The Hindu Business Line : State Finances: A Study of Budgets 2006-07 Are States ready to shoulder increasing responsibility?

With the Centre's resources certain to be stretched as a result of increasing commitments, the States have been called upon to chip in more to finance Plan expenditure. Assessing the States' fiscal position, R. SRINIVASAN examines to what extent they will be able to do so without rocking the growth boat.

Since the formation of the UPA Government in May 2004, there has been renewed thrust on increasing public investment in the social sector, initially manifest in the form of the levy of 2 per cent education cess to finance primary education. The drive has been reinforced by the recommendation of the Twelfth Finance Commission (TFC) that special grants be provided for States that lag in human development. At the threshold of the Eleventh Five-Year Plan (the Plan), the States have been called upon to step up expenditure in both the social and agriculture sectors. Financing such huge expenditure is, no doubt, a stupendous task. As pointed out by the Prime Minister, Dr Manmohan Singh: "We cannot hide the fact that the Centre's resources will be stretched in the immediate future and an increasing share of the responsibility will have to be shouldered by the States".

Apparently, the Central government's capacity to finance the Eleventh Plan is limited. The Finance Ministry states that if tax revenues grow by 15 per cent per annum in 2007-08 and 2008-09, it would be just enough to meet the FRBM (Financial Responsibility and Budget Management) targets and only additional resource mobilisation would facilitate higher public expenditure. This expected growth of tax revenue critically depends on increasing both tax buoyancy and economic growth.

The FRBM Act stipulates the removal of revenue deficit and containing of fiscal deficit to 3 per cent of GDP by 2008-09. The Plan panel has suggested that these goal-posts be shifted to facilitate the liberal bond financing of Plan expenditure, while the Finance Ministry has stoutly opposed this, as fiscal laxity at this stage would undo the gains of fiscal correction achieved so far. Evidently, the States do indeed have to shoulder a larger responsibility in financing the Eleventh Plan.

States' fiscal situation

The recent edition of the RBI's State Finances: A study of Budgets 2006-07 is a useful document to assess the capability of the State governments in financing the Plan. The report not only documents the financial statements of all the State governments and their fiscal initiatives but also gives an incisive analysis of States' fiscal situation.

The report notes: "The State Governments presented their budgets for 2006-07 against the backdrop of the commitments to prepare the process of fiscal correction and consolidation, according to Fiscal Responsibility Legislation (FRL), and aided by larger devolution and transfer by the TFC and implementation of a seemingly buoyant sales tax system, namely VAT". No doubt, the States have shown improvement in the key deficit indicators from 2004-05 to 2006-07. But whether the process of fiscal correction is sustainable in the long run is a moot point.

The fiscal correction achieved in the years 2004-05 (accounts), 2005-06 (revised estimate) and 2006-07 (Budget estimate) has been due to better revenue mobilisation and expenditure compression. In 2004-05, the fiscal correction was "largely on account of the decline in non-interest revenue expenditure, including development expenditure, and a rise in States' own taxes despite decline current devolution from centre and States' own non-tax revenues".

In 2005-06 the revenue deficit ratio declined to 0.5 as both the States' own tax collection and devolution from the Central government increased, the latter with the implementation of the TFC recommendations. At the same time "there was a rise in revenue expenditure, mainly due to higher developmental expenditure... the rise in capital outlay was mainly in respect of economic services such as energy, irrigation and flood control and transport, as a result of which there was a slight increase in the gross fiscal deficit ratio."

"The consolidated fiscal position of State Governments indicates that the revenue deficit is budgeted to decline sharply in 2006-07 to achieve near balance in the revenue account; the gross fiscal deficit is set to decline to 2.8 per cent of GDP'. In 2006-07 the States' own tax revenue is budgeted to increase by 14 per cent, against 22 per cent the previous year; revenue expenditure growth is also budgeted to decline to 11.3 per cent from 15.4 per cent for 2005-06. Thus higher expenditure compression, rather than revenue growth, is the reason for the fiscal consolidation of 2006-07.

Priority areas

The process of fiscal consolidation is not costless As the report notes: "Fiscal priority to social sectors, defined as the ratio of social sector expenditure to total expenditure, on an average, was nearly 37 per cent during the 1990s. This ratio has shown a declining trend since 1998-99 to reach 29.7 per cent in 2004-05."

This picture is being reversed by the priority accorded to the sector since 2004-05, by the Central government as well as the recommendation of the TFC to release larger grants to the backward States for health and education. The States are expected to increase public expenditure under three different heads over the next five years.

The Approach to the Eleventh Plan emphasises the aim of increasing the growth rate of agricultural sector from 1.7 per cent in the Tenth Plan to 4.1 per cent in the Eleventh Plan.

Though agricultural production takes place almost entirely in the private sector, without significant public investment in irrigation, research and extension services, and subsidies for inputs, revival of the farm sector will be very difficult.

Even to assume the desired proportion of social sector expenditure to total expenditure as 40 per cent would require a near doubling of social sector expenditure. The report notes that capital outlay for the social sector also should be increased.

The Sixth Pay Commission awards threaten to take a lion's share of the revenue expenditure. The point to note here is that the States' expenditure on both revenue and capital accounts is bound to increase manifold during the Plan.

Revenue mobilisation

Turning to the revenue scenario, the States have been rationalising the two major sources of tax revenues — sales tax and stamp duty on conveyance.

By design, VAT is bound to reduce tax buoyancy because of the input tax credit and lowering of tax rates, provided there has been a corresponding increase in personal consumption expenditure. This was the case with Central excise during the late 1980s and the early 1990s. The rationalisation of stamp duty on conveyance will reduce revenue flow to States if the secondary market for immovable properties is not vibrant.

Given the lower revenue mobilisation and self-imposed constraints on bond financing of public expenditure, the States have to curtail expenditure, pouring cold water on the efforts to achieve `faster and inclusive growth' during the Plan.

Alternatively, both the Central and the State governments should relax the self-imposed fiscal rules and facilitate bond financing of Plan expenditure. At the same time, the interest rates in the Treasury bill market should be eased to reduce the interest burden on the government.

(The author is a Full-Time Member, State Planning Commission, Government of Tamil Nadu. He can be reached at seenu242@yahoo.com)