State Finances Since 1952

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STATE FINANCES SINCE 1952

STATE FINANCES SINCE 1952 In order to analyze the trends in state finances in India since the mid-twentieth century, and to identify reform issues that need to be addressed for better macroeconomic management, it is necessary to examine the fiscal role of state governments in India's federal polity and their effectiveness in fulfilling their fiscal roles. As in other important federal fiscal systems, the states play an important role in providing public services in India. The country's 1.2 billion people live in twenty-eight states and seven centrally administered territories (two with their own elected governments). The seventh schedule of India's Constitution demarcates the legislative and fiscal domains of the union and state governments in terms of union, state, and concurrent lists. The states have exclusive authority over the items specified in the state list and coequal powers in regard to those in the concurrent list. While on the one hand the states are required to make substantial investments in providing efficient physical and social infrastructure, they face binding constraints on resources. Restructuring the finances and expenditure priorities to release resources to the desired activities has not been easy. The declining revenues and transfers from the central government have only added to India's woes. The states are faced with challenging times in creating a business-friendly environment.

The Assignment System

The tax and expenditure powers of the central and the state governments are specified in the seventh schedule of the Constitution. The functions required for maintaining macroeconomic stability, international relations, and activities having significant scale economies have been assigned exclusively to the central government, or have to be carried out concurrently with the states. Functions that have a statewide jurisdiction are assigned to the states. Most broad-based and progressive taxes have been assigned to the central government, which also has residual tax powers. A number of tax vehicles have been assigned to the states, but from the viewpoint of revenue productivity, only the sales tax is important. The states can borrow from the central government. They have the powers to borrow from the market, but if a state is indebted to the central government, such borrowing must be approved by the center. The important taxes assigned to the states include the sales tax, excise duties on alcoholic products, stamp duties and registration fees, taxes on motor vehicles and passengers and goods. They can also levy taxes on incomes from agriculture, but none of the states has found this feasible for political reasons. Even land revenue, which contributed significant revenue thirty years ago, has ceased to contribute any worthwhile resources in recent years.

The states play a very important role in the development of agriculture and have a significant role in the provision of infrastructure for industrial development. Even more significant is their role in human development, as they have responsibility for the provision of basic education and health care. The states raise 35 percent of the total revenues and incur 57 percent of total expenditures. Their role in providing social services is particularly significant. In fact, their expenditure share in education, public health, and family welfare is close to 90 percent of public expenditures.

Trends in State Finances: Macroeconomic Implications

The trends in state finances in India since the mid-twentieth century can be examined in two distinct phases. In the first phase, from 1950–1951 to 1986–1987, increased revenue receipts kept pace with revenue (current) expenditures. The emphasis on resource mobilization, particularly to finance large development plans, resulted in the steady increase in both revenues and expenditures, with states' own revenues as well as central transfers steadily increasing. In fact, from 1975–1976 to 1983–1984, revenue receipts exceeded revenue expenditures by a significant margin, enabling the states to finance an appreciable portion of their capital expenditure from savings in the current account.

The second phase in state finances began with the pay revision, following the implementation of the recommendations of the pay commission by the central government. The central government itself had such a significant revenue deficit that it could not increase transfers to meet the additional requirements to finance the pay revision. The states, on their part, did not undertake serious fiscal restructuring, and as the buoyancy of both the states' own revenues and central transfers declined (the latter more than the former), public dissaving at the state level increased steadily. In fact, in the 1990s the states' revenue-gross domestic product (GDP) ratio remained steady at about 5.5 percent, whereas the central tax-GDP ratio declined by two percentage points. The consequence of this has been to reduce transfers to the states by one percentage point. Thus, with stagnant revenues, declining transfers from the center, and everincreasing pressure on expenditures, revenue deficits in the states widened significantly in the 1990s. Although the states tried to contain their expenditures to adjust for stagnant revenues, the revision of pay scales of state government employees, following the implementation of the fifth central pay commission, did not help matters. Thus, since 1998–1999, the revenue deficits of the states increased sharply, and borrowed resources of over 2.5 percent of GDP were being used to meet states' current expenditures. Correspondingly, fiscal deficit on states' accounts increased from 1.3 percent in 1975–1976 to 2.8 percent in 1985–1986 and accelerated to 4.7 percent in 2001–2002.

The deterioration in state finances since 1987–1988 also marked a sharp deterioration in the quality of deficits as well. Infrastructure spending declined from 3.7 percent of GDP in 1980–1981 and about 3 percent in 1985–1986 to 1.7 percent in 2000–2001. As a ratio of total expenditures, capital expenditure declined from about 27 percent in 1980–1981 to a mere 13 percent in 2001–2002. Sharp increases in expenditures crowded out maintenance expenditures, thereby reducing the productivity of the infrastructure sector as well. Even in labor-intensive social services such as education and health, increases in the pay scales have significantly escalated the input cost of providing these services, and increasing expenditures have not been reflected in the improvement in the standard of these services.

The persistence of large and growing fiscal deficits in India's states over the years has led to a steady accumulation of debt. The states' outstanding debt as a ratio of GDP was steady from 1965–1966 to 1997–1998, but thereafter increased sharply. This deterioration in fiscal imbalances is not just an aggregate phenomenon. It is seen in the case of each of the individual states, particularly after the pay revision in 1998–1999. Even in 1995–1996, some of the states had surpluses in the revenue account, but after the pay revisions in 1998–1999, every state has had revenue deficits of varying magnitude, and capital and maintenance expenditures have been lower than in 1995–1996.

There are a number of reasons for fiscal imbalances at the state level. Since the 1980s, the growth of the states' revenue expenditures has outpaced the growth of revenue receipts mainly because of the two pay revisions, one in the late 1980s and another in the late 1990s. The last one in particular had disastrous effects on state finances. Pay revision was not accompanied with any restructuring plan in public employment, and expenditures on salaries and pensions increased sharply after 1998–1999. The second important reason for the states' imbalances is the decline in transfers from the central government as a ratio of GDP. The central government's own revenues as a ratio of GDP declined by about two percentage points in the 1990s, and this led to the compression of transfers to states by one percentage point. Third, there has also been a significant deceleration in the growth of states' own tax revenue. Fourth, the artificial distinction between plan and nonplan expenditures and an emphasis on increasing the plan size year after year have led to unbridled growth of expenditures. Fifth, increased borrowing, particularly from uncontrolled sources at high interest rates, has caused a sharp increase in the debt service burden. Finally, public enterprises, particularly the power utilities, have continued to be a drain on the states' funds.

The states' fiscal operations have important implications on microeconomic efficiency as well. On the tax side, the structure and operation of sales tax systems has been a major source of distortion. The relative price distortions caused by complicated, cascading type, preretail and partly origin-based sales tax and the impediments to internal trade and distortions and inequity arising from multiple tariff zones (created by interstate sales tax and the tax on the entry of goods into a local area for consumption) are well known. These are only some of the problems in the tax side. On the expenditure side, steady decline in the allocation to the creation and maintenance of infrastructure has adversely affected its quality. Similarly, a significant increase in the input cost due to pay revision has adversely impacted the standards of social services.

Reforming State Finances: Challenges Ahead

Concerned over the perilous condition of their finances, some of the states have taken reform initiatives. A number of states have published white papers on their finances. Some of the states have initiated reforms in their tax and expenditure systems, have tried to quantify contingent liabilities, and have passed fiscal responsibility legislation to cap deficits and impose fiscal discipline. In some cases, reform initiatives have been taken at the instance of multilateral lending agencies as a condition for their lending. The central government also has initiated a fiscal reform program for the states and has linked a portion of its transfers to fiscal performance. However, the design of the program and its implementation leave much to be desired.

In a more open market economy, the state governments will have to provide a higher quality infrastructure. In particular, their role in human development is critical. This change would require a number of reform initiatives. These initiatives include: restructuring the administrative machinery, improving the buoyancy of the tax system, better cost recovery on the services provided, downsizing of bureaucracy, and prioritizing expenditure allocation to provide quality infrastructure and the creation of a business-friendly environment.

One of the most important areas requiring urgent reform is the power sector. Reform is necessary not only to achieve fiscal consolidation but also to ensure the quality of the infrastructure. Restructuring other public enterprises will also prevent a drain on resources. Reforms in the tax systems are important to ensure that the resources for investment in infrastructure are generated in the least distortionary manner. The states took initiatives to substitute the prevailing cascading sales tax with the value-added tax (VAT) in April 2002. Transition to VAT was necessary not only to impart efficiency to the tax system but also to enhance revenue productivity. The reform journey for the achievement of fiscal consolidation, the improvement of efficiency and productivity, and the creation of a competitive environment will be long and arduous. Political will and administrative competence, along with an awareness of the need for reform among the general public, are the most important ingredients that will be needed in abundance to achieve the desired goals.

M. Govinda Rao