Fiscal Responsibility of States

Fiscal Responsibility of States

Context

• It is a grand achievement that the fiscal deficit target of 3.5% of GDP for the past year was met successfully.
• As a result of which, beyond the 3.2% fiscal deficit target for the current year, the government has accepted a 3% target thereafter. Continuing this trend in the future will enable the realisation of the preferred 60% debt-GDP ratio by 2023.
• The Fiscal Responsibility and Budget Management (FRBM) Review Committee report headed by N.K. Singh has preferred a debt to GDP ratio of 60% for the general government by 2023, comprising 40% for the Central government and 20% for the State governments.
• Given the recent track record, there is a reasonable probability of the Central government achieving the 40% debt to GDP ratio. The focus now is on the States.
• Can the states, in partnership with the Central government, enable the near optimum of 60% to be achieved by the terminal date?
• For international investors and rating agencies, what matters is the fiscal position of the country as a whole. The challenge of States achieving a debt ceiling of 20% by 2023 is undoubtedly Herculean for more reasons than one.

Position of states

1. Government debt and Growth rate trajectory

• A key issue in assessing long-run fiscal sustainability is the future trend of the differential between the interest paid to service government debt (r) and the growth rate of the economy (g).
• For highly indebted countries, an increase in this differential of a couple of percentage points, if sustained, could lead to a change from a declining to an explosive path for the debt-to-GDP ratio.
• A negative interest rate-growth differential (i.e. r-g, growth rate greater than the interest rate) causes debt to GDP to decline over time.
• However, the advantages on account of a favourable r-g depend primarily on the level of debt stock.
• In this context, the Union government, which has larger domestic liabilities of 49.23% of GDP as compared to that of the States (21% of GDP), benefits more due to a negative interest rate-growth differential.
• The combined debt dynamics necessitate States to run successively lower primary and fiscal deficits just to maintain their combined debt to GDP ratio at the current level.

2. Role of exogenous factors

• Till FY13, fiscal conduct of the States was exemplary, strictly adhering to and even outperforming the targets of the Fiscal Responsibility Legislations (FRLs) which was facilitated by positive externalities undoubtedly.
• Consolidation of Central loans and debt waiver to States based on their fiscal performance effectively reduced their interest payments to about 0.9% of Gross State Domestic Product (GSDP).
• Given the debt-restructuring scheme of the Twelfth Finance Commission (FC), Central relief packages and positive economic scenario, it is difficult to differentiate the fiscal correction due to improved management and fiscal discipline.

3. Deterioration in Fiscal health of the states

• The Fourteenth Finance Commission enhanced the borrowing limits up to 0.5% of GSDP for the States. This was conditional on debt to GSDP ratio being less than or equal to 25% and/or interest payments being less than or equal to 10% of the revenue receipts in the preceding year.
• The fact that only six States in FY17 were eligible for enhanced borrowing is indicative of States’ decaying fiscal prudence.
• The recent spate of farm loan waivers is episodic and symptomatic of deteriorating State finances.

Way Forward

1. Effectively using existing constitutional and legal provisions

• The most obvious one is the prudent use of powers defined in the Constitution of India under Clause (3) of Article 293. This makes it mandatory for a State to take the Central government’s consent for raising any loan if the state owes any outstanding liabilities to the central government.
• But what happens when States cease to have any outstanding liabilities to the Central government, as states rarely confront the situation of liabilities to the centre.
• Also, the Union Cabinet recently has permitted State government entities to directly borrow from bilateral partners of India for vital infrastructure projects. Incentivising prudent fiscal management is a welcome initiative.
• There must be symmetry between the cost of borrowing and the quality of financial governance.
• Combined market borrowings have been rising consistently from 18% in FY11 to 28% in FY16. The gross market borrowing of States through State Development Loans (SDLs) increased by a sharp 27% in FY17 from ₹9 trillion in FY16.
• Markets expect this to rise even further by 22% in FY18 consequent upon pay revisions, implementation of Ujwal DISCOM Assurance Yojana (UDAY) and exclusion of State governments from the National Small Savings Fund (NSSF).
• Risk variations across States are not reflected adequately in the cost of borrowings.
• This is a major concern. Fiscally healthy States should be enabled to attract higher investments at lower costs.

2. Transparent accounting

• The current stock of State debt at 21% of GDP could be underestimated owing to fallacious budgetary practices and operational intricacies.
• Off-budget expenditures through State Public Sector Undertakings’ (PSUs) borrowings and explicit guarantees offered by the States do not form a part of State government liabilities.
• Private researchers and public auditors alike have been pointing out the growing trend of off-budget public spending and mis-categorisation of budget data. The Comptroller and Auditor General of India (CAG), while appraising States’ finances, has repeatedly censured such practices.
• The Fourteenth Finance Commission’s (FFC) recommendation of adopting “a template for collating, analysing and annually reporting the total extended public debt in their respective budgets as a supplement to the budget document” must be implemented.

3. Quality of expenditure

• The quality of state spending (proxied by the ratio of capital to current spending) has been gradually worsening over the past few years.
• The share of States’ revenue expenditure in total expenditure has remained around 80% and States’ non-developmental expenditure has risen by over 50% from FY2013 to FY2016.
• The RBI’s latest assessment of State Budgets with the theme, ‘Quality of Sub-national Public Expenditure’, raises the concerns about dominance of revenue expenditure in the States.
• While the quantum of “untied funds” from the Centre to the States has increased owing to the recommendations of the FFC, expenditure on physical and social infrastructure by the States has remained stagnant.
• While according permission to States to undertake fresh borrowings, their expenditure quality should be a prime condition.

4. Encapsulating ‘Fiscal Discipline’ in determining inter se tax shares

• Fiscal discipline as a criterion for tax devolution was used by Eleventh, Twelfth and Thirteenth Finance Commissions for incentivising the States in prudent management of its finances.
• However, the FFC dropped this indicator and accommodated ‘Population (2011)’ and ‘Forest Cover’ in its devolution formula.
• Given the deteriorating condition of State finances, the Fifteenth Finance Commission could consider restoring fiscal discipline as a determinant for horizontal devolution of funds.

Fiscal Responsibility and Budget Management Act, 2003

• TheFiscal Responsibility and Budget Management Act, 2003 (FRBMA) is an Act of the Parliament of India to institutionalize financial discipline, reduce India’s fiscal deficit, improve macroeconomic management and the overall management of the public funds by moving towards a balanced budget and strengthen fiscal prudence.
• The main purpose was to eliminate revenue deficit of the country (building revenue surplus thereafter) and bring down thefiscal deficit to a manageable 3% of the GDP by March 2008.
• However, due to the2007 international financial crisis, the deadlines for the implementation of the targets in the act was initially postponed and subsequently suspended in 2009.
• In 2011, given the process of ongoing recovery, Economic Advisory Council publicly advised the Government of India to reconsider reinstating the provisions of the FRBMA.
• K. Singh is currently the Chairman of the review committee for Fiscal Responsibility and Budget Management Act, 2003, under the Ministry of Finance.

N.K. Singh Committee Report

Conclusion

• Borrowing today to pay tomorrow is by no means financially viable for long-term growth.
• After all Thomas Jefferson had said, “The principle of spending money to be paid by posterity, under the name of funding, is swindling futurity on a large scale.”

Practice Questions

1. How does the fiscal position of the states affect the overall fiscal scenario in the economy at the national level? What are the steps that are being suggested to make an ambient balance?
2. What was the context in which N.K. Committee on FRBM Act was constituted? Critically discuss its recommendations.