The Hindu Business Line : The death of fiscal federalism?

The Twelfth Finance Commission's recommendations on the conditions to be met by States in order to take advantage of the proposed debt reduction package may become the death warrant of fiscal federalism. In this edition of Macroscan, C. P . Chandrasekhar and Jayati Ghosh examine the nature of this package and the implications for State finances.

THE crippling role of the debt burden in affecting the finances of State governments in India was noted in the previous issue of Macroscan (Business Line, May 24). The Twelfth Finance Commission (TFC) specifically addressed this issue, as one of its terms of reference specified that "the Commission may, after making as assessment of the debt position of the States as on March 31, 2004, suggest such corrective measures as are deemed necessary, consistent with macroeconomic stability and debt sustainability."

The high interest payment obligation of States is one of the principal reasons for the tremendous pressure on their finances.

Some attempt to reduce this pressure has been made since September 2002 under the debt-swap scheme of the Central Government, under which "high-cost debt" (that is, carrying an interest rate of 13 per cent or above) on State plans or small savings could be exchanged for market borrowings and small savings securities, which at that point carried interest of around 7 per cent.

Until March 2005, around Rs 1,03,000 crore of State government debt was swapped under this scheme. This reduced the average interest rate paid by States to some extent, and also changed the composition and maturity profile of the debt, but not the overall stock of the debt. However, the rather limited nature of the swap has limited the beneficial effects for the States.

The TFC has introduced a package for debt reduction with two main components.

The first is the consolidation of all State debt outstanding to the Centre on March 31, 2004, at an interest rate of 7 per cent to be repaid over 20 years.

The second, and much more problematic, proposal is a new debt relief scheme linked to the reduction in the revenue deficits of States.

Under this scheme, the repayments due on Central loans from the current year to 2009-10 (after consolidation) will be eligible for write-off, but the amount of write-off of repayment will be linked to the absolute amount by which the revenue deficit is reduced in each successive year over the entire period. A pre-condition for eligibility to this scheme is the enactment of the fiscal responsibility legislation: thus the scheme will be available to States only from the year they "qualify" by bringing in such a law.

In turn, States would increasingly seek market borrowing or borrowing from other sources than the Centre, in line with another recommendation of the TFC, that the Centre stop acting as an intermediary for debt taken on by the States.

The rationale for these oppressive conditions is stated as follows: "As the States are increasingly exposed to the markets for borrowing, their fiscal position would be increasingly assessed by the markets. They may be forced to pay higher than average interest rates to cover additional risk if the public finances are not evaluated to be robust by the assessment of the market. We are relying, therefore, on two mechanisms for fiscal correction: self-evaluation under the Fiscal Responsibility Act and exposure to the market." (page 84)

It is evident from the Chart that the role of the Centre as creditor to the States has already declined quite sharply over the past five years, and the value of the central loan outstanding has fallen both in nominal value terms and as a share of the total outstanding debt of the States.

This has not meant that the debt burden of States has been very much reduced — the Table indicates that a significant number of States still have debt-GSDP ratios of more than 40 per cent and interest payments amounting to more than 28 per cent of revenue receipts.

Not content with requiring that States enact fiscal responsibility legislation as a precondition for availing of debt relief, the TFC has also specified what such legislation should provide for "at a minimum"! This includes the following features:

* eliminating the revenue deficit by 2008-09;

* reducing the fiscal deficit to 3 per cent of GSDP or its equivalent defined as a ratio of interest payments to revenue receipts; and

* bringing out annual reduction targets of the revenue and fiscal deficits.

In addition, the TFC states that "States should follow a recruitment and wage policy, in a manner such that the total salary bill relative to revenue expenditure net of interest payments and pensions does not exceed 35 per cent."

The TFC even demands withdrawal of reduction of the public sector: "In the period of restructuring, that is 2005-10, State governments should draw up a programme that includes closure of almost all loss making SLPEs (State level public enterprises)."

The problematic theoretical framework and lack of recognition of socio-economic reality that are embedded in these conditions are truly disturbing. The macroeconomic problems with a rigid fiscal responsibility framework that specifies what are finally only arbitrary limits to revenue and fiscal deficits are now well known across the world and are even becoming evident in India within the first year of such legislation been enacted.

These rigid numerical constraints are not just awkward and unnecessary but also pro-cyclical, since they operate to intensify and prolong slumps and even convert them into depressions. They are also foolish, since they can prevent important and socially necessary public expenditure, which is required to improve current welfare and future growth prospects.

There is no reason to keep capital expenditure within some predetermined numerical limit, since even debt sustainability depends upon the relation between the interest rate and anticipated return from public investment. So restricting capital account deficits to 3 per cent of GSDP makes little sense.

In addition, there is the issue of social returns, which appear to be completely ignored by the TFC. In requiring the States to keep the salary bill within a pre-specified limit, and demanding the closure of loss-making public enterprises, the TFC is ignoring the social role that can be played by public employees and even loss-making public enterprises that fulfil some social functions.

Let us consider what precisely such conditions will entail for the State governments. Remember also that the revenue raising capacity of the States is limited, more so since the Centre has taken upon itself all power to tax service sector incomes.

If revenue deficits are to be progressively reduced and brought down to zero, this necessarily means that revenue expenditures will have to be cut.

In most States, by far the largest item of expenditure on the revenue account is in fact that for salaries. It is completely wrong to see these as unnecessary or unproductive expenditures, since these are for those who are to provide the important public services that every

one acknowledges to be essential. Since State governments are responsible for almost all of the expenditures that affect the quality of life of ordinary citizens on the ground, from infrastructure and sanitation to health and education, preventing expenditure on wages and salaries for those who would perform these functions is bizarre in the extreme.

The role of the Finance Commission, as envisaged by the Constitution, is to deal with and prevent State governments from running up large revenue deficits, by ensuring a distribution of fiscal resources between the Centre and States that would allow the States to fulfil their social and constitutional responsibilities within their means.

However, successive Finance Commissions have failed to achieve this. And a substantial part of the problem is that the Centre itself has failed on the revenue mobilisation front, especially since the early 1990s, such that central transfers to the States have been falling as a share of GDP.

In this context, instead of confronting this problem and addressing the central issues of inadequate revenue generation by the Centre and its adverse implications for State finances, what the TFC has done is effectively to sound the death knell of fiscal federalism.

State governments are to be forced into the same neo-liberal economic policy straitjacket that the Centre has chosen to function within. They are to be prevented from exercising their own options with respect to how much revenue and capital spending they can undertake; they are to be limited in terms of how many people they can employ and how much they can be paid; they are to close down loss-making state-owned enterprises even if these are contributing to the public good; they are to be forced to turn directly to un-intermediated market borrowing or accessing loans from mutlilateral institutions that also carry similar conditionalities, and so on.

All in all, this amounts to a direct attack on the fiscal autonomy of States, and, therefore, in effect a betrayal of the spirit of the Constitution, which recognises the possibility of different economic approaches by different State governments.

It is ironic — but also alarming — that the social and political fallout of such apparently "technocratic" decisions is not recognised.

Depriving people of necessary public services and reducing the possibilities of sustained development are not only likely to make those at the helm of particular State governments unpopular.

They are also likely to increase disaffection with the entire national supposedly federalist system and thereby encourage extremely dangerous separatist tendencies.

The evident reaction of people in many parts of the European Union to a similar project should provide a telling example. The "Growth and Stability Pact" which specified similarly foolish fiscal constraints upon EU member-governments has created higher unemployment and levels of economic activity well below potential, and has led to a popular backlash which is increasingly questioning the entire project.

The reason is that the policies — and even the proposed Constitution — were seen as driven by corporate interests and operating against the interests of people and the broader social good, which cannot be calculated in terms of market principles.

Policymakers in India should take note: there is no reason why such policies should not lead to similar backlash in our own federal structure.

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