The Hindu Business Line : Fiscal reforms by States — Will the new incentive plan pay off?

The Twelfth Finance Commission is said to have devised an incentive scheme based on fiscal performance, which would meet the objectives prescribed for the Fiscal Reform Facility and simultaneously accord debt relief to States. But will it work?

ONE of the bold initiatives of the National Democratic Alliance (NDA) government was the introduction of the Fiscal Reform Facility (FRF) to help-stressed States, while ensuring reforms to restructure their finances. As a multi-party coalition drawing support from regional parties, the NDA government could ill-afford to rub the allies the wrong way by attaching conditionalities to providing fiscal support to the States.

Yet, drawing up from the recommendations of the Eleventh Finance Commission (EFC), the NDA Government did create a `States' Fiscal Reforms Facility (2000-01 to 2004-05) that set out in no uncertain terms conditions to qualify for accessing the facility. But this is being given up by the new United Progressive Alliance dispensation at the Centre, as the UPA is not comfortable with making its alliance partners bite the bullet and becoming politically unpopular.

Under the FRF, the Centre set up an Incentive Fund to encourage fiscal reforms in the States on the basis of a programme that can be monitored. In turn, the States have drawn up a Medium-Term Fiscal Reform Programme (MTFRF), to reduce their fiscal deficit to sustainable levels. This was necessitated by the fact that the gross fiscal deficit of the State governments rose from 3.3 per cent of GDP in 1990-91 to 4.7 per cent in 1999-2000; their revenue deficit, as a proportion of fiscal deficit, shot up from 28.3 per cent to 58.8 per cent during this period, thereby draining them of precious funds to build physical and social infrastructure and generate employment opportunities. The reasons for the widening revenue deficit of the States include the slow growth in revenue receipts in the face of ever-escalating committed expenditure such as salaries, interest and pensions, inadequate user charges from public utilities and jejune returns on their investments.

Notwithstanding the mounting revenue deficits, the Centre had taken several measures such as placing a cap on overall borrowings of the State governments, bringing borrowings through such Special Purpose Vehicles (SPV) under the discipline of Article 293 (3), and a Debt Swap Scheme to contain growth of States' debt overhang. As a result of these measures, therate of new borrowings fell from 58.5 per cent in 1997-99 to 1.2 per cent in 2002-04, the Minister of State for Finance, Mr S. S. Palanimanickam, told the Rajya Sabha on December 21, 2004. The ratio of revenue deficit to revenue receipts also fell from 26.29 per cent in 1999-2000 to 21.97 per cent in 2003-04 (revised). As per the RBI Report on State Finances 2003-04, the total debt of 29 States amounted to a staggering Rs 7,91,400 crore as on end-March 2004.

It is true that the high dimensions of debt pre-empt resources away from investment in the private sector, while pushing up the interest burden, leading to an increase in revenue and fiscal deficit, thereby resulting in higher debt.This sets off a vicious cycle.

It is precisely to lessen the fiscal stress caused by massive public debt and to ensure a modicum of fiscal consolidation that the NDA government saw merit in implementing the EFC's suggestion of instituting the FRF. The idea of the FRF is to incentivise States to take up fiscal reforms in the medium-term to reduce their revenue deficit by improving tax and non-tax receipts and reprioritising expenditure.

While introducing the FRF, the Centre prescribed a single monitorable indicator for the purpose for making releases from the incentive fund. Each State was expected to score a minimum improvement of 5 per cent in the revenue deficit/surplus, as a proportion of its revenue receipt each year till 2004-05 measured vis-à-vis the base year 1999-2000. The revenue deficit was to be inclusive of contingent liabilities such as guarantees and subsidies due to public sector enterprises.

As per the broad guidelines of the Finance Ministry, each State was expected to take effective steps for revenue augmentation and expenditure compression over the five-year span so as to broadly comply with the goals, that include reducing the gross fiscal deficit of the States to 2.5 per cent of the gross state domestic product; briging to zero the revenue deficit of all States and keeping interest payments as a percentage of revenue receipts of the States at 18-20 per cent.

A supplementary report of the EFC said the rise in wages and salaries should not exceed 5 per cent of the increase in consumer price index, whichever is higher; the increase in interest payments should be limited to 10 per cent per year, and the explicit subsidies should be halved over the next five years before being eliminated by 2009-10. Based on these guidelines, each State was to draw up an MTFRP and enter into a Memorandum of Understanding (MoU) with the Centre.

As on August 31, 2004, 25 States had finalised their MTFRP and 19 signed the MoUs. The total amount released from the Rs 10,607.72-crore incentive fund till mid-November 2004 was Rs 5029.51 crore, which included Rs 40.65 crore for voluntary retirement scheme. The releases related for the period from 2000-01 to 2002-03 except for Tripura, Orissa, Rajasthan and Karnataka, which were granted releases for 2003-04 also. An assessment review by the Ministry of Finance of the FRF reveals that on tax and non-tax revenues, the performance of the States has been in line with the EFC projections.

On the basis of performance, five States could be classified as consistently improving, four as deteriorating, 12 as showing initial improvement but slipping into deterioration, and the remaining improving after initial deterioration.

The Finance Ministry maintains that there was `admittedly' a design flaw in prescribing a uniform 5 percentage point improvement in the ratio for all States, since at the beginning of the reform period (1999-2000) States had different magnitudes of revenue deficits as a percentage of revenue receipts. Hence, a design alternative could have addressed the asymmetry effectively.

It further said the facility has largely failed to address the need for a steady convergence to a stable, sustainable debt path. The eventual goal of any medium-term fiscal reform is to bring down debt to sustainable levels. The stock of consolidated debt (including guarantees) to total revenue receipts should not exceed 300 per cent.

It is also pointed out that as 50 per cent of the incentive fund was contributed from the withheld portion of the non-Plan revenue deficit grant of 16 States and the rest came from the Government of India, the revenue-deficit States contributed disproportionately to the fund and the remaining 12 none at all. While 16 revenue-deficit States lost fiscal resources to cover their non-Plan deficits, in case they did not bring about the necessary correction, other States gained from the FRF and there was no negative incentive for them.

The Finance Ministry contends that the size of the incentive fund, at Rs 10,600 crore, over five years was relatively small, considering that the total transfers to the States, including tax devolution, grants (Plan and non-Plan) and small-savings transfers/Plan loans average Rs 60,000 crore, Rs 40,000 crore and Rs 90,000 crore respectively per annum. Moreover, some other reform facilities fashioned by the Plan panel such as the Accelerated Power Development and Reforms Programme (APDRP) have larger financial allocation.

The Twelfth Finance Commission (TFC), headed by Dr C. Rangarajan, which submitted its report to the President recently, is understood to have found major drawbacks in the scheme as:

(i) it does not provide an adequate incentive for prudent fiscal behaviour, as the size of the fund is relatively small;

(ii) the withholding of deficit grant itself leads to a deterioration in the finances of the States inasmuch as the additional gaps so left open is covered by borrowings with implications for future;

(iii) the prescription of a uniform target does not sedulously reward prudent behaviour as it extends a soft and easily achievable target for States with large deficits and a difficult one for the more prudent States.

The TFC is also reported to raised the point that the definition of the revenue deficit has not been uniform for all States. Changes appear to have been made on a selective basis to accommodate States when they faced a fiscal crisis and a scheme, which lends itself to such arbitrary flexibility, is not desirable, the TFC is understood to have said.

While not recommending the continuation of the FRF over 2005-10, the TFC is said to have devised an incentive scheme based on fiscal performance, which would meet the objectives prescribed for the FRF and simultaneously accord debt relief to the States. With the UPA Government also a coalition ofparties that are regional powers and with the outside support of the Left parties, how this cocktail of an incentive scheme with fiscal reform and debt relief to States would be concocted remains to be seen.

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