The Hindu Business Line : RBI's survey of State finances

A recent RBI study analysing State budgets and highlighting the trends in overall fiscal indicators shows that the stresses have increased in 2003-04, and suggests ways in which they can be alleviated.

STATE finances have been the Achilles' heel of India's economy. This has been highlighted in many RBI reports. There is a special problem in finalising State budgets, which are, in a sense, trickier than that of Central budgets because State Finance Secretaries do not have access to the printing press to balance their budgets. At least at the Centre, the Finance Minister has always counted on deficit financing in some measure, at least within certain limits.

Fortunately, today neither the States nor the Centre has unlimited access to this shortcut, particularly in the light of the Fiscal Responsibility and Budgetary Management Act. From this point of view, State budgets have to receive even more attention than the Central Budget.

At present, most of the States are getting ready for presentation of their budgets for 2005-06. A review of their finances is, indeed, appropriate. The publication of the RBI's study of the State budgets for 2004-05 has, however, come in only recently, in December 2004. This is perhaps a bit too late.

If the analysis of the central bank is to convey useful signals to the State governments that are making their budgets for 2005-06, it would be reasonable to demand a less leisurely approach to the review by the RBI. Perhaps, sometime in August-September would be much more purposeful if the study is not to deteriorate into an academic exercise. This would be feasible considering that State budgets are mostly presented in February-March.

For what it is worth, the RBI study of State budgets for 2004-05 has performed its usual useful function, of highlighting the trends in overall fiscal indicators, their variations among States and guidance for the future.

The study would be particularly useful to those who are concerned about the increasing trend towards fiscal irresponsibility on the part of a few States.

The study discloses that the fiscal situation of States as a whole has shown stresses that were exacerbated in 2003-04 following a transitory moderation in the previous three years. The study acknowledges that there has been a growing recognition of the need for fiscal consolidation among the States.

There has also been a progressive implementation of fiscal reforms by a number of States, although not all. Notwithstanding these initiatives, the evolving fiscal scenario has confirmed the existence of vulnerabilities in State finances.

The study notes that the fiscal deficit indicators, such as the ratio of gross fiscal deficit to GDP, have shown a decline in BE 2004-05 compared to RE 2003-04. For the States as a whole, the ratio of gross fiscal deficit to GDP is estimated at 3.6 per cent in 2004-05 compared to 5.1 per cent in 2003-04 (RE).

Similarly, revenue deficit as a percentage of GDP is expected to come down from 2.6 per cent in 2003-04 (RE) to 1.4 per cent in 2004-05 (BE). The RBI report notes that over the last few years, budget estimates have usually deviated from revised estimates, reflecting poor fiscal marksmanship.

The Budget estimates of the States and the Centre are, at best, educated guesswork, bringing together a number of efforts at estimating how revenue and expenditure will shape. While perfect marksmanship cannot be expected, wide variations are evidence of shoddy work.

The RBI study tantalisingly refers to the relevance of a cyclically-adjusted budget balance. This concept takes into account the impact of the economic cycle on the budget. If we eliminate the cyclical factor, such as boom or recession, we will be able to derive the residual structural element in the deficit.

While the RBI study refers to the literature on the subject and mentions some data, it leaves us guessing as to what exactly are the specific results pertinent to Indian States — except for a sweeping statement that measured as a percentage of GDP, cyclical deficit on an average accounted for -0.2 per cent of GSDP in the post-1990 period for 15 major States, while structural deficit accounted for 4.9 per cent. The conclusion is that the States' fiscal deficit is mostly structural.

In the absence of more detail, the split between structural and cyclical deficit does not lead to any policy perspective for the States in India — unless it be that the institutional structure and spending priorities as well as the weak tax base were responsible for the fiscal fragility.

One would have expected greater clarity from the research workers of the central bank on this subject — if the study is to have greater policy relevance.

The study also emphasises the fact that the States' debt service obligations are on the increase, particularly because of the revenue deficit — especially the problem of financing Electricity Boards. The States' interest burden as a percentage of total revenue is as high as 25 per cent, far in excess of the figure of 18 per cent, which the Eleventh Finance Commission had indicated as an outer limit for sustainable debt burden.

The RBI report also emphasises the danger involved in the States resorting to guarantees, which they use to help the public sector bodies to raise funds from institutions and banks. The danger is that if these entities become unviable, the guarantee will finally fall on the States themselves. The report points to the danger and suggests that States observe moderation in resorting to such guarantees.

The study emphasises the need to devote more attention to the efficiency of Government expenditure. There is no reason why, merely because a State spends more on some department, it will deliver more effective social outlays. This is obvious.

It only reinforces what the Prime Minister, Dr Manmohan Singh, has emphasised in many recent statements that better governance is ultimately the key to departmental effectiveness. Various States have attempted administrative reforms in this direction. But, given the trend towards decentralisation, the key to success may be to marry an efficient bureaucratic delivery system with greater democratic decentralisation.

Ultimately, there is no escape from entrusting bodies of democratic decentralisation with greater powers. But we cannot escape the fact that bureaucracy is still needed to implement the various development programmes.

Motivating bureaucracy, rewarding success and penalising it for failures is essentially a job that calls for new and holistic initiatives. But budgets can only do so much in policy formulation. The rest lies in the hands of the implementers.

The RBI study points out the crucial role of reforms in the system of recoveries of user charges. The reason for high revenue deficit lies in the under-recovery of user charges, particularly in power and irrigation. Health and education also need to step up their recovery rates.

The study touches on the question of tax effort vs tax capacity of different States. This will be a particularly pertinent subject with the impending announcement of the Twelfth Finance Commission's recommendations.

The data in the RBI report show, in particular, that Punjab, Karnataka, Andhra Pradesh and Haryana were usually the top performers in terms of tax efforts, whereas West Bengal, Bihar and Orissa were usually at the lower end of the scale. The results reflect better efforts at tax reforms in the higher-ranked States.

Prima facie, the data provided in the report seem to go against conventional wisdom to the extent it ranks Punjab's tax capacity at an index of 42, while Uttar Pradesh, a much poorer State, is placed at 153.

The difference in population explains the discrepancy. Per capita tax capacity for UP is 54 and that of Punjab is 132. The tax capacity for Tamil Nadu, at 153, seems on the high side compared to Karnataka at 97.

The per capita tax capacity of Tamil Nadu is reported as 142 while that of Karnataka is 106. The difference seems to fly in the face of our perception of relative affluence of the two States. A more detailed review of the basis on which the data are derived may reconcile the apparent discrepancies.

The report lays stress on the urgency of reforming the pension systems, especially in view of the changing demographic pattern. Whether the decision to move pension administration to contribution-based pension system will improve the situation remains to be seen. Equally significant would be the Government's recent decision to privatise the investment of pension funds.

On the whole, the study on State budgets by RBI is an instructive document. It stresses the usual potential suggestions to alleviate the current fiscal stress. The forthcoming budgets for 2005-06 will show whether and how far State Governments have persevered in their reform path and whether they have resisted the populist bang.

With the next State and Central elections being not too far away, it may be too much to expect fiscal prudence to overwhelm political calculations, especially at State Governments' top management levels, which are much more sensitive to the cutting edge of implementation.

Ultimately, budgets are an exercise in political brinkmanship, balancing considerations of fiscal prudence with political strategy. Hopefully, the advice of fiscal hawks will have some weight in guiding the fiscal decisions of State Governments. The RBI's warnings are loud and clear for those who wish to hear them.

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