The Hindu Business Line : Centre-State relations

The need to reform resource-sharing between the Centre and States cannot be put off any longer. To provide financial autonomy to States, the Centre should raise their tax collection powers, moving beyond the 80th Amendment to the Constitution, says A. SRINIVAS.

After nearly a decade of attempts to restructure the finances of State Governments, the task before the Thirteenth Finance Commission, whose tenure begins in 2010, is to take stock of achievements and mistakes and chart a modified course.

The pluses cannot be denied. Expenditure reforms and improved tax collections at the Centre and States have played a big role in improving the finances of State Governments in particular. The tax-to-GDP ratio of the Centre and States increased from 14.7 per cent in 1995-96 to 18.6 per cent in 2007-08.

Direct taxes have played a bigger role than indirect taxes in fuelling this rise. The sharp rise in tax mobilisation has enabled the Centre and States to implement fiscal responsibility laws. While States improved their revenue collection, higher transfers from the Centre in recent years provided them with the elbow room to prune expenditure. Whether the States made the right expenditure choices in this scenario is a moot point.

The recently released Reserve Bank of India’s (RBI) Annual Report brings out the sharp improvement in the fiscal condition of all States.

From a revenue deficit of 2.63 per cent of gross domestic product in 2000-01, States are now left with an annual revenue surplus of Rs 25,000-30,000 crore — a trend that goes back to 2006-07.

The Kelkar Task Force (KTF) suggests that fiscal correction should be led by revenue increases rather than expenditure cutbacks, for it not to have an adverse impact on creation of physical and social infrastructure.

REVENUE ACHIEVEMENTS

There can be no denying that the tax system has become more progressive over the last decade. In 1995-96, indirect taxes made up 76 per cent of all taxes collected by the Centre and States, a share that is down to 60 per cent now.

The proportion of direct taxes in tax revenues collected by the Centre has increased from 30 per cent in 1995-96 to an estimated 53 per cent this fiscal year. High rates of economic growth since 2003-04 have contributed to the rise in both indirect and direct tax revenues.

The role of voluntary compliance and implementation of value added tax (VAT) will, however, become clearer in the event of an economic downturn.

The Centre’s direct tax revenues increased from 2.8 per cent of gross domestic product (GDP) in 1995-96 to 6.5 per cent of GDP in 2007-08. They are expected to account for 6.9 per cent of GDP in 2008-09 or Rs 365,000 crore, against Rs 33,563 crore in 1995-96.

In 2003-04, just before the economy went into a high growth trajectory, the Centre’s direct tax collections accounted for 3.8 per cent of GDP.

This performance should not detract from the fact that there is much scope to improve the tax base. The number of income tax assesses is still only a fraction of the 300 million who constitute India’s middle class.

Indirect tax revenues of the Centre fell as a share of GDP between 1995-96 (6.5 per cent) and 2001-02 (5.2 per cent), but have increased gradually since then to form 6 per cent of the GDP.

In the case of States, their indirect tax collection as a proportion of GDP has increased steadily since 1995-96, from 4.7 per cent to 5.4 per cent at present. Given the double digit rates of growth in many States, this is a notable achievement.

While VAT has yielded results, there is scope for improvement in excise collections, given the size of the black economy.

Input credits will not encourage compliance among those who are completely out of the tax net, as has been observed in the case of the transport sector.

Tax governance, despite the use of improved technological methods laid down by KTF, remains an area of concern.

FISCAL PRUDENCE

With a view to enabling States to create infrastructure, KTF advocated a fiscal target of 3 per cent of GDP for all States taken together. No fiscal deficit target is clearly spelt out for each State in the legal framework.

However, to bind each State to a regime of fiscal discipline, the Twelfth Finance Commission incentivised prudence through conditional write-offs of debt stocks and interest payments.

In order to obtain funds on favourable terms, a State would commit to reduce its fiscal deficit to 3 per cent of gross State domestic product by a particular year. The Eleventh Finance Commission began conditional transfers in a small way by withholding a portion of the grant entitlement of States and making its release conditional on curtailing revenue deficit.

These moves have had their effect: fiscal deficit of States fell from 4.18 per cent of GDP in 2000-01 to 2.29 per cent in 2007-08. It is estimated to fall to 2.12 per cent of GDP by the end of this fiscal year.

The revenue deficit as a proportion of GDP has fallen from 2.63 per cent in 2000-01 to a surplus of about 0.5 per cent of GDP over this period. Even if one accounts for off-budget liabilities, this order of prudence is more than what the law might have expected.

The late Raja Chelliah argued that a fiscal deficit target of 3 per cent of GDP does not leave room for capital expenditure. He also said that the impact of factors beyond a State’s control such as monsoon failure and slowdown in the world economy should have been taken into account while fixing such targets.

How have the States economised? Interest payments as a proportion of revenue receipts have fallen from 17.6 per cent in 2006-07 to an estimated 15.1 per cent by the end of 2008-09.

Non-development revenue expenditure as a proportion of revenue receipts have fallen from 39.1 per cent in 2006-07 to an estimated 37.3 per cent by the end of this fiscal year. This leaves some room for development expenditure, as interest payments, salaries and pensions account for a bulk of States’ revenue receipts.

Development expenditure of States as a proportion of GDP has increased from 9.5 per cent to 10.5 per cent over the two years. It is heartening to note that social sector expenditure has increased as a percentage of GDP, from 5.4 per cent in 2006-07 to an estimated 6.3 per cent this year. This marks a departure from a 15-year long trend when fiscal correction by the centre squeezed out development expenditure in the States.

Whether the change is on account of tax buoyancy alone or a realisation that infrastructure creation should not suffer is hard to say.

LEARNING FROM MISTAKES

In the case of Bihar, development expenditure as a percentage of revenue expenditure fell from 64 per cent in 1990-91 to 49 per cent in 2003-04.

This squeeze occurred despite the fact that the revenue deficit of States climbed alarmingly over this period.

The high rates of interest and liability imposed by the Fifth Pay Commission award left little for development expenditure.

Will the implementation of the Sixth Pay Commission award and the return of high market rates of interest nullify fiscal and developmental gains?

Add to this the possibility of an economic slowdown and there could be a dip in tax collections and transfers from the Centre as well. The real test of reconciling fiscal prudence with developmental needs will come in a time of economic slowdown.

In this context, the need to reform resource-sharing between the Centre and States cannot be put off any longer. To provide financial autonomy to States, the Centre should raise their tax collection powers. It should go beyond the 80th Amendment to the Constitution, which enhanced the size of the shareable pool, to include surcharges, cesses and service tax as well.

The effects of conditional transfers, initiated by the Twelfth Finance Commission, should be reviewed, keeping in mind the limitations and needs of individual States. One of the central tasks before the Thirteenth Finance Commission is to redefine fiscal discipline, so that commitments to health and education in particular do not suffer.

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