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Thursday, Oct 24, 2002

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State finances — Perils of procrastination

S. D. Naik

While there are considerable variations in their position, almost all States experienced fiscal deterioration since 1997-98 because of their inability to contain the growth in revenue expenditure and the reluctance to raise additional tax and non-tax revenues. Launching the economy on a higher growth path would depend to a large extent on the State-level fiscal reforms, which cannot be delayed any longer, says S. D. Naik.

THE October 18 meeting of the Chief Ministers with the Prime Minister, Mr Atal Bihari Vajpayee, and the Finance Minister, Mr Jaswant Singh, to formulate an agenda for fiscal reform, turned out to be a damp squib with many States opposing the Centre's key proposals on debt swap and dearness allowance (DA) freeze. About 50 per cent of the total debt of the States comprises the Centre's loans. An agreement on the debt swap proposal would have resulted in an estimated interest saving of Rs 37,000 crore over the maturity of loans to be retired.

Instead of swapping the high interest debt with low interest ones, the States wanted the Centre to forego the entire interest on their high cost debt. They should realise that the resources at the disposal of the Centre are also limited. Moreover, such blanket waivers would only encourage the States to continue with their fiscal profligacy.

In his opening remarks, expressing concern over the unacceptably high fiscal deficit of the Centre and the States, the Prime Minister said: "Unless we broaden political consensus, and the consensus between the Centre and the States, on critical development and governance reforms, the problems we face will get compounded." But the majority of States failed to heed to his wake-up cry despite the impending fiscal crisis facing them.

State finances have witnessed a steady deterioration, particularly since 1998-99 and today they are in dire straits, with several frontline States on the verge of bankruptcy. Despite repeated warnings by the Reserve Bank of India (RBI) and the Centre, the majority of the States continue to squander resources on non-productive populist schemes; the proportion of their development expenditure has been falling steeply.

The gravity of the situation is reflected in the unprecedented surge in the outstanding debt of States in recent years. According to the latest RBI study (RBI Bulletin, October 2002), the total outstanding debt of States mounted to Rs 5,89,219 crore at end-March 2002 from Rs 1,60,028 crore in 1993-94. With the rapid increase in debt stock, the interest liability of all States together increased more than six-fold during the decade from less than Rs 9,000 crore to over Rs 54,000 crore.

The States' revenue deficit, which accounted for less than 30 per cent of the gross fiscal deficit in the early 1990s, reached a staggering 60 per cent by the end of the decade. Incidentally, the States had revenue surpluses till 1987-88. However, they have been running huge revenue deficits post-reform because of reckless pursuit of political populism.

While there are considerable variations in the fiscal position of different States, almost all have experienced fiscal deterioration since 1997-98 because of their inability to contain the growth in revenue expenditure and the reluctance to raise additional tax and non-tax revenues.

As many experts have pointed out, the fiscal situation in most States is much worse than what is reflected in their annual budgets. For instance, in his study on State Finances in India, Dr M. Govinda Rao, Director, of the Bangalore-based Institute for Social and Economic Change, points out that in recent years, States have resorted to unsound practices such as increasing their liability in Public Account, particularly small savings loans and creating special purpose vehicles (SPVs) in investment activities in irrigation, etc. They have also been borrowing heavily from the institutions such as Nabard, LIC, Hudco and IDFC to finance infrastructure development.

Another source of growing fiscal imbalance not reflected in the State budgets is the losses incurred by public enterprises, notably the State electricity boards (SEBs). In 2000-01, the estimated losses of SEBs amounted to Rs 26,000 crore. Of this, only Rs 6,000 crore was taken into account in State Budgets by way of explicit subsidy given to the SEBs.

One more source of fiscal imbalance, which has been building up over the past few years, is the guarantees extended by State governments to the bonds floated by various corporations. According to the rating agency Crisil, States went overboard in the last five or six years in extending guarantees to many weak entities whose standalone capacity to service debt is virtually non-existent. The outstanding guarantees of State governments rose from Rs 1,32,029 crore (6.8 per cent of GDP) at end-March 2000 to Rs 1,68,712 crore (8.1 per cent of GDP) at end-March 2001.

Five large States — Gujarat, Maharashtra, Karnataka, Andhra Pradesh and Tamil Nadu — together account for almost 50 per cent of the aggregate State level guarantees. The State governments may face devolvement of about Rs 5,400 crore falling on them this fiscal to honour the guarantees given to bond issues floated by State corporations. Crisil estimates that they may end up shelling out Rs 44,200 crore in the next five years as many corporations that floated bonds are likely to default on their repayment obligations.

Things have come to such a pass that having been junked by the market, State government undertakings are trying to woo the investors by dangling higher returns of up to 450 basis points over yields on Central government securities. Still, the markets are not impressed and many bond issues have been languishing for months.

Crisil has now downgraded Maharashtra Government's status to default category `D(so)' from `BB plus (so)' following a delay in the payment of interest and principal obligations on seven bonds issued by its SPVs for irrigation projects. Of these, five belong to the Maharatra Krishna Valley Development Corporation, amounting to Rs 213 crore, and two to the Vidarbha Irrigation Development Corporation.

Thus, it is evident that State government finances have been fast hurtling towards a debt trap. Even the once prosperous and better-managed States such as Maharashtra, and Punjab are no exception to this. The problem has been aggravated not only because of the unbridled growth in non-productive expenditure but also because of the lack of political will to raise both tax and non-tax revenues.

States' own tax revenues, as a per cent of GDP, remained stagnant at around 5.4 during the 1990s. Their non-tax revenues as a per cent of GDP have been steadily going down. User charges for non-merit goods and services do not even cover more than a fraction of the operation and maintenance costs. This is an area where "competitive populism" has taken a heavy toll of State finances. The power sector is the classic example of this.

To add to the woes of the States, the share of Central tax revenues devolving them has also fallen short of the projections of the Tenth Finance

Commission (TFC) in the second half of the 1990s, reflecting the decline in the tax-GDP ratio of the Centre since 1997-98. The Plan grants to the States, as a proportion of GDP, have also declined for the same reason.

There is no denying that the Centre's own failure to pursue the path of fiscal consolidation and reform is partly responsible to the plight of the State governments. It is a genuine grievance of the State governments that the unprecedented burden imposed by the implementations of the Fifth Pay Commission award has crippled their finances. The combined salary bill of all States had crossed Rs 100,000 crore in 1999-2000 or five per cent of the GDP. Many State governments now find it difficult even to pay the salaries of their employees, let alone finding the resources for economic development.

Besides emoluments of their own employees, the State governments are required to provide grants-in-aid for salaries of teachers of all-aided educational institutions and employees of local bodies as also other assisted organisations, all of which would work out to an additional two per cent of GDP.

Consequently, pension liabilities have now emerged as the fastest growing item of revenue expenditure in the States in recent years. Pension outgo almost doubled within two years from Rs 11,600 crore in 1997-98 to Rs 22,000 crore in 1999-2000. It is likely to grow faster in the coming years.

The consequences of the continuing fiscal deterioration are alarming. The State governments have now run out of all the soft options of raising funds and it is time they heeded the Prime Minister's warning. They will have to make serious efforts to cut their non-productive expenditure on subsidies and raise tax and non-tax revenues.

What they can do in the short run is to vigorously pursue privatisation of all State level corporations that have become a perennial burden on the exchequer. There should be reasonable cost recovery for all the services provided such as electricity, water, health services, road transport etc. In this context, the Punjab Government's decision to stop free electricity to farm sector and charge a small level is a welcome beginning towards fiscal pragmatism.

Accelerated power sector reforms aloe would make a big difference to the improvement of fiscal situation of States. For it is estimated that commercial losses suffered by SEBs alone amounted to 1.2 per cent of the GDP. SEBs owed Rs 41,473 crore or 1.9 per cent of GDP to Central PSUs at end-February 2001. Another area requiring urgent attention is the rising salary and pension bills. Both the Central and State governments will have to make serious efforts to downsize their staff strength, which was a part of the Fifth Pay Commission recommendation.

Apart from the urgent need to avoid the debt trap, restoring the fiscal health is a pre-requisite to step up the GDP growth during the Tenth Plan as projected.

Since States incur almost 55 per cent of total expenditure and raise 37 per cent of revenues, launching the Indian economy on a higher growth path would depend to a large extent on the State level fiscal reforms. Already, the growing resource crunch has crowded out capital expenditures in States.

The capital expenditure in States declined from 3.6 per cent of GDP in early 1980s, to just 1.8 per cent in 2000-01. The share of capital expenditure in total expenditure fell from 26 per cent to just about 13 per cent over the same period. This trend needs to be reversed at the earliest if the economy is to grow at a faster rate during the Tenth Plan period.

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