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Deficits and Recession: Role of Subnational Governments

A critique of two arguments in "Subnational Public Finance in Times of Recession" (EPW, 28 August 2010) relating to fl exible, state-specifi c fi scal targets and the role of the state governments in dealing with the effects of the fi nancial crisis.


Deficits and Recession: Role of Subnational Governments

Archana R Dholakia

(FRA) and using the same for devolving grants under the TFC indicates rigidity, which may have serious implications on the states’ finances as well as autonomy.

We disagree with this view because states with fi scal deficits greater than 5% of their GSDP are precisely the ones that require

A critique of two arguments in “Subnational Public Finance in Times of Recession” (EPW, 28 August 2010) relating to fl exible, state-specifi c fiscal targets and the role of the state governments in dealing with the effects of the fi nancial crisis.

Archana R Dholakia (archana_dholakia@gidr. is at the Gujarat Institute of Development Research, Ahmedabad.

Economic & Political Weekly

october 16, 2010

n the note “Subnational Public Finance in Times of Recession” (EPW, 28 August 2010), Lekha Chakraborty and Kaushik K Bhadra (henceforth Chakraborty and Bhadra) make some interesting observations and inferences, of which two are in debatable. The first is their suggestion to have fl exible, state-specifi c fi scal defi cit targets rather than use the same set of targets for all, as has been laid out under the Fiscal Responsibility and Budget Management (FRBM) and the Thirteenth Finance Commission (TFC) report. The second point relates to their contention that the state governments’ efforts to counter the recession induced by the global financial crisis (GFC) were only marginal. The authors have critically reviewed the Reserve Bank of India’s (RBI) report on State Finances for 2009-10 and also analysed the latest data on state fi nances from the Economic Outlook 2010-11 to substantiate their arguments. This article will examine and discuss these points in detail.

State-Specific Fiscal Targets

Chakraborty and Bhadra have noted that the fi scal deficit as a percentage of the gross state domestic product (GSDP) for all non-special category states was less (3.25%) than the enhanced fi scal targets of 3.5% and 4% for 2008-09 and 2009-10, respectively, and that a similar pattern was also observed for the revenue defi cit. Thus they (rightly) conclude that “(the) fiscal imbalance profile does not refl ect a massive increase in deficits – especially for non-special category states”. The authors express concern about the performance of states such as West Bengal, Jharkhand, Uttar Pradesh and Punjab, whose fi scal deficits would have crossed 5% of their GSDP for 2009-10 (BE). To deal with this, the authors have emphasised the need for fl exible state-specific targets. They argue that deciding the same target limits for all states under the Fiscal Responsibility Act

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stricter fiscal rules. Even during the pre-crisis year(s) 2007-08 and earlier, when all the other non-special category states had revenue surpluses, and fi scal deficits of less than 3% of their GSDP, the above-mentioned states had positive figures for revenue deficit, over and above the high fi scal defi cits on their accounts. Thus, their current p osition has less to do with the GFC crisis and more to do with fundamental, longterm disequilibrium in fi scal accounts, arising from e xpenditure/revenue mismanagement. The case of Punjab suggests that fiscal imbalance is not necessarily correlated with the level of per capita i ncome or growth, implying that sociopolitical factors might be at work.

Even if one agrees to the proposal of flexible targeting, what should be the criterion employed to determine the limits for states – efficiency or equity? Use of effi ciency would dictate that the states with higher growth performance be allowed higher limits (of revenue defi cit, fi scal defi cit and debt) compared to the laggard states, as the former can sustain larger defi cits. The famous Domar equation used by the Twelfth Finance Commission can even help us derive the sustainable targets for different states. While this may help the high growth performers to grow faster because of liberal borrowing limits, the low growth states would be in a complete shamble.

Discretionary Fiscal Targets?

The second alternative implied by Chakraborty and Bhadra’s suggestion is the equity/need based criterion, which necessitates the use of discretion in setting the target limits. Given the dynamics of political economy, any such “discretion” has the potential to become a tool for achieving noneconomic or personal objectives. Reports of the earlier finance commissions, especially during the pre-reform era, contain substantial evidence of the use of “discretion” or “discretionary” formulae designed for


helping the needy states. Unfortunately, several policies, designed perhaps with such noble intentions, created unintended consequences and worked as “perverse incentives” for the better fi scal performers (Dholakia 1999). This is generally described as a problem of wrong “signalling” in the standard readings in economics of information (Pindyck et al 2009). In view of such problems, the Tenth Finance Commission had emphasised the need for positive fi scal incentives and the later fi nance commissions worked further in this direction to finally come up with more objective and performance-based formulae for the fiscal awards. The targets and values of fiscal parameters are now being derived on the basis of sound macroeconomic framework rather than ad hoc considerations. This seems to have resulted in improving the fiscal balance of almost all states during 2002-07. Thus the use of flexible target limits suggested by Chakraborty and Bhadra would be taking a step backward in terms of fi scal reforms.

The authors also argue that the states’ autonomy could be jeopardised due to adherence to the state-specific paths of fi scal variables, as recommended by the TFC. While it cannot be disputed that autonomy of the subnational governments is important and on several occasions in the past, the centre has denied the states this autonomy (Dholakia 1999), fortunately, over the years, the state governments also seem to have become conscious of it. The postponement of the goods and services tax (GST) roll-out in the recent meeting (27 August 2010) and the tough arguments about the threshold limits, rates of GST, etc, under the so-called “grand bargain” process, evince the states’ power to protect their autonomy.

Moreover, autonomy must go hand in hand with responsibility, and the challenge is to ensure the latter. For decades, some states have been heavily dependent on the centre, which necessarily implies that the fiscally better off states have been contributing more towards the common kitty to meet the former’s requirements. Given the variations in socio-economic and geographic conditions of certain states, this could be justified to some extent. But to what extent is this justifi ed and what constitutes a “fair” degree of dependence? Without fiscal reforms in terms of a time bound programme and targeting, it would be impossible to judge this and create fiscal consciousness among the states. Thus the objective of such reforms may be to make some states responsible for their actions and not to reduce autonomy.

There have been several instances which reveal the irresponsible behaviour of the state governments. The estimates by the National Institute of Public Finance and Policy of implicit and explicit subsidies by for various states are worth looking into for this purpose. Similarly, the gross underutilisation of the National Highways Authority of India funds for the construction of highways during 2009-10 in some states is a case in point (Business Standard, 30 March 2010). Despite the fact that all financial responsibilities were undertaken by the centre and that the states were just required to spare the necessary land, Bihar and West Bengal respectively, provided only 13.3% and 5% of the required land. Even worse, the states of Uttarakhand, Chhattisgarh, Jharkhand, and Himachal Pradesh did not provide any land at all! We often forget about the responsibility, when we are (over)concerned about the autonomy of the states.

Countering Recession

Chakraborty and Bhadra also contend that the states’ efforts during the post-GFC period were inadequate. They conclude: “Despite an economic recession induced by the global financial crisis, the state level fi scal stance has not been expansionary in the last two years”. Their inference is based only on the fact that increased deficits during the period largely resulted due to a “fall” in revenue rather than “increase” in the states’ expenditure on “stimulus packages”. The problem is that the authors measure the size of the stimulus package only through fi scal expenditure, which may seriously undermine the efforts of the state government(s) due to the following reasons. One, “expansionary policy” not only implies an increase in government expenditure, but also necessarily includes the measures relating to tax reduction. Though the impact of the latter is difficult to estimate in the short run, the effort cannot be ignored. Second, in the current environment of economic reforms, we give significant emphasis to the “enabling” efforts of the government(s)

october 16, 2010

which may not necessarily get refl ected in either revenue or expenditure side of the budget – at least in the short run. Nonetheless, they may succeed in affecting the i mportant components of the aggregate demand, namely private consumption, i nvestment and more importantly expectations. For instance, the Gujarat government did not formally announce a special e xpenditure or tax package to curb the adverse effects of the recession, as is evident from Table 2 in Chakraborty and Bhadra’s article. Yet, it encouraged investments in infrastructure through the public-private partnership model, by organising a “Vibrant Gujarat” summit within six months of the GFC, and encouraging “realty exhibitions”, “housing melas”, etc, in the state.

It is also interesting to point out that although the revenue expenditure in almost all states showed an increase, the authors practically discount this effort of the states on the grounds that it was largely due to implementation of the Sixth Pay Commission awards and not as a result of a “stimulus package”. The question is: if the short-term objective of the states is to boost the aggregate demand, how does it matter whether this was achieved through a pay revision or through the National Rural Employee Guarantee Scheme or under a special head of “stimulus package”? Given the objective, the component “G” alone matters, not its kind or quality.

This also gives rise to another question regarding the role of subnational governments during such macroeconomic crises. Contrary to what the authors perceive, we believe that the states’ role is limited and not very significant. This is because in a federal structure such crises are better a ddressed at the national level, as has been demonstrated by the recent fi nancial crisis. Although the states must have their own fiscal policy agenda, they should f ocus on addressing the medium- and long-term objectives rather than pure short-term ones.


Dholakia, Archana (1999): “Role of the Centre in Fiscal Balance of States – The Case of Gujarat”, Journal of Indian School of Political Economy, Vol XI, No 2, April-June.

– (2005): “Measuring Fiscal Performance of States

– An Alternative Approach”, Economic & Political Weekly, Vol 40, No 31, 30 July.

Pindyck, Rubinfeld and Mehta (2009): Micro Economics, Seventh ed. (Asia: Pearson Education).

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Economic & Political Weekly

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