0.71	-1.42	1.07	1.06	-3.07	-0.55
Gujarat	5.46	-0.17	-1.67	0.66	0.07	-6.58	-0.88
Haryana	2.53	0.88	0.47	0.37	0.16	-0.64	-1.01
Karnataka	4.30	4.52	-0.14	0.76	0.75	1.60	-0.19
Kerala	1.30	2.04	0.04	0.81	0.68	2.28	-0.06
Maharashtra	3.18	0.80	-0.69	0.58	1.44	-1.04	-0.31
Punjab	4.06	1.66	-0.19	0.83	2.27	1.19	-0.69
Tamil Nadu	1.87	2.59	0.13	1.32	0.98	3.14	-0.32
West Bengal	3.32	0.94	0.07	1.24	-0.16	-1.24	-0.17
Average	3.17	1.82	-0.18	0.84	0.86	0.20	-0.40
Low income states
Bihar	6.42	0.70	-0.12	6.43	6.04	6.63	-1.15
Chhattisgarh	4.16	1.80	-0.05	1.73	2.15	1.45	-0.94
Jharkhand	3.29	1.57	0.77	1.23	0.97	1.25	0.73
Madhya Pradesh 5.52	4.02	0.15	3.01	2.68	4.35	0.38
Orissa	6.52	0.97	0.35	1.41	2.16	-1.63	-2.35
Rajasthan	4.83	2.30	0.45	2.61	0.61	1.14	-0.48
Uttar Pradesh	6.18	3.19	0.69	3.90	1.65	3.24	-1.27
Average	5.58	2.43	0.44	3.19	2.11	2.60	-0.84
Average of
general
category states	3.89	2.03	0.01	1.49	1.22	0.89	-0.54
II Special category states
Arunachal Pradesh 20.52	0.89	9.50	8.41	26.21	24.49	0.47
Assam	5.04	1.04	1.46	2.90	7.21	7.57	-0.35
Himachal Pradesh	5.22	1.34	2.47	0.70	1.14	0.43	-0.77
Jammu and
Kashmir	11.00	2.83	0.67	2.71	1.24	-3.55	-1.27
Manipur	18.76	0.41	1.72	2.94	3.77	-9.92	-2.12
Meghalaya	6.88	1.58	0.30	4.25	13.14	12.39	-0.07
Mizoram	18.56	1.10	0.98	9.71	5.63	-1.13	-1.83
Nagaland	9.74	0.40	0.47	5.09	2.72	-1.07	-0.73
Sikkim	4.99	0.73	2.78	2.28	-2.86	-2.06	-2.18
Tripura	5.51	1.16	-0.54	2.41	2.14	-0.34	-0.82
Uttarakhand	6.80	2.17	1.36	3.49	4.30	4.52	0.13
Average	7.47	1.56	1.43	2.91	4.57	2.98	-0.62
Average of
all states	4.10	2.00	0.09	1.58	1.40	1.00	-0.55

GSDP figures are projected using average growth rate of last two available years. Source: Finance accounts and budget documents of state governments.

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june 20, 2009 vol xliv no 25

The low income states, on the other hand, reduced their revenue deficit – GSDP ratio by 4.8 percentage points. This was achieved even as non-interest revenue expenditures on social and economic services increased by 2.3 percentage points but due to lower interest payments, total revenue expenditure increased by 1.7 percentage points. Thus, larger transfers from the centre increased the revenues of these states by 4 percentage points and better revenue effort from own sources increased the revenues by another

2.4 percentage points. However, easing of resource constraints enabled these states to make additional allocation to social and economic services in both revenue and capital accounts.

In the case of special category states, the revenue deficit relative to GSDP was compressed by 5.9 percentage points mainly on the strength of higher central transfers. The ratio of tax devolution and grants to the GSDP from the central government increased by over 5 percentage points since 2001-02 and the increase in own revenues was about 2.5 percentage points. At the same time, revenue expenditures too increased by 1.8 percentage points. Although revenue deficits were reduced by 5.9 percentage points, compression of fiscal deficit since 2001-02 was only 2.3 percentage points as a significant portion of revenue deficit reduction (3.6 points) was used to augment capital expenditures.

The analysis of the indicators of fiscal health in different states summarised in Table 7 (p 84) shows that going purely by deficit indicators, the performances of low income states were as good if not better than those of high income states. In fact, in 2006-07 (RE), the average revenue and fiscal deficit in the latter were higher than in the former. While the low income states, on average, had a revenue surplus of 0.65% of GSDP, the high income states had a deficit of 0.77%. Similarly, the average fiscal deficit in low income states (3.9%) was only marginally higher than that of the high income states (3.3%). The revenue and fiscal deficits in individual states do not show a clear pattern with their per capita income levels. The correlation coefficient of the revenue deficit with per capita income in the general category states is 0.15 indicating that the deficits are higher in high income states, though the coefficient was not significant. Similarly, the correlation of coefficient of fiscal deficits with per capita income was not significant (-0.09). It is also seen that among the low income states every state except Bihar and Jharkhand had revenue surpluses whereas among the high income states all the states except Karnataka and Gujarat had deficits.

5 Improving the Fiscal Environment: Fiscal Correction versus Additional Stimulus

Given the difficult fiscal situation in the country, the new finance minister faces the formidable challenge of providing additional fiscal stimulus to the slowing economy, making additional funds available for initiating and expanding the flagship programmes and schemes expounded in the Congress Party’s manifesto while containing the fiscal deficit which has reached alarming proportions. Although the interim budget estimates the fiscal deficit of the centre at 5.5% of GDP, the tax cuts announced after the interim budget and the additional expenditure needed to expand the flagship programmes and to fulfil the promises made in the election manifesto could increase the deficit to about 6.5% of GDP and deficit at the state level would be close to 3% of GDP. Thus, the consolidated fiscal deficit in 2009-10 could remain at the same level as in 2008-09 at about 9.5% of GDP.

With the recessionary climate in the OECD countries and the slowdown in the Indian economy, it would be unrealistic to expect any significant adjustment in the deficit and the 2008-09 level of deficit would continue. Nevertheless, there will be a lot of expectations that the budget will provide yet another stimulus package. Furthermore, from the viewpoint of reviving the economy speedily, the government will have to increase allocations to infrastructure and some of the asset creating flagship schemes such as rural roads. Equally important is the need to provide clear signals to the private sector and this would require initiating a number of reforms.

Table 7: Important Fiscal Performance Indicators in States (2006-07)

Average Revenue Fiscal % of Per Capita Tax-GSDP Per Capita Deficit Deficit Revenue Dev Ratio GSDP (Rs) (% of GSDP) (% of GSDP) to Fiscal Spending (%)

Deficit (Rs) 2006-07 2006-07 (RE) 2006-07 (RE) 2006-07 (RE) 2006-07 (RE) 2006-07 (RE)

On the revenue front, the most important measures are:

There are a number of reforms the government could initiate in this year’s budget on the expenditure front. Given that the international prices of crude oil and gas are low, the volume of fertiliser subsidy would be substantially lower and the interim speed up the process so that even if it misses the target of April 2010, it can set a clear time table for the switchover.

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In the mean time, it is possible for the central government to make substantial progress in rationalising its domestic indirect taxes with a view to evolving a GST at the manufacturing stage. The time is opportune because both the CENVAT rates and the rates of service tax have been reduced by 6 and 4 percentage points, respectively to provide a fiscal stimulus and the rates have been reduced to 8% and 10%, respectively. This would require the implementation of the important recommendation of the Expert Group on Service Tax in 2001-02. The group recommended that the service tax should be generalised by extending it to all services excluding a small exempted and negative list of services. Converting the selective taxation of services into a general taxation of services is an important precondition to move towards the GST. This will not only extend the tax base significantly, but also will obviate the need to define each service and avoid tremendous scope for litigation that exists at present. In addition, it will also help to generalise input tax credit for all goods and services. On the excise duty front, it is necessary to bring about convergence of tax rates. In fact, it is easy to move towards a single tax rate for all commodities excluding sumptuary items.

In the next stage, it is possible to switch over to the GST at the manufacturing stage by unifying the two taxes simply by having a common threshold and a uniform tax rate and enabling input tax credit for both goods and services. The government may keep the threshold at Rs 1 crore which is much higher than the prevailing threshold for service tax, but much lower than that of union excise duties. This helps to expand the tax base and to begin with, levying the tax at 9% which would be revenue neutral. In respect of sumptuary items of consumption such as cigarettes and petroleum products, a separate excise may be levied in addition to the general GST. This reform can be initiated in the forthcoming budget itself by converting the prevailing selective service tax into general and effecting convergence in central excise duties and in the next budget, the centre can move over to the manufacturing stage GST.

Another important fiscal issue that the budget will have to deal with is to address the next stage of fiscal consolidation. Although the final blueprint for this will have to wait for the recommendation of the Thirteenth Finance Commission, it is important to think about the next stage of fiscal consolidation based on the experience gained from the implementation of the FRBMA. The important issue that needs to be noted is that static fiscal targets are clearly inappropriate to deal with cyclical changes in the economy. It may be appropriate to fix the deficit target with a band. Similarly, it may be more appropriate to fix the fiscal deficit target as a ratio of expenditure rather than GDP as it takes a longer time to get the firm estimate of the latter. The fiscal responsibility legislation should be followed by a Medium-Term Fiscal Plan (MTFP) which should specify the targets on both revenue and expenditure sides. It is important to note that fiscal discipline is not a function of the finance ministry alone; it has to be owned by the government and all spending departments should be a part of implementation. This would entail that along with the passing of the FRA, the Ministry of Finance should put forth the indicative targets of expenditure to each of the spending departments for

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the next three years and the latter, in turn, should work out a clear prioritisation and action plan based on the indicated targets. In case there are additional priority expenses, the spending departments should negotiate with the Ministry of Finance. The important issue is that the medium-term fiscal framework as well as expenditure plan will have to be initiated as a part of the fiscal responsibility and budget management exer cise and this should be updated every year. Mere passing of a legislation without a proper implementation mechanism will put the burden of adjustment only on the Ministry of Finance and that will result in phasing out capital expenditure, delaying payments, creating off-budget liabilities and showing a lower deficit estimates in the budget but coming out with large supple mentary demands later in the year which puts a heavy premium on expenditure management.