Project on MONITORING AND ANALYSIS OF BUDGETS IN MAHARASHTRA STATE

RESEARCH BRIEF - 2

THE 13th FINANCE COMMISSION: FISCAL ROADMAP OR FISCAL ROADBLOCK? R. Ramakumar

The overall approach of the Commission is to foster inclusive and green growth promoting fiscal federalism. This is the vision underlying the Commissions recommendations on inter-governmental fiscal arrangements and on the road map for fiscal adjustment. (13th Finance Commission, 2010)

2010-11 and 2014-15 was keenly watched for two reasons. First, the FC recommendations were to determine the extent to which fiscal stimulus packages could be continued at the State-level. In the wake of the global slowdown, the central government had allowed State governments to exceed the targets set for revenue and fiscal deficit in 2008-09 and 2009-10. Secondly, given the emphasis laid by the UPA-II government on inclusive growth, the fiscal freedom provided by FCs to States was seen as critical. In India, about 80 per cent of the social sector expenditure is undertaken by the States. On both these counts, the 13th FC report, chaired by Vijay Kelkar, comes as a dampener. It closes the possibilities of autonomous fiscal expansion at the State-level, arguing that the exceptional circumstances of 2008-09 and 2009-10 are behind us. Further, the nature of recommendations of the 13th FC is such that even the existing space available for States to decide on spending priorities is shrunk. For a worthwhile discussion of the proposals of the 13th FC, it is necessary to delve briefly into certain historical features and imbalances in Indian federalism.

The Context An important event that preceded the presentation of Union Budget 2010-11 was the submission of the report of the 13th Finance Commission (FC). The fiscal roadmap to be laid out by the 13th FC for the period between

Published 8 March 2010

Finance Commissions in India India is often described as a union of nationalities. Yet, under the Indian Constitution based broadly on the Government of India Act of 1935 majority of powers are vested with the Centre, and States do not have significant room for independent initiatives. Scholars have referred to the Constitution in diverse ways: quasi-federal, federal in form, but not in intent and appearing to be a fundamentally federal constitution with a unitary garb. The sphere of economic relations between the Centre and the States best reflects the unitary spirit of the Constitution. While the Centre is the dominant entity with respect to the control of finances, the States have a large share of responsibilities over spending for development. As the Constitution envisaged, the sharing of receipts between Centre and States was to be governed by a statutory body called the Finance Commission. Each FC was to have a five year term and envisaged as an independent body that would lay down principles governing primarily (a) transfer of tax resources between the Centre and States, and (b) the sharing of resources between States. Over the years, as eminent scholars like I. S. Gulati argued, the Indian fiscal model made the States more dependent on the Centre for budgetary and institutional transfers.1 In Ashok Mitras words, fiscal centralisation resulted in the Centre being the dispenser of monetary and fiscal bounty and the States queuing up for benediction.2 There was little progressiveness in the patterns of intertemporal changes in either the FC transfers or
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their outcomes.3 For instance, the fiscal transfer model was unsuccessful in reducing inter-State disparities in development.4 As Amaresh Bagchi argued, one of the failures of the Indian fiscal model was that there were large inefficiencies created by the Centres attempt to take on too much and manage the economy at the micro level. 5 In other words, the strong centralising tendencies within the Indian federal structure were militating against the idea of efficiency itself, in addition to the idea of equity. However, the 13th FC report puts an interesting spin onto this history of centralising tendencies. It has argued that there is a marked tendency towards stability in the relative share of Centre and States in respect of aggregate transfers, and considers this trend as remarkable! State Finances: The Crisis of the 1980s It was the progressive deterioration in the finances of States from the mid-1980s that set the context for a new phase in Centre-State economic relations in the 1990s. Two factors were pivotal in precipitating the fiscal crisis of States. First, after the mid-1980s, and especially after 1990-91, the rates of interest on borrowings of States from the Centre increased sharply due to interest rate deregulation under economic reforms. The coupon rates of State government securities were raised sharply by the RBI from 1990-91 onwards. The weighted average of coupon rates, which was 11.5 per cent in 1990-91, reached its historic peak of 14
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I. S. Gulati (1988), The Indian Federal Fiscal Model: A Case of Increasing Centralisation, Social Scientist, 16 (2), February. Elsewhere, Gulati observed that in this process, many State subjectsbecame Concurrent, if not Central subjects. See I. S. Gulati (ed.) (1987), Centre-State Budgetary Transfers, Oxford University Press, New Delhi. 2 See Ashok Mitra (1975), Will Growth and Centralised Arrangements do?, Kale Memorial Lecture, Gokhale Institute of Politics and Economics, Pune.

See I. S. Gulati and K. K. George (1978), Inter-State Redistribution through Institutional Finance, Economic and Political Weekly, August. 4 See Raja Chelliah and colleagues (1980), Trends and Issues in Federal Finance, Allied Publishers, New Delhi; and John Toye (1981), Public Expenditure and Indian Development Policy, Cambridge University Press, Cambridge. 5 See Amaresh Bagchi (2001), Fifty Years of Fiscal Federalism in India: An Appraisal, Kale Memorial Lecture, Gokhale Institute of Politics and Economics, Pune.
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per cent in 1995-96. In the same period, the interest rates on small saving borrowings of States also increased from 13 per cent in 199091 to 14.5 per cent in 1992-93, and remained stable till 1997-98. The rates of interests that States had to pay the Centre were clearly usurious, much higher than the growth rate of the GDP and thus, a sure recipe for a financial crisis. Even though the interest rates started falling after the late1990s, the financial burden that the long period of high interest rates placed on State finances was significant. The interest payments of States increased from Rs 8,655 crore in 1990-91 to Rs 21,932 crore in 1995-96 and Rs 62,489 crore in 2001-02. As a ratio to total revenue receipts, interest payments amounted to 13 per cent in 1990-91, 16 per cent in 1995-96 and 24 per cent in 2001-02. Ironically, in the period that the Centre was raising the rates of interest on States borrowings, the rates of interest on the Centres borrowings were not only lower in levels, but were also rising at a much slower rate (see Figure 1). The result was that the differential between the rates of interest faced by the Centre and the States widened

significantly in the 1990s, which continued into the 2000s. In fact, the differential in every year in the 2000s was higher than the differential for any year between 1980 and 2000. The average rate of interest of States borrowings was above 10 per cent even in 2004, while that of the Centre had dipped below 7 per cent. Secondly, there was an additional shock to State finances in 1997-98, when the recommendations of the Fifth Pay Commission were implemented. This measure sharply raised the revenue deficits of States after 1997-98. In just one year, the revenue deficit of States more than doubled from 1.1 per cent in 1997-98 to 2.5 per cent in 1998-99. The rise in interest burden and higher salary payments constituted the two proximate factors responsible for the deterioration of State finances in the 1990s. The common outcome of these two factors was a sharp rise in the debt burden of States. As a ratio to GDP, the total outstanding liabilities of States increased from 21 per cent in March 1997 to 26.1 per cent in March 2000 and 33.2 per cent in March 2004.

Figure 1 Average rates of interest on the liabilities of the Centre and all States, 1980 to 2004, in per cent per annum
12

10

Rate of interest (per cent)

0
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Centre
Source: Chandrasekhar and Ghosh (2005a).

States

Difference between States and Centre

Economic Reform and Centre-State Economic Relations The solutions offered by the Centre to the problem of State finances were closely linked to the objectives of fiscal reform. Fiscal reform was characterised by restraints on government expenditure relative to the size of the economy. It was firmly believed in the neoliberal circles that there is an innate synergy between acceleration of GDP growth and fiscal consolidation.6 The Centre recommended that each State should drastically cut its revenue and fiscal deficits over a specified time frame. There were two separate, and complementary, ways in which the fiscal reform programme was incentivised by the Centre for the States. First, the Centre began to use the constitutional body of Finance Commissions to force the States to accept the fiscal reform programme. Secondly, central transfers to States were explicitly linked to successes in fiscal compression and the passage of fiscal responsibility legislations (FRLs).7 From the 11th FC onwards, extra-constitutional powers were given to the FCs through the issue of additional terms of reference. These FCs chose to have a narrow definition of constitutional transfers to mean only the divisible pool. It was argued that other grants and benefits were over and above the constitutional transfers, and thus could be tied to specific conditions. In fact, under Article 275 of the Constitution, the FC has no powers to impose conditionalities on resource transfers to States. Yet, in the report of the 11th FC, about 15 per cent of the revenue deficit grants was explicitly linked to the progress achieved in the implementation of the fiscal reforms programme (that even included the
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forced reduction of food and fertiliser subsidies as well as privatisation of the power sector). The 12th FC recommended a fiscal restructuring plan for each State, according to which (a) the revenue deficit had to be eliminated by 2008-09; and (b) the fiscal deficit had to be brought down to 3 per cent in 2008-09. All States had to enact a Fiscal Responsibility and Budgetary Management (FRBM) Act to make these targets legally binding. The 12th FC also recommended a general scheme of debt relief and a loan writeoff scheme. However, the benefits of both these schemes were to be made available to only those States that had passed FRBM Acts. Thus, the passage of FRBM Acts became an indicator of progress achieved by States in fiscal consolidation. In this way, the Centre has been progressively reducing the space available to States for evolving autonomous policies; it has actually been forcing the States to follow the principles of sound finance. Even if a State wanted to borrow more to invest in social and economic services, it had to pay a penalty by foregoing a part of central transfers, which are constitutionally obligatory. Fiscal Compression under FCs It would be instructive to look at certain trends in the finances of States till 2009-10, the year that coincides with the end of the 12th FC period and the first UPA government (2004-09). Given the penalties involved, States had moved fast in this period to meet the deficit reduction targets (Figure 2). The revenue deficit for all States declined from 2.9 per cent in 1999-00 to (-) 0.2 per cent (i.e., a revenue surplus) in 2008-09. Similarly, the fiscal deficit for all States declined from 4.7 per cent in 1999-2000 to 2.6 per cent in 2008-09, far ahead of the targets set.

Government of India (2004), Report of Task Force on Implementation of the FRBM Act, Ministry of Finance, July, New Delhi. 7 For a detailed discussion, see T. M. Thomas Isaac and R. Ramakumar (2006), Why do the States not Spend? An Exploration of the Phenomenon of Cash Surpluses and the FRBM Legislation, Economic and Political Weekly, 2 December.

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Figure 2 Revenue Deficit and Fiscal Deficit of States, 1970-71 to 2008-09, as per cent of GDP

5.0

4.0

Deficit as share of GDP (%)

3.0

2.0

1.0

0.0
1970-71 1971-72 1972-73 1973-74 1974-75 1975-76 1976-77 1977-78 1978-79 1979-80 1980-81 1981-82 1982-83 1983-84 1984-85 1985-86 1986-87 1987-88 1988-89 1989-90 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

-1.0

-2.0

Revenue deficit
Source: Reserve Bank of India.

Fiscal deficit

The sharp contraction of deficits was achieved by the States by cutting expenditures across the board.8 If we compare the averages for 2000-05 and 2005-10, the total expenditure of States fell from 17 per cent of the GDP to 15.9 per cent of the GDP (Table 1). Both revenue and capital expenditure of the States fell in this period: as a ratio to GDP, while revenue expenditure fell from 13.3 per cent to 12.4 per cent, capital expenditure fell from 3.6 per cent to 3.5 per cent. As revenue expenditure has been the major target of FRBM Acts and the 12th FC, we could compare the composition of revenue

expenditures of States between 2000 and 2010 (Table 2). As a ratio to GDP, both development expenditure and nondevelopment expenditure of States fell between 2000-05 and 2005-10. Within development expenditure, the expenditure on Education, Art, Sports and Culture fell from 2.5 per cent to 2.2 per cent. The expenditure on Medical and Public Health stood stagnant at 0.5 per cent in both the periods. In other words, the period covered by the 12th FC (also of the first UPA government) was one where the efforts to raise expenditures in education and health, as a ratio to GDP, received a major setback.

Table 1 Trends in Expenditures of all State Governments, 1980 to 2010, as % of GDP Ratio to GDP (%) of Period Revenue expenditure Capital expenditure Total expenditure 1980-85 10.6 4.5 15.1 1985-90 12.2 3.9 16.1 1990-95 12.7 3.2 15.9 1995-00 12.4 2.5 14.9 2000-05 13.3 3.6 17.0 2005-10 12.4 3.5 15.9 Source: Reserve Bank of India, State Finances: A Study of Budgets of 2009-10, 2010.
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For an analysis till 2005-06, see R. Ramakumar (2008), Levels and Composition of Public Social and Economic Expenditures in India, 1950-51 to 2005-06, Social Scientist, 36 (9/10).
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The expenditure on Economic Services, as a ratio to GDP, also declined from 2.9 per cent to 2.8 per cent. Within Economic Services, the expenditure on Agriculture and Allied Sectors declined from 0.7 per cent of the GDP to 0.6 per cent of the GDP. The expenditure on Rural Development stood stagnant as a ratio to GDP in this period. The objective of fiscal consolidation has to be a reduction of expenditures on unproductive items, including interest payments. However, the extent of fiscal compression forced on the States by the 12th FC was such that States slowed down the growth of expenditures across the board. Thus, even though interest payments fell in ratio to GDP, development expenditure also fell in ratio to GDP between 2000-05 and 2005-10. It is a paradox then that the 13th FC has termed the fiscal consolidation efforts of the 12th FC as sterling. The data presented in Table 2 are averages for the period between 2005 and 2010. However, because the Centre had relaxed the FRBM provisions for 2008-09 and 2009-10, States

had been able to raise expenditures in these two years. The Centre allowed additional market borrowings for States to the upper limits of 3.5 per cent of the GSDP in 2008-09 and 4 per cent of the GSDP in 2009-10. All States did not undertake explicit fiscal stimulus measures at the State-level. Only three States Kerala, West Bengal and Haryana had explicit stimulus packages. In 2009-10, Kerala announced a stimulus package worth Rs 10,000 crore. About 80 per cent of this expenditure was capital expenditure, and spent in infrastructure development. West Bengal announced a stimulus package of Rs 5,106 crore in February 2009, which was to be spent on housing, rural power supply, healthcare and education. Haryana also announced a stimulus package worth Rs 1,500 crore in 2009-10, focusing on infrastructure spending. Even in those States that did not have explicit stimulus measures, the increased expenditures were, on the whole, capital expenditures. For all States, the aggregate capital outlay in the

Table 2 Composition of Revenue Expenditures of State Governments, Selected Items, 2000 to 2010, as per cent to GDP Ratio to GDP (%) in the period Sl No. Item 2000-05 2005-10 I Development Expenditure 7.3 7.2 A Social Services 4.4 4.4 A.1 Education, Sports, Art & Culture 2.5 2.2 A.2 Medical & Public Health 0.5 0.5 A.3 Family Welfare 0.1 0.1 A.4 Water Supply & Sanitation 0.2 0.2 A.5 Housing 0.1 0.1 A.6 Urban Development 0.1 0.3 A.7 Welfare of SCs, STs & OBCs 0.3 0.3 A.8 Social Security & Welfare 0.2 0.4 B Economic Services 2.9 2.8 B.1 Agriculture & Allied Activities 0.7 0.6 B.2 Rural Development 0.5 0.5 II Non-Development Expenditure 5.8 4.9 A Interest Payments & Debt Servicing 2.8 2.2 B Pensions 1.2 1.2 TOTAL REVENUE EXPENDITURE 13.3 12.4 Source: Reserve Bank of India, State Finances: A Study of Budgets of 2009-10.

budgets increased by 32.2 per cent between 2007-08 and 2008-09 and at a slower rate of 1.9 per cent between 2008-09 and 2009-10 (BE). While SDP data for 2009-10 are not released yet, available information suggests significant multiplier effects for these countercyclical measures in many States. The 13th FC has made it impossible for the States to continue with these packages and increased expenditures (see next sub-section). The 13th Finance Commission Report The report of the 13th FC does not deviate from the path laid out by the 11th and 12t h FCs. In fact, it goes one step ahead to further restrict the States space in determining fiscal priorities. The main features of the report are listed below. First, the FC has provided an interesting justification for trespassing into the constitutional duties of States. According to the FC, a fiscal framework has to serve the purposes of the contemporary development project, thus making it responsive to internal and external policy imperatives, such as political integration and globalisation. In other words, while the conditionalities laid out by the FCs may be circumscribed by constitutional obligations, its primary duty would be to dutifully serve the existing dominant paradigm. Indeed, this specious argument stands on weak legal grounds, and may not stand the test of objective judicial scrutiny by a learned constitutional bench. Secondly, the FC has ended the temporary relief that the Centre had provided the States in 2008-09 and 2009-10, in view of the global slowdown, to spend beyond the FRBM limits. It has asked States to return to their fiscal correction paths by 2011-12, by cutting down on expenditures during 2010-11. Thus, all States have to reduce their revenue deficit to zero and fiscal deficit to 3 per cent in 2011-12. This premature closure of the fiscal stimulus package at the State-level sits uncomfortably with trends in the GDP figures in the

Economic Survey, as well as global trends in recovery. Thirdly, apart from the two targets of revenue and fiscal deficit, the 13th FC has added a third target for States. By 2014-15, the combined debt stock of States has to be brought down to 25 per cent of the GDP. It is yet unclear as to how this would be apportioned across States. Fourthly, the FC has asked States to amend their FRBM Acts in such a way that the fiscal reform paths (or, the annual targets for reduction of deficits) are written into the Acts and thus made legally binding on an annual basis. It has also recommended that the release of State-specific grants by the Centre be made contingent on States meeting these annual targets. Fifthly, the FC argues that most of the central subsidies as in food and fertilisers are regressive. It has argued that these subsidies are a fiscal obstacle to Indias development, and has recommended that these are closely targeted. In other words, the 13th FC has recommended that Indias public distribution system (PDS) cannot be made universal and has to remain targeted. Sixthly, the FC has asked each State to prepare a roadmap for the closure of lossmaking PSUs and establish a taskforce for the disinvestment or privatisation of other PSUs. Thus, the 13th FC actually aims for the opposite of what the 12th FC ended up achieving: in the words of the 13th FC, expansionary fiscal consolidation, with no compression of development expenditures. What the FC means by this strange phrase is an increase in the quality and effectiveness of public expenditure, by providing States the fiscal space to promote both public and private investment. According to the FC, such a development will only enhance the confidence of the markets, particularly the capital markets, thus adding to Indias reputational capital.

In the debates on State finances in India, an important point that is missed is that the reduction of revenue and fiscal deficits of States were achieved by force, and it does not necessarily reflect a healthier state of their finances. A healthier state of finances would have been one where, along with reducing non-development expenditures, development expenditures are raised substantially. On the other hand, over the 12th FC period, States achieved fiscal consolidation by simply cutting down spending on vital sectors. In the recommendations of the 13th FC also, there is nothing that would avoid such a response from States. Most importantly, the effort to eliminate revenue deficit by 2011-12 would mean that revenue expenditures on social sectors essential in maintaining a minimum level of quality of social services would be cut by the States. Incidentally, this was precisely the point that the Planning Commission raised in its draft approach paper to the 11th five year plan in 2006. As most of the 11th plan schemes in education, health, drinking water and rural infrastructure belonged to the revenuedevelopment expenditure category, the Commission argued that the very thrust of the approach to the 11th Planmay be defeated if the FRBM discipline is insisted upon.9 The 13th FC is totally silent on this issue, and opens the door for another round of massive cuts in revenue expenditures by the States. The 13th FC also appears to believe that by reducing revenue expenditures, States can raise capital expenditures substantially. It is here that the aversion of the FC to fiscal deficit is revealed fully. It recommends that any State that has a revenue surplus along with a higher fiscal deficit should compress its capital expenditure, or alternately, increase its surplus on the revenue account. In essence, the FC is recommending not just a cut in capital expenditure, but also a squeeze of revenue expenditures to reduce fiscal deficit.
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Further, due to the presence of a third and new target for States in the form of a reduction in debt/GDP ratio, any new borrowal of States would be spent not on capital expenditures, but to repay old loans. Such a bizarre status is likely to continue until the debt/GDP ratios are reduced to 25 per cent of the GDP by 2014-15. In Conclusion The grave state of finances has seriously undermined the ability of State governments to meet obligations in social and economic services. The roots of the crisis in State finances have to be traced to the postindependence evolution of Centre-State economic relations in India. Historically, there was a gross inadequacy in the volume of resource transfers from the Centre to the States. On the other hand, the autonomy of State governments in policy making has been increasingly eroded in the period of economic reforms. In this period, the Centre has been forcing the hands of States, using statutory bodies like the FCs, by linking resource transfers to successes with fiscal adjustment. Given such constraints, most States have fallen in line with the mainstream neo-liberal ideas of fiscal contraction. The 13th FC was supposed to act as a neutral umpire between the Centre and States in the allocation of resources in a democratic manner. However, it has ended up further eroding the autonomy of States in economic policy making. Evidently, the period of UPA-II is unlikely to be different from that of UPA-I in the sphere of public expenditure. Thanks to the 13th FC, there would be one more round of expenditure cuts by States in the social and economic sectors, leaving all the promises of enhanced public spending hollow.

Government of India (2006), Towards Faster and More Inclusive Growth: An Approach to the 11th Five Year Plan, Planning Commission, June, New Delhi.
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This Research Brief was prepared at the School of Social Sciences as part of the project titled MONITORING AND ANALYSIS OF BUDGETS IN MAHARASHTRA STATE, internally funded by the Research Council of the Tata Institute of Social Sciences, Mumbai. Corresponding email: rr@tiss.edu. Research Briefs are envisaged to be short and structured summaries on important research and policy issues. The opinions and comments in the research briefs are the personal views of the authors, and do not reflect the official positions of the institutions with which they are associated.