No more incentives please

Since the 12th Finance Commission is supposed to be in the process of finalising its recommendations around now, and the states are forcefully making their cases for more funds/debt writeoffs, this is perhaps the best time to point out the previous commission’s medium-term fiscal reforms programme, now almost completing its fourth year, has been a near disaster.

The plan was to give states around Rs 10,600 crore extra over a period of five years as an incentive to get their fiscal houses in order. Well, the fiscal numbers are out for most states for the year 2003-04, and they don’t show any major improvement, indeed they have worsened this year.

Even more worrying, the states that have had some leeway in terms of their ability to raise further debt (like Maharashtra, for instance) have actually got a lot more indebted, and the overall debt-to-GDP ratio for all states has gone up from 20 per cent in 1990-91 to around 30 per cent today.

Not surprisingly then, a state like Tamil Nadu, even, was bankrupt, in 2002, it had unpaid bills of Rs 3,100 crore of which salary and pension arrears were Rs 1,800 crore.

The best proof of this failure in fiscal correction, of course, is the fact that under 60 per cent of the incentive fund has been utilised—of the Rs 8,486 crore allocated for the scheme in the first four years, just Rs 5,000-odd crore has been used up. Worse, the utilisation is falling with each passing year.

In the first year, around 95 per cent of the allocation was used up by states who achieved their fiscal goal. The next year, this fell to under 80, and to under 50 in the third year. This year, so far, the utilisation has been around 12 per cent!

How pathetic this is, is underscored by the fact that the fiscal correction required was itself very modest—in the case of a state like West Bengal, which has managed to get its incentive funds every year, for instance, the expenditure compression called for was only of the order of around 13 per cent over five years.

As a result, a recent World Bank publication on the states’ fiscal problem points out real expenditure by state governments (that is, expenditure minus that on interest, pensions and higher salaries to bureaucrats as a result of the Fifth Pay Commission) has fallen from 13 per cent of GDP in 1991-92 to an estimated 10 per cent in 2002-03.

Put another way, in 1991-92, while rich states used to spend around Rs 1.3 on recurring non-salary items per rupee spent on salaries, this fell to around a rupee by 2001-02—for the poor states, this fell from 0.9 to 0.7.

In a non-reforms scenario, the Bank estimates that spending on unproductive and committed expenditure (like that on interest, pensions, and salaries) will increase dramatically, and the non-salary expenditure will fall further from the 2003-04 average of 72 paise to just 33 in 2007-08.

The cause of the problem, of course, is two-fold. While central transfers to states have gone down, from around 5 per cent of GDP in 1991-92 to around 4.5 today, revenue mobilisation by states has remained at more or less the same level of around 7 per cent, and within this, there has been a fall in non-tax revenues.

Indeed, power sector subsidies eat up a large part of state revenues (these are up from 0.6 per cent of GDP in 1992-93 to 1.4 per cent in 1999-00) even though it is evident this can’t be going to poor farmers whose lands remain unirrigated—yet, a host of states like Tamil Nadu, Madhya Pradesh, and Andhra Pradesh have gone back to the days of free power populism.

While it is tempting to think the solution lies in getting more funds through the 12th Finance Commission, there are several studies which have shown how higher grants/transfers from the central government only reduce the state’s tax effort.

Indeed, the Bank’s report cites some interesting studies on fiscal adjustment. In one, of 60 episodes of fiscal correction between 1960 and 1994, it was found that only 16 were of a lasting nature. Of these, 73 per cent were based on recurrent expenditure cuts being made as well.

In another study, of 74 episodes of fiscal correction between 1970 and 1995, around half of those which relied on recurrent expenditure cuts were successful as compared to one in six for those that depended more upon tax hikes or cuts in capital expenditure.

Of course, if the forecast for the future is so bleak and increased central transfers not the answer, then what is? Perhaps the only meaningful solution is looking at using Article 293 of the Constitution to lay down conditions for states’ borrowing—Brazil’s fiscal responsibility bill, for instance, allowed states to use only 11.5 per cent of their annual revenues to service debt and set a limit to the amount of debt states could accumulate at twice their net current revenue.

It’s interesting, as well as sobering, to know that, at current levels, India’s states are perhaps the most debt-stressed in the entire world—while the ratio of debt to revenues was 203 per cent for Indian states in 2000, that for Canada was 189, 170 for Brazil, 100 for Pakistan and 69 for Argentina.