isaac ramakumar epw paper

Economic and Political Weekly December 2, 2006 4965

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Shri P Chidambaram (finance minister): …the most importantthing is that the government must spend. Now, who is not spend-ing? I am sorry to say that states are not spending. … (Interrup-tions)… As on day before yesterday, the state governments’ cashbalances were Rs 45,000 crore. The states are today cash rich.Every state has got a cash balance. There is no state with overdraft;there is no state with WMA as of today.… (Interruptions)

Md Salim (Calcutta – North-East): Most of them wait for March 31.

Shri P Chidambaram: No, they are not waiting. This is my worry…Every state is cash rich; every State must spend. One of the reasonswhy there is some tightening of liquidity is that states are unableto spend. The system does not have this absorptive capacity tospend in time and reach the target. I had appealed to the statefinance ministers; I had appealed to the state chief ministers. AndI would, therefore, appeal to all sections of the House aboutthis…All states must spend the money. Unless money is spent,the targets will not be achieved. Unless money is spent, you willnot achieve your growth targets either…Therefore, Members musturge the state governments to spend more on primary education,to spend more on primary health, spend more on rural roads,drinking water, sanitation and so on. If the states also join andspend wisely and prudently and with proper monitoring, you willfind that the rate at which we achieve our target is accelerated.

– Excerpts from the combined discussion on the Budget for2006-07, Supplementary Demands for Grants for 2005-06 and

Demands for Excess Grants for 2003-04, XIV Lok Sabha.

This paper is an examination of the claim – made by theunion finance ministry – that state governments in Indiaare cash rich, but are not spending due to lack of “absorptive

capacity”. As on September 8, 2006, the state governments’investment in the treasury bills (all denominations) of the ReserveBank of India (RBI) was Rs 66,659 crore. Even the so-calledBIMARU states, with a track record of abysmally low provisionof basic needs, have joined the rich states’ club with large amounts

of surpluses. Against the background of widespread rural distress,the phenomenon of cash surpluses of states appears bizarre. Thissituation makes the question raised by the union finance ministryeven more significant: why do the states not spend?

The focus of the present paper is on this issue: why are states notable to spend even with surplus cash balances? Is it really agovernance issue, as the finance ministry would make it out to be,or something more fundamental affecting the fiscal powers of thestate governments? We shall start with a brief analysis of theemergence of the phenomenon of cash surpluses in state governmenttreasuries (Section I), and then go on to analyse the factors respon-sible for the phenomenon from the receipts side and the expenditureside. We argue that the limits to expenditure increases set throughlegislation are primarily responsible for the cash surplus pheno-menon. The constraint on expenditure is imposed by the FiscalResponsibility and Budgetary Management (FRBM) Acts passed bythe centre and most state governments (Section II). As we argue, thecash surplus phenomenon is a perverse outcome of the FRBM Acts.

There have been some states, where expenditures continue togrow or receipts do not keep pace with expenditure rise, andtherefore, continue to be on deficit in cash balance. Kerala isthe most prominent case in this context. What is the price thatKerala has to pay for being an outlier? The mechanical constraintsimposed by the FRBM Acts and their essential anti-democraticnature are brought out in our case study of Kerala (Section III).

IThe Phenomenon of Cash Balance

Surplus of States

When state governments’ day-to-day disbursement require-ments are in excess of receipts, temporary accommodation is soughtfrom the RBI in the form of Ways and Means Advances (WMA).

Why Do the States Not Spend?An Exploration of the Phenomenon of Cash Surpluses

and the FRBM LegislationThis paper investigates the unusual phenomenon of state governments currently maintaining

large cash balances even as many important sectors call for substantial outlays. Is ita governance issue, as the union finance ministry makes it out to be, or is it something more

fundamental affecting the fiscal powers of state governments? We argue that the constrainton expenditure is imposed by the Fiscal Responsibility and Budgetary Management Acts passed

by the centre and most state governments; the cash surplus phenomenon is a perverseoutcome of such legislation. This essay also investigates the price paid by Kerala, an outlier

where receipts do not keep pace with expenditure growth, because of the mechanicalconstraints imposed by the fiscal responsibility legislation.

T M THOMAS ISAAC, R RAMAKUMAR

Economic and Political Weekly December 2, 20064966

Ceilings have been determined for each state and when the WMAexceeds the ceiling, the state gets into a position of overdraft(OD). The persistence of an OD beyond a specified period wouldresult in temporary suspension of treasury operations by the RBI.State finances in India, from the latter half of the 1980s, weredistinctly characterised by the persistence of cash balance deficitsand consequent WMA and OD positions. However, from the early2000s, the situation began to change; the extent to which stategovernments availed of WMA from the RBI declined sharply.As Table 1 shows, the number of non-special category states thatavailed normal WMA for 200 days or more declined from 14to just one between 2000-01 and 2005-06. Out of the 17 states,13 were not in WMA for even a day in 2005-06.

Surplus in cash balances, which was a relatively rare pheno-menon in the 1990s, began to be a regular feature of the states’treasuries in the 2000s. As on March 31, 2002, the treasury cashbalance of all states in India was in deficit of Rs 7,873 crore.In two years, the deficit was gradually transformed into a surplus.As on March 31, 2006, treasury cash balance of all states wasin a surplus of Rs 48,909 crore [Ministry of Finance 2006].

When there is a surplus balance in the treasury, the RBI investsthe surplus in the intermediate treasury bills of the centralgovernment on behalf of the states. Figure 1 shows the quarterlytrends in the growth of investments by states in the differenttreasury bills of the centre. The trends are easily discernible.Between 1998 and 2001, not only were the volumes of investmentlow, but were also declining. On December 28, 2001, the totalinvestment by states in all denominations of treasury bills wasonly Rs 1,988 crore. Within this amount, the investments in longerduration treasury bills were almost negligible. However, fromthe beginning of 2002, these investments started rising slowly,reaching Rs 2,926 crore as on January 9, 2004. After January2004, there was a phenomenal and continuous rise in the invest-ment by states in the treasury bills. As on August 18, 2006, thetotal investment by states in all denominations of treasury billswas a whopping Rs 61,886 crore. The composition of securitieswithin this investment also changed considerably between 2004and 2006. States began to invest much more in longer duration

Table 1: Distribution of the States That Availed Normal WMA bythe Number of Days the State Government Availed WMA

(2001-02 to 2004-05)

Number of days in WMA 2001-02 2002-03 2003-04 2004-05 2005-06

(a) Non-SpecialCategory States:0-99 3 5 5 10 (4) 16 (13)100-199 0 1 3 2 0200 and above 14 11 9 5 1

(b) Special Category states:0-99 3 3 5 4 (1) 9 (1)100-199 2 1 1 4 0200 and above 4 5 3 1 0

Note: Figures in brackets show the number of states that had availed WMAfor zero days.

Source: RBI (2005b); RBI (2006).

Table 2: Investment Outstanding in 14-Day IntermediateTreasury Bills, All-States, 2001-02 to 2005-06, as on End-March

(Rs crore)

States 2001-02 2002-03 2003-04 2004-05 2005-06

Andhra Pradesh 139 190 1183 1701 253Assam – – – – 854Bihar 91 943 299 2845 3931Chhattisgarh 352 589 271 335 711Gujarat – 747 289 227 3166Haryana – 149 632 1571 3894Himachal Pradesh – – – – 317Jharkhand 1482 217 1259 1139 982Karnataka 1885 388 296 2033 971Kerala – – – – 343Madhya Pradesh – 27 – 200 777Maharashtra 857 1021 1831 1095 2300Orissa – – 102 653 1080Punjab – – – – 911Rajastan – – 179 930 1051Tamil Nadu – – – – 5075Tripura – 103 8 297 421Uttar Pradesh – 407 240 – 3017Uttaranchal – 311 77 – 307West Bengal – – – 935 2408Other states 137 502 190 353 813All-states 4943 5594 6856 14314 33582

Note: For 2005-06, the figures are as on January 18, 2006.Source: RBI (2005a: S99).

Figure 1: Investment Outstanding of State Governments in Intermediate Treasury Bills, Quarterly Estimates, 1998 to 2006(Rs crore)

1 4 - d a y 9 1 - d a y 1 8 2 - d a y 3 6 4 - d a y T o t a l

Sep

t 19

98

Dec

199

8

Mar

199

9

Jun

1999

Sep

t 19

99

Dec

199

9

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200

0

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2000

Sep

t 20

00

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200

1

Jun

2001

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t 20

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t 20

02

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200

2

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200

3

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2003

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t 20

03

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200

3

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200

4

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2004

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t 20

04

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200

4

Mar

200

5

Jun

2005

Sep

t 20

05

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200

5

Mar

200

6

Jun

2006

Sep

t 20

06

70000

60000

50000

30000

20000

10000

0

Inve

stm

ent

outs

tand

ing

(Rs

cror

e)

14-day 91-day 182-day 364-day Total

Date

Source: Weekly Statistical Supplement, Reserve Bank of India, various issues.


securities, such as the 91-day, 182-day and 364-day treasury bills.Around 9 per cent of the investment by states (about Rs 5,350crore) were in 364-day treasury bills as on August 18, 2006.

For the first time, RBI has published state-wise data on theinvestment outstanding in 14-day intermediate treasury bills inits report on state finances in 2005-06 [RBI 2005a]. Data showthat in 2001-02, majority of the states did not have any outstandinginvestment in treasury bills (Table 2). By 2005-06, all stategovernments had significant investment outstanding in 14-dayintermediate treasury bills. Tamil Nadu, with more than Rs 5,000crore investment, was in the forefront. Interestingly, Bihar andUttar Pradesh shared with Gujarat and Haryana the distinction ofhaving investments of more than Rs 3,000 crore in treasury bills.

The phenomenon of significant investment by states in treasurybills is worrisome for a number of reasons. First, the investmentsby states in the 14-day intermediate treasury bills of the centreearn them a return of 5 per cent per annum. However, as weshall see, the average cost of mobilisation of funds for the statesis much higher. In 2005-06, the interest rate on borrowings ofstates against small savings was 9.5 per cent per annum (thecostliest debt in the market) and the average interest rate on marketborrowings was 7.4 per cent per annum. The total transfer ofNSSF loans from the centre to states was Rs 90,000 crorein 2005-06. At the end of the same period, the total reverseinvestment by states in the treasury bills was Rs 61,886 crore,or about two-thirds of its NSSF borrowing! Even the RBI, inits recent study on state finances, has commented that this situ-ation implies a “reverse transfer of resources from states to thecentre” [RBI 2005a:52).1

Secondly, the centre has also been recycling the cash surplusof states to itself at a very low rate of interest for treasury securityoperations. In 2005-06, the centre enjoyed a surplus cash balancefor most months of the year. According to the RBI, “had it notbeen for the investments of States’ surplus cash balances in 14-day Intermediate Treasury Bills, the Centre would have been inWMA” in 2005-06 [RBI 2005a: 52]. Also, the centre deploys

its cash balances in securities held by the RBI (which fetchesthe centre a yield higher than the 5 per cent), thus saving on theinterest to be paid on the dated securities held by the RBI (ibid).This has enabled the centre to make profits, through positivespreads, from the states’ cash surpluses.

There is a growing resentment among states against this reverseflow of resources. Many states have openly stated that they donot want to borrow from the NSSF. The centre has respondedto this criticism by forming a sub-committee of selected chiefministers and state finance ministers, which even after a yearhas not reached any concrete decision. Reading through theminutes of the deliberations of various official forums, one isamazed at the total absence of discussions on how the surpluscash balances can be fruitfully employed to meet the basic needsof the people. There is a peculiar myopia towards the expenditureside of the problem.

No doubt, a discussion on the reasons behind the cash surplusphenomenon has to take into account both the receipts andexpenditure sides of state finances. We shall first discuss thereceipts side.

Trends in States’ Receipts

The sources of receipts of a state government can be broadlydivided into central transfers (shareable taxes and grants), ownrevenue (own tax receipts and own non-tax receipts) and capitalreceipts (loans from the centre and other sources).Central transfers: The significant increase in transfers from thecentre to the states has been cited as a prominent factor leadingto the phenomenon of cash surpluses [RBI 2005a: 52]. Data show,first, that the ratio of central grants to GDP has tended to declinefrom around 2.4 per cent in the late-1980s to 1.7 per cent in thelate-1990s (Figure 2). However, there was a significant rise inthe ratio of grants to GDP between 2004-05 and 2005-06. Secondly,the ratio of central taxes to GDP was more or less stagnant tillthe mid-1990s, but fell between 1997-98 and 2002-03. After

Figure 2: Ratio of Different Components of Devolution of Resources from Centre to States to GDP(Per cent)�

Year

Total central transfers (share in taxes and grants) Grants from centre Share in central taxes

Source: Handbook of Statistics on the Indian Economy, Reserve Bank of India, various issues; RBI (2006).

1970

-71

1971

-72

1972

-73

1973

-74

1974

-75

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-76

1976

-77

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-78

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-79

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-80

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-81

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-82

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-83

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-84

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-85

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-86

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-87

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-88

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-89

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-90

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-91

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-92

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-93

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-94

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-95

1995

-96

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-97

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-98

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-99

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-200

0

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-01

2001

-02

2002

-03

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-04

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-05

2005

-06

re

Year

Total central transfers (share in taxes and grants) Grants from centre Share in central taxes

6.0

5.0

4.0

3.0

2.0

1.0

0.0

Sha

re in

GD

P (

Per

cen

t)


2002-03, the ratio of central taxes to GDP increased, but in 2005-06 it was still below the corresponding ratio for 1997-98. Finally,the ratio of total central transfers (i e, share in central taxes plusgrants) to GDP, after stagnating from the late-1980s at around5 per cent, declined from 1997-98 and improved significantlybetween 2002-03 and 2005-06. In absolute terms, the total centraltransfers increased from Rs 1,00,008 crore in 2002-03 toRs 1,82,796 crore in 2005-06: an increase of about 82 per centover three years.Own revenue: The ratio of own revenue to GDP, particularlyof owntax revenue, of state governments has increased the recentyears (Table 3). The own tax revenue of states increased from5.2 per cent of GDP in 1999-2000 to 6.4 per cent of GDP in2005-06. As a result, the total own receipts of states as a ratioto GDP also rose from 6.8 per cent in 1999-2000 to 7.7 per centin 2005-06. Due to the rise in central transfers and own revenues,the ratio of total revenue receipts to GDP rose from 10.6 percent in 1999-2000 to 12.9 per cent in 2005-06.Capital receipts: The ratio of capital receipts to the gross statedomestic product rose sharply from 3.1 per cent in 1996-97 to6.7 per cent in 2004-05. Between 2004-05 and 2005-06, datashow a fall in the ratio of capital receipts to GDP. Among capitalreceipts, high-cost loans from the NSSF rose significantly after1999-2000. The ratio of NSSF loans to GDP rose from 1.3 per centin 1999-2000 to 2.4 per cent in 2004-05 and 2.1 per cent in2005-06 (Table 4). Also, the share of NSSF loans in total capitalreceipts of states rose from 26 per cent in 1999-2000 to 46 percent in 2005-06. Till 1999-2000, loans from the NSSF wereconsidered as loans from the centre; from 1999-2000, however,they were considered as internal debt and classified separatelyas “Special Securities Issued to NSSF.” Currently, the entirecollection of NSSF in each state is returned to the respective stategovernments by the centre in the form of borrowings. Till2004-05, the states had access to only 60 per cent of the netsmall savings collection, but from 2005-06 onwards, they areforced to borrow the entire small savings collections even if theydo not require it. The interest rate on NSSF borrowings is 9.5per cent per annum with the states bearing the additional burdenof the special incentives that are provided under the small savingsscheme.

In sum, the ratio to GDP of high-cost NSSF loans of states,own tax revenue of states and total central transfers to states haverisen in the recent years. The total contribution of the three abovecomponents together, as a ratio to GDP, rose from 10.2 per centin 1999-2000 to 13.1 per cent in 2004-05. Even if we grant thatthis extent of increase in receipts has made a significant differenceto state finances, it still begs the question: how are the statesusing these increased receipts to meet the needs of people?

Trends in States’ Revenue Expenditures2

Coming to the expenditure side, a distinct feature of statefinances in the 2000s has been the overall stagnation, if notdecline, in revenue expenditures relative to the size of the economy.This stagnation in expenditures has taken place, as we have seen,in a period of increase in the ratio of revenue and capital receipts(especially NSSF borrowings) of states to GDP. This is evidentfrom the data on trends in the ratio of revenue expenditure toGDP for all states, provided in Table 5. In fact, between 2000-01 and 2005-06, the ratio of revenue expenditure to GDP of statesfell slightly from 13.8 per cent to 13.3 per cent. This slight fall

Table 3: Selected Features of the Pattern of Revenue Receiptsof State Governments, 1990-91 to 2005-06(As percentage of GDP at current market prices)

Year As a Ratio to GDP at Current Market PricesTotal Revenue Total Own Own Tax Own Non-tax

Receipts Receipts Receipts Receipts

1990-91 11.6 6.9 5.3 1.61991-92 12.2 7.3 5.4 1.91992-93 12.0 7.0 5.3 1.71993-94 12.1 7.1 5.3 1.81994-95 11.9 7.6 5.4 2.11995-96 11.4 7.2 5.3 1.91996-97 11.0 6.8 5.1 1.71997-98 11.1 6.9 5.3 1.61998-99 10.0 6.4 5.1 1.41999-00 10.6 6.8 5.2 1.52000-01 11.3 7.1 5.6 1.52001-02 11.2 7.0 5.6 1.42002-03 11.4 7.3 5.8 1.52003-04 11.2 7.1 5.7 1.32004-05 11.9 7.6 6.1 1.52005-06 RE 12.9 7.7 6.4 1.3

Source: Indian Public Finance Statistics, Ministry of Finance, various issues;State Finances: A Study of Budgets, various issues, RBI (2006).

Table 4: Selected Features of the Pattern of Capital Receipts ofState Governments, 1990-91 to 2005-06

(As a percentage of GDP at current market prices)

Year As a Ratio to GDP at Current Market PricesCapital Receipts Special Securities Share of NSSF

Issued to NSSF Loans in CapitalReceipts

1990-91 4.3 – –1991-92 4.1 – –1992-93 4.0 – –1993-94 3.3 – –1994-95 4.3 – –1995-96 3.6 – –1996-97 3.1 – –1997-98 3.9 – –1998-99 4.9 – –1999-00 5.3 1.3 25.52000-01 5.3 1.5 29.22001-02 5.2 1.6 30.22002-03 5.9 2.1 36.12003-04 na 2.4 na2004-05 6.7 2.4 39.32005-06 RE 4.6 2.1 45.6


in the ratio of revenue expenditure to GDP has been associatedwith a slight fall in the ratio of developmental revenue expenditureto GDP and a slight rise in the ratio of non-developmental revenueexpenditure to GDP.

On the other hand, the revenue deficit of states, expressed asratio to GDP, sharply fell from 2.9 per cent in 1999-2000 to just0.5 per cent in 2005-06 (Figure 5). In other words, the declinein the revenue deficit has been achieved by the states by notspending the increasing revenue receipts and capital receipts. Thisconclusion becomes evident from the changes in the ratio ofrevenue expenditure to revenue receipts of states: this ratio fellcontinuously from 1.3 in 1999-2000 to 1.0 in 2005-06.

Data at the state-level also show stagnation, if not a fall, inthe size of revenue expenditure relative to the size of the economy(Table 6). In Table 6, we have plotted the change (in percentagepoints) in the ratio of revenue expenditure to GSDP (of thecorresponding states) between 2004-05 and three earlier years


(2000-01, 2001-02 and 2002-03) for 19 states. What we see isa general decline in the ratio of revenue expenditure to GSDPin the states. In fact, between 2002-03 and 2004-05, there wasa decline in the ratio of revenue expenditure to GSDP in 14 outof the 19 states considered.

The overall stagnation, if not decline, in the ratio of revenueexpenditure to GSDP of state governments cannot be the resultof lack of “absorption capacity” of states, as the finance ministryhas argued. states like Haryana, Karnataka, Gujarat and TamilNadu, which have been characterised by many as fiscally “bettermanaged”, have also exhibited an overall falling trend. Thereare, of course, many state-specific factors that would have to beconsidered, but a factor common to almost all the state govern-ments is the compulsion, set by the FRBM Acts, to eliminaterevenue deficits by 2008-09. A discussion on the FRBM Actsand their implications for expenditure of states is attempted inthe next section.

IIFRBM Acts and Expenditure Contraction

State Finances: The Genesis of the Crisis

The FRBM Acts were the neo-liberal response to the fiscalcrisis of the state in the latter part of the 1990s. The roots ofthe crisis in state finances in India have to be traced to the post-independence evolution of centre-state economic relations.Nevertheless, the present deterioration in state finances beganin the mid-1980s when states as a whole started recording revenuedeficits. This period also marked the end of the era of low andadministered interest rates. The interest rates sharply increasedthereafter, but as Chaudhuri (2000) has pointed out, its impactwas masked by the presence of pre-existing cheap debt that thestates had availed. From the latter half of the 1990s, the highcost debts incurred since the mid-1980s took their toll on theinterest burden of states and started a process of debt escalation.The earlier policy of the cancellation of part of states’ debts byfinance commissions was given up by then. The severe imbalance

in state finances in 1980s and 1990s has been the topic for manyscholarly enquiries [Bagchi, Bajaj and Byrd 1992; Rao 1992;Kurian 1999; Chaudhuri 2000; Vithal and Sastry 2001; Rao 2002;EPWRF 2004].

The role of the central government was critical in the processof deterioration of state finances. The rates of interest on bor-rowings of states were sharply increased after the mid-1980s,and especially so after 1990-91 (Table 7). The coupon rates ofstate government securities were raised sharply by the RBI from1990-91 onwards. The weighted average of coupon rates, whichwas 11.5 per cent in 1990-91, reached its historic peak of 14per cent in 1995-96. In the same period, the interest rates on smallsaving borrowings by states also increased from 13 per cent in1990-91 to 14.5 per cent in 1992-93, and remained stable till1997-98. These rates of interests that the states had to pay were

Source: Chandrasekhar and Ghosh (2005a).

Figure 3: Average Rates of Interest on the Liabilities of the Centre and All States, 1980 to 2004 (Per cent per annum)

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

YearDifference between states and centre

12

10

8

6

4

2

0

Rat

e of

Int

eres

t (P

er c

ent)

Centre States

Ch d kh d Gh h (2005 )

Centre States

Table 5: Selected Features of the Pattern of RevenueExpenditure of State Governments, 1990-91 to 2005-06

(As percentage of GDP at current market prices)

Year As a Ratio to GDP at Current Market PricesRevenue Develop- Within Developmental Non-Deve-

Expenditure mental Expenditure lopmentalExpenditure Social Economic Expenditure

Services Services

1990-91 12.5 8.5 4.9 3.6 3.81991-92 13.0 8.9 4.7 4.2 4.01992-93 12.7 8.4 4.6 3.8 4.21993-94 12.6 8.2 4.5 3.7 4.31994-95 12.5 7.7 4.4 3.3 4.71995-96 12.1 7.4 4.5 3.0 4.51996-97 12.2 7.7 4.4 3.3 4.41997-98 12.1 7.4 4.4 3.0 4.51998-99 12.5 7.5 4.7 2.8 4.81999-00 13.3 7.7 4.9 2.8 5.42000-01 13.8 8.0 5.0 3.0 5.62001-02 13.8 7.6 4.7 2.9 6.02002-03 13.7 7.4 4.6 2.8 6.12003-04 13.4 7.4 4.3 3.1 6.02004-05 13.1 7.4 4.5 2.9 6.02005-06 RE 13.3 na na na na



clearly usurious, much higher than the growth rate of the GDPand thus, a sure recipe for financial disaster. Even though theinterest rates started falling thereafter, the financial burden thatthese periods of high rates of interest placed on state financeswas significant. The interest payments of states increased fromRs 8,655 crore in 1990-91 to Rs 21,932 crore in 1995-96 andRs 62,489 crore in 2001-02. As a percentage of total revenuereceipts, these interest payments amounted to 13 per cent in1990-91, 16 per cent in 1995-96 and 24 per cent in 2001-02.

In the period in which the centre was raising the rates of intereston states’ borrowings, the rates of interest on the centre’s bor-rowings were not only lower in levels, but were also rising ata much slower rate (Figure 3). The result was that the differentialbetween the rates of interest faced by the centre and the stateswidened significantly in the 1990s, which has continued into the2000s [Chandrasekhar and Ghosh 2005a; EPWRF 2004]. In fact,the differential in every year in the 2000s was higher than thedifferential for any year between 1980 and 2000. The averagerate of interest of states’ borrowings was above 10 per cent evenin 2004, while that of the centre had dipped below 7 per cent.

In 1997-98, there was another shock to state finances whenthe recommendations of the Fifth Pay Commission were imple-mented. This measure sharply raised the levels of revenue deficitof states from 1997-98 onwards. In just one year, the revenuedeficit of states more than doubled – from 1.1 per cent in 1997-98 to 2.5 per cent in 1998-99. While we do not wish to neglectother factors, the rise in interest burden and higher salary pay-ments constitute the two most prominent factors responsible forthe deterioration of state finances. The outcome of these twofactors was a sharp rise in the debt burden of states. As apercentage of GDP, the total debt outstanding of states increasedfrom 21 per cent in March 1997 to 26.1 per cent in March 2000and 33.1 per cent in March 2006 (Figure 4).

These changes are clearly visible when we analyse the longterm trends in the levels of revenue deficit and fiscal deficit ofall states (Figure 5). Through the 1970s, states as a whole wereenjoying a revenue surplus. It was only by the late 1980s thatthe revenue account of states fell into deficit. The revenue deficitincreased gradually between 1986-87 and 1997-98, and thereafterincreased sharply till 1999-2000. Interestingly, the fiscal deficitof all states was rarely above 3 per cent till 1997-98. However,driven by the rise in the revenue deficit, the fiscal deficit of statesrose sharply after 1997-98.

Introduction of FRBM Acts

It was in this context that the FRBM Bill was introduced inthe Parliament in 2000. The task force appointed by the gov-ernment on the FRBM Act noted that

The gravity of the situation, and the multi-year process of debateand discussion, led to a far-sighted response. All political partiesvoted in favour of the Fiscal Responsibility and BudgetaryManagement Act 2003…It is the deeply held view of the TaskForce that their implementation will reshape our destiny, and takeIndia to a commanding position in the world economy [GoI2004:13].

It was thus firmly believed in the neo-liberal circles, ex-emplified by the report of the task force, that “there is an innatesynergy between acceleration of GDP growth and fiscal consoli-dation” (ibid). As the first step, the government appointed theE A S Sarma Committee to prepare a draft of the legislation;

this committee submitted its report in July 2000. The FRBM Actwas passed by the Lok Sabha on May 7, 2003 and by the RajyaSabha on July 29, 2003. The bill was passed by a voice vote,and not unanimously, as the task force erroneously claimed.Members from the Left parties had raised their serious objectionsto the provisions in the Bill (see report in the People’s Democracy,10 August 2003). The Bill was notified as an Act on August 26,2003. In this version of the Act, the government had to eliminatethe revenue deficit to zero by 2005-06. In July 2004, the Actwas amended to postpone the year of elimination of revenuedeficit to 2008-09. In February 2004, a task force was appointedby the government to “draw up the medium term framework for

Table 6: Changes in the Ratio of Revenue Expenditure to GSDPof States between 2004-05 and 2000-01, 2001-02 and

2002-03, 19 Indian States(Percentage points)

State Difference in Revenue Expenditure/GSDP Ratio between 2004-05 and

2000-01 2001-02 2002-03

Andhra Pradesh 0.01 0.13 -0.3Bihar -0.5 3.7 4.2Chhattisgarh -7.8 -19.5 -24.1Gujarat -8.7 -6.7 -4.1Haryana 0.9 -0.5 -1.2Himachal Pradesh -4.7 -2.9 -7.6Jharkhand 22.7 0.6 -2.5Karnataka 0.9 -0.6 -0.6Kerala 2.5 3.1 3.0Madhya Pradesh -2.4 1.5 -1.1Maharashtra -1.9 -0.4 0.2Orissa 0.1 -0.8 -2.4Punjab 3.2 2.9 -0.5Rajastan -1.1 0.0 -3.4Tamil Nadu -0.1 0.2 -2.2Tripura -5.0 -32.6 -2.8Uttar Pradesh 1.6 2.0 0.8Uttaranchal 25.6 9.5 2.2West Bengal -1.7 -1.1 -1.1Number of states with a fall in ratio 10/19 9/19 14/19

Note: The last year of analysis is 2004-05, because 2004-05 was the latestyear for which NSDP data were available.


Table 7: Key Interest Rates on State Government Borrowingsfrom the Centre and the Market, 1990-91 to 2005-06

(Per cent per annum)

Year Coupon rates on State Interest rates on Interest Rates onGovernment Securities Small Savings Plan and Non-Plan

(Weighted Average) Borrowings by Loans from theStates Centre

1990-91 11.5 13.0 10.31991-92 11.8 13.5 10.81992-93 13.0 14.5 11.81993-94 13.5 14.5 12.01994-95 12.5 14.5 12.01995-96 14.0 14.5 13.01996-97 13.8 14.5 13.01997-98 12.8 14.5 13.01998-99 12.4 14.0 12.51999-2000 11.9 13.5 –2000-01 11.0 12.5 –2001-02 9.2 11.0 –2002-03 7.5 10.5 –2003-04 6.1 9.5 –2004-05 6.4 9.5 –2005-06 7.6 9.5 –2006-07 (till Oct) 8.1 9.5 –

Source: EPWRF (2004), RBI (2005c); RBI (2005d); RBI (2006).


fiscal policies to achieve the FRBM objectives”, and “alsoformulate the annual targets indicating the path of adjustmentand required policy measures” [GoI 2004: 201]. Introducing itsprojections on fiscal consolidation, the task force noted that“States finances would obtain an enormous boost under theproposals of this report” (ibid: 11).

Concurrently, the centre was also forcing the hands of the statesto pass similar acts in their state assemblies. The finance com-missions chose to have a narrow definition of “constitutionaltransfers” to mean only the divisible pool. The other grants andbenefits were held to be over and above the “constitutionaltransfers” and thus could be tied to specific conditions. For thefirst time, the Eleventh Finance Commission started the processof linking resource transfers and other benefits from the centreto fiscal consolidation by states. The passage of the FRBM Actsat the state-level became an indicator of the progress achievedby states in fiscal consolidation. States were asked to model theirlegislations on the legislation prepared by the centre. Karnatakawas the first to pass an FRBM Act in August 2002. Kerala, TamilNadu and Punjab followed suit in 2003. Uttar Pradesh passedits legislation in 2004. The other state governments, with theexception of a few, passed their FRBM Acts in 2005 and 2006.As on August 2006, 23 states had passed FRBM Acts [Ministryof Finance 2006].

The hurried passage of these legislations in 2005 and 2006 bymany states had to do with the conditionalities put forward bythe Twelfth Finance Commission (TFC). States had to pass theFRBM Act in 2005 itself to take advantage of the debt waiverscheme offered by the TFC. The main elements of the FRBMacts passed by the states were the following:

(a) 2 to 3 per cent target for fiscal deficit to be achieved by2005-06 to 2010-11; (b) elimination of revenue deficit by aroundthe same time; (c) limits to state government guarantees on debt;(d) limits to overall liabilities that could be incurred; (e) formu-lation of a medium-term fiscal plan to reach these targets; and(f) institution of a complaint redressal mechanism.

The specific point of our interest in this paper is the targetsfor revenue deficit, which are summarised in Table 8. Thesurprising rapidity with which FRBM Acts were passed by thestates is an issue that requires some examination by politicalscientists. Vouching from the personal experience of one of theauthors of this paper, most legislators in states knew prettynothing about what they were passing. The legislature in Kerala,in a fit of reform fury, determined a 2 per cent ceiling for fiscaldeficit by 2006-07. This was later de facto amended, but the factthat any political leadership could even propose a 2 per centceiling for fiscal deficit is indeed intriguing. The key players inthis process were the bureaucracy of the state governments, who

2 2 .5 2 2 .5 2 2 .52 1 .9 2 1 .4 2 1 .1 2 1 .0

2 2 .12 2 .8

2 6 .1

2 8 .4

3 0 .2

3 2 .43 3 .4 3 3 .5 3 3 .1

Figure 4: Total Outstanding Liabilities of All-Indian States, 1991 to 2006, as on End March(as per cent of GDP)

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Year

40

35

30

25

20

15

10

5

0

Sha

re in

GD

P (

Per

cen

t)

Source: RBI Bulletin; State Finances: A Study of State Budgets, RBI, various issues.

Table 8: Year of Passing of State FRBM Acts and the Proposed Year of Elimination of Revenue Deficits

Year of Passage Proposed Year of Elimination of RD Other/Specialof FRBM Act 2006 2007 2008 2009 2010 Cases

2002 Karnataka2003 Kerala Tamil Nadu Punjab2004 Uttar Pradesh2005 Gujarat Orissa, Maharashtra, Assam Himachal Pradesh,

Rajasthan, Haryana, TripuraChhattisgarh, Madhya Pradesh,Andhra Pradesh

Note: Eight states passed their FRBM Acts in 2006, which are not shown in this table.Source: RBI (2005a).


had so totally internalised the neoliberal reform rhetoric. Howelse could one explain the proposal of a 2 per cent ceiling forfiscal deficit?

The Role of Finance Commissions

There have been a number of criticisms of the Twelfth FinanceCommission (TFC) exceeding its constitutional brief in propos-ing conditionalities on central transfers. The Constitution hasdefined the role of the finance commissions as to make recom-mendations on “the distribution between the union and the statesof the net proceeds of taxes” and set “principles which shouldgovern the grants-in-aid of the revenues of the states out of theConsolidated Fund of India”. In other words, the commissionswere supposed to act as a neutral umpire to fix the levels of transferof resources from the centre to states as well as the distributionof these transferred resources across states.

However, in recent years, extra-constitutional powers havebeen given to the finance commissions through the issue ofadditional terms of reference by the central government. Thesepowers were provided to the commission in order to tune theirreports to dovetail the policies of the central government. Forinstance, the terms of reference of the Eleventh Finance Com-mission (EFC) included the mandate to “draw a monitorable fiscalreforms programme aimed at reduction of revenue deficit of thestates and recommend the manner in which grants to states…maybe linked to progress in implementing this programme”. In fact,under Article 275 of the Constitution, the finance commissionshave no powers to impose conditionalities on resource transfersto states. According to the report of the EFC, 15 per cent of therevenue deficit grants were explicitly linked to the progressachieved in the implementation of the fiscal reforms programme(that even included a forced reduction of subsidies and privatisationof the power sector).

The TFC had similar terms of reference, including the mandateto “review the state of the finances of the Union and the Statesand suggest a plan by which the governments, collectively andseverally, may bring about a restructuring of the public finances

[by] restoring budgetary balance [and] achieving macro-eco-nomic stability and debt reduction along with equitable growth.”The TFC was also given powers to “review the Fiscal ReformFacility introduced by the Central Government on the basis ofthe recommendations of the Eleventh Finance Commission, andsuggest measures for effective achievement of its objectives.”

The TFC recommended a fiscal restructuring plan in its report,according to which (a) the revenue deficit had to be eliminatedby 2008-09; (b) the fiscal deficit had to be brought down to 3per cent in 2008-09; and (c) annual targets were set for thereduction of revenue deficit and fiscal deficit (0.4 percentagepoints for the revenue deficit and 0.3 percentage points for thefiscal deficit for all states put together). Each state had to enacta fiscal responsibility legislation to this effect. The TFC, in orderto address the rising debt burden of states, also recommendeda general scheme of debt relief and a loan write-off scheme. Asper the general scheme, all loans from the centre (excluding thehigh-cost loans under NSSF) were to be consolidated and auniform interest of 7.5 per cent charged on them. Under the loanwrite-off scheme, repayments on loans from the centre between2005-06 and 2009-10 were to be written-off, with the quantumof write-off linked to the absolute amount of reduction of revenuedeficit of the state in each successive year as well as the con-tainment of the fiscal deficit at the level of 2004-05. The benefitsof both these schemes were to be made available to only thosestates that had passed fiscal responsibility legislations.

Such has been the environment generated by the neoliberalreformers that few states are willing to break the rules. The WestBengal government has refused to pass an FRBM Act. The presentgovernment in Kerala, in its revised budget for 2006-07, hasdeclared that its FRBM Act would be amended. Nevertheless,as can be seen from Figure 5, state governments on the wholehave been moving fast to meet the targets set by FRBM Actsand the TFC. The revenue deficit for all states has declined from2.9 per cent of the GDP in 1999-2000 to 0.7 per cent of the GDPin 2005-06. As we have seen already, this contraction has beenachieved mainly by cutting important social sector expenditures.The states are thus set to reach the target of elimination of revenue

Figure 5: Revenue Deficit and Fiscal Deficit of States, 1970-71 to 2005-06(as per cent of GDP)

Source: Ministry of Finance (2006); RBI (2006).

Revenue deficit Fiscal deficit

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

-200

0

2000

-01

2001

-02

2002

-03

2003

-04

2004

-05

2005

-06

re

Year

6.0

5.0

4.0

3.0

2.0

1.0

0.0

–1.0

–2.0

Def

icit

as s

hare

of

GD

P (

per

cent

)

Revenue deficit Fiscal deficit


deficit by 2009. Same is the case with respect to the fiscal deficit;it declined from 4.7 per cent of the GDP in 1999-2000 to 3.2per cent in 2005-06 (Figure 5).

Economists from the Left have been the most consistent criticsof the central policies of framing legislations to cap revenue andfiscal deficits [Patnaik 2000, 2001; Chandrasekhar and Ghosh2000, 2001, 2005a, b]. More recently, the Planning Commissionalso seems to have understood the implications of continuing withthe FRBM Acts to any strategy to development that would involveacceleration of revenue expenditure. The Planning Commission,in its attempt to have “faster” but “more inclusive” growth inthe Eleventh Five-Year Plan, has outlined a strategy that includesa number of new initiatives, such as the expansion of schooleducation, programmes for provision of healthcare, drinkingwater, rural infrastructure and schemes for “bridging the divides”.All these ambitious programmes belong essentially to the revenue-development expenditure category and cannot be implementedif the FRBM/TFC targets of elimination of revenue deficit areachieved. The entire strategy of the Eleventh Plan would collapseif revenue deficit is eliminated by 2008 or 2009.

The Planning Commission is draft approach paper also dis-cusses the issue of fiscal deficit targets in the FRBM Acts. Itsays that important Plan expenditures, such as in infrastructure,may have to be postponed if the targets of fiscal deficit are adheredto. Such postponement, the paper argues, “could jeopardisegrowth” and could reduce the space available for “counter-cyclical fiscal measures” in times of economic slowdown. Again,as the approach paper reminds us, the state governments wouldhave no option but to postpone capital investments as they havea double bind – apart from being forced by the FRBM Acts tocut fiscal deficits, they are also bound by the much stiffer targetsset by the TFC that has linked such adjustments to resourcetransfers. As the centre is not bound by the TFC, it may avoidthis situation either by postponing the achievement of targets orby modifying the central FRBM Act to remove the targets set.

International Experience

It may be useful here to look at the experience of countriesthat have passed and implemented fiscal responsibility legisla-tions. In the US, the ‘Gramm-Rudman-Hollings Act’ of 1985and 1987 has been amended many times to incorporate clausesthat allow the government to raise deficits. In the European Union,the ‘Growth and Stability Pact’ was adopted to enforce budgetarydiscipline among all countries using the Euro. Germany was themain mover behind the introduction of the pact. The irrationalityof the pact was soon understood by Germany itself, when Germanyand France went through a major economic recession in the early2000s. For four years in succession from 2002, Germany brokethe ceiling of 3 per cent set by the pact for budget deficits. Ason 2005, six of the 12 Euro-area countries were facing proceduralaction under Article 104 of the EC Treaty for excessive deficits[Zeitler 2005]. In seven countries, the consolidated gross debt ratioin 2004 was above the 60 per cent reference value for debts (ibid).There has been a spate of election defeats in Europe, reflectingpublic anger against for governments that have tried to cut socialsector spending to respect the deficit ceilings set by the pact.

In this context, it would be interesting to examine the case ofKerala. The state was one of the first to pass the FRBM Act,and that too with much more stringent clauses than most states.However, unlike most of other states, Kerala is characterised by

a very vibrant political society that refuses to accept the impli-cations of externally set targets for elimination of revenue deficits.We wish to emphasise here that this is not an outcome of theideological predilections of the present Left Democratic Frontgovernment in office. Even the previous Congress-led UnitedDemocratic Front government that initiated the fiscal reformprogramme had to admit the infeasibility of the time-phasing ofthe programme. The case of Kerala brings out sharply theimplications of the issues that we have so far discussed.

IIIThe Case of Kerala

Kerala is one of the states that is characterised by severe fiscalimbalance: its revenue deficit, fiscal deficit and public debt, asratios to GSDP, have been significantly higher than the averagefor all Indian states. On the one hand, its expenditure patternis characterised by a heavy commitment to recurring socialservices expenditure, as high priority has been accorded to socialinfrastructure historically. While social sector investment inKerala has led to better health and longevity to its people, it hasalso resulted in a high burden of pension payments on theexchequer. In 2005-06, pension payments in Kerala constitutedabout 51 per cent of the total salary expenditure.

On the other hand, Kerala’s revenue potential is circumscribedby the relatively high ratio of exports among the taxable com-modities and the domination of services in the GSDP. Further,the inappropriateness of the Finance Commission criteria fordevolution, weightage and its indicators, have been responsiblefor the fall in the share of central taxes to the state over the years.The share of Kerala among all states in the central taxes declinedfrom 3.9 per cent in the Tenth Finance Commission period to3.1 per cent in the Eleventh Finance Commission period and to2.7 per cent in the Twelfth Finance Commission [George et al2006]. The widening non-plan revenue gap of the state has alsonot been addressed by the successive finance commissions. Therelatively improved social indicators and the lower headcountratio of poverty have reduced the state’s share in central sectorschemes (CSS) to less than 1 per cent in 2005-06. Finally, therise in the high-cost debt burden has resulted in the escalationof the interest charges in the disbursements of the state.

We do not wish to go into a more detailed analysis of the factorsresponsible for the fiscal imbalance of Kerala’s finances beyondthe above summary [George 1999; George and Krishnakumar2003; Kannan and Mohan 2003; Mohan and Shyjan 2005]. Ascan be seen from the data in Table 9, similar to the experienceof most Indian states, the latter half of the 1990s saw a significantincrease in the revenue deficit, fiscal deficit and the debt burdenof the state. This trend assumed crisis proportions in 2000-01when the revenue deficit increased to 4.5 per cent and the fiscaldeficit increased to 5.6 per cent of the GSDP. The severe agrariancrisis that engulfed the state’s economy at the end of the 1990s(due to the sharp downturn in the prices of commercial crops)took a heavy toll on the state’s tax collection. The own tax GSDPratio, which averaged 8.6 per cent in the second half of the 1990sdeclined to 8.4 per cent in 2000-01. It can also be seen that therewas a sharp decline in the share of central transfers in the totalrevenue of the state from 32 per cent in the first half of the 1990sto 28.1 per cent in the second half of the 1990s and further to25.2 in 2000-01. The unexpected decline in the central devolution,primarily as a result of the lower share in the central transfers


awarded by the Eleventh Finance Commission, left a gap of morethan Rs 500 crore in the budget of 2000-01. As a result, the totalrevenue receipts, as a share of GSDP, declined to 12.5 per cent in2000-01 from 13.4 per cent in the period 1995-96 to 1999-2000.

On the expenditure side, the implementation of the PayEqualisation Committee recommendations increased the salarypayments by over Rs 1,000 crore per annum. There occurred avery severe crisis of Overdraft in 2001, and even the closure ofthe treasury. The substantial devolution of funds to the local self-governments and the consequent spurt in the number of treasurycheques in circulation issued by the LSGIs to thousands ofbeneficiaries made the crisis highly visible and vulnerable. Thisfiscal crisis was an important factor, among others, that contri-buted to the defeat of the LDF in the 2001 assembly elections.

The UDF government that came to power in 2001 brought outa white paper that sought a dramatic exaggeration of the fiscalcrisis of the state government so as to prepare ground for a drasticfiscal adjustment programme [GoK 2001]. The remedial mea-sures to deal with the so-called impending disaster includedexpenditure compression (such as curtailment of benefits toemployees and reduction in social subsidies, including welfarepensions), closure of sick public sector undertakings and all-roundincreases in user charges. These prescriptions became the con-ditionalities in the semi-structural adjustment loan that the stategovernment took from the Asian Development Bank (ADB).These were further reinforced by the Fiscal Responsibility Act 2003,which set the goal to wipe out the revenue deficit and reduce thefiscal deficit to 2 per cent of the GSDP by 2006-07. The governmentguarantees for liabilities were capped at an absolute figure ofRs 14,000 crore. Meeting the above targets would have requireddraconian measures, which even the UDF government foundpolitically and socially difficult to carry out. The move to curtailgovernment employees’ benefits and rights met with stiff resis-tance including a month-long strike. A major “Save-PSU”movement emerged and numerous agitations by the workers inthe traditional sector took place. There was also a mass movementagainst privatisation policies in the educational and health sectors.

Between 2000-01 and 2001-02, the revenue expenditure of thestate declined sharply from 17 per cent to 16.1 per cent of theGSDP and the revenue deficit of the state declined from 4.5 percent to 3.6 per cent of the GSDP (Table 9). The fiscal deficitof the state also declined from 5.6 per cent to 4.5 per cent ofthe GSDP between 2000-01 and 2001-02. However, the ratioswere reversed in the very next year. The state government, in

its memorandum to the TFC in 2003, admitted that the “short-term measures, such as expenditure compression and postpone-ment of liabilities, are bound to show up as expenditure in thefollowing years” [GoK 2003: 14]. But the government hopedthat “the medium-term measures are expected to bring in the fiscalsustainability” (ibid).

However, the confidence of the UDF government in the successof the fiscal adjustment programme was already shaken with noconcomitant increase in the central devolution. The state’smemorandum to the TFC openly stated that it would be impossibleto realise the fiscal targets of the Medium-Term Fiscal Restruc-turing Programme (MTFRP) that had been drawn up followingthe recommendations of the EFC. The UDF government madethe following judgment on the MTFRP:

In the present situation, we believe that it would be futile to havea target of reducing fiscal deficit without first attempting to tacklethe core issue of non-plan revenue deficit and plan revenuedeficit…As a basic pre-requisite of the fiscal reform programme,the revenue deficit should have been taken care of. In the absenceof this requirement being met, the fiscal reforms programme wasab initio faulty. Therefore, in spite of our continued commitmentto fiscal correction, we would not meet the targets of MTFRP.We would urge that any fiscal correction programme be basedon realistic and not merely prescriptive parameters to break thevicious circle of rising revenue deficit, increasing borrowing anddeepening fiscal crisis [GoK 2003: 16].

The achievement of the fiscal targets by 2006-07 required anannual reduction in revenue deficit from 5.1 per cent of the GSDPin 2002-03 at 1.3 per cent per annum, if the annual fiscalcorrection was prorated [Rajaraman and Kurian 2006]. Therevenue deficit tended to move in the right direction of correctionin 2003-04 and 2004-05, but at around half the targeted pace.The revenue deficit declined from 5.1 per cent of the GSDP to3.7 per cent of the GSDP between 2002-03 and 2004-05.

The required annual rate of reduction of fiscal deficit from thepre-FRA level of 5.8 per cent in 2002-03 to reach the target of2 per cent in 2006-07 worked out to be 0.88 percentage points(ibid). Data presented in Table 9 show that the fiscal deficitdeclined from 6.2 per cent in 2002-03 to 6.1 per cent of theGSDP in 2003-04. It declined to 4.4 per cent of the GSDP in2004-05.

However, the TFC recommendations for interest rate concessionand debt consolidation raised the optimum fiscal deficit ceilingto 3 per cent of GSDP, and extended the date for attaining fiscal

Table 9: Indicators of State Finances, Kerala State, 1980-81 to 2006-07(in per cent)

Item 1980-81 to 1985-86 to 1990-91 to 1995-96 to 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-071984-85 1989-90 1994-95 1999-00 RE) (BE)

Own tax-SDP ratio 7.0 8.4 8.3 8.6 8.4 8.2 9.0 9.0 8.9 8.6 9.2Own non-tax SDP ratio 2.3 1.5 1.2 1.1 0.9 0.8 0.8 0.9 0.8 0.8 0.9Share of central transfersin total revenue 32.0 33.2 32.0 28.1 25.2 28.6 24.9 24.7 27.5 29.8 33.3

Revenue expenditureas ratio to SDP 13.4 16.3 16.0 16.2 17.0 16.1 18.3 17.2 17.1 16.6 19.5

Capital expenditureas ratio to SDP 5.0 5.0 4.0 3.0 1.2 0.8 0.9 0.7 0.7 0.9 1.8

Revenue receipts as ratio to SDP 13.6 14.9 14.3 13.4 12.5 12.5 13.2 13.1 13.4 13.7 15.2Capital receipts as ratio to SDP - - - - 5.6 4.6 5.9 6.1 4.7 4.3 6.0Revenue deficit as ratio to SDP 0.6 1.4 1.7 2.8 4.5 3.6 5.1 4.1 3.7 4.0 4.3Fiscal deficit as ratio to SDP 2.7 3.9 3.7 4.8 5.6 4.5 6.2 6.1 4.4 5.3 6.0Revenue deficit as ratioto fiscal deficit -27.3 36.4 44.0 53.3 81.2 79.7 82.5 66.4 82.4 76.6 71.9

Debt stock as ratio to SDP 26.9 29.8 28.8 29.8 36.0 39.4 41.3 43.1 43.9 44.4 -

Source: Computed from different official sources.


deficit targets and eliminating the revenue deficit to 2008-09.This was more lenient than the fiscal correction as originallyenvisaged in Kerala’s Fiscal Responsibility Bill of 2003. Con-sequently the reduction required in the revenue deficit declinedto 0.85 percentage points per annum and in the fiscal deficit by0.42 percentage points per annum [Rajaraman and Kurian 2006].The Public Expenditure Review Committee (PERC), constitutedunder the FRA 2003, concluded that

Aggregating across the first two years of the FRA, therefore, theFD correction remains in conformity with the (amended) correc-tion requirement…[However,] the actual decline in the RD of 1.01percentage points in 2003-04, and 0.43 percentage points in2004-05, falls short of the combined requirement over two years,by 0.26 per cent of GSDP [Rajaraman and Kurian 2006: 20-21].

The PERC also drew attention to the fact that the majorproportion of the grants given to LSGIs is capital outlay. If arealistic modification is made in the accounts to take care of theabove fact, the revenue deficit of the state would sharply decline.

Starting from an RD, so adjusted [for the capital outlays involvedin the grants to local bodies and PWD expenditure on mainte-nance], of 3.88 per cent of GSDP in 2002-03, the yearly requiredreduction in the adjusted RD is 0.68 per cent of GSDP. Theachieved reduction over two years is 1.42 per cent, higher thanthe 1.30 per cent required (ibid: 21).

Rebuffed by the electoral setbacks in the successive assemblyby-elections, Lok Sabha elections and the elections to the LSGIs,the UDF government tried to reverse some of its draconianmeasures and distanced itself from the fiscal adjustmentprogramme. As per the revised budget estimate for 2005-06, therevenue deficit was 4 per cent of the GSDP and the fiscal deficitwas 5.3 per cent of the GSDP (Table 9). However, accordingto the supplementary figures of the CAG, which are not yetpublished, the revenue deficit has declined further in 2005-06to 2.83 per cent of the GSDP and the fiscal deficit to 3.77 percent of the GSDP. We may have to wait for some more timebefore conclusive figures are arrived at. Nevertheless, there hasbeen a reduction in the ratio of revenue expenditure to GSDPfrom 17.1 per cent in 2004-05 to 16.6 per cent in 2005-06. Thishas been achieved largely by postponement of payments of someof the current liabilities like dues to contractors (Rs 950 crore),welfare pension liabilities (Rs 250 crore), and food subsidy (Rs 21crore). There was also a significant increase in central transfers(that included VAT compensation), which increased from 24.7per cent in 2003-04 to 29.8 per cent in 2005-06. Even then, thepopular discontent was too severe and conclusive; the UDFgovernment was voted out and the LDF government came topower with an overwhelming majority.

Any illusion on the success of the fiscal adjustment programmehas been removed with the implementation of the report of thePay Commission of the state, the order for which was passedon the eve of the assembly elections. This report was to beimplemented from the financial year 2006-07. The additionalcommitment to the state government on this account was Rs 2,922crore. Even after freezing a part of the arrears in the providentfund, the net requirement of funds in the budget for 2006-07 wasRs 2,017 crore. Even without providing fully for the arrears dueto contractors and welfare funds, it is seen from Table 9 thatthe ratio of revenue expenditure to GSDP increased sharply from16.6 per cent in 2005-06 to 19.5 per cent in 2006-07. Despitea higher ratio of revenue receipts to GSDP assumed (15.2 per

cent in 2006-07 as compared to 13.7 per cent in 2005-06), therevenue deficit in the budget of 2006-07 increased to 4.3 percent of the GSDP and the fiscal deficit to 6 per cent of the GSDP.It is likely that the year 2006-07 would end at a much higherlevel of revenue deficit.

The budget for 2006-07, with a total expenditure of Rs 26,768crore and a Planning Commission-approved plan outlay of Rs 6,210crore, was drawn up on the assumption of a fiscal deficit ofRs 7,535 crore, and a borrowing limit of Rs 7,200 crore. As wehave seen, there was an increase of nearly 70 per cent in thefiscal deficit between 2005-06 and 2006-07. This increase wasa major deviation from the fiscal correction path envisaged. Asthe union finance ministry pointed out to the state, according tothe fiscal correction path drawn up, the borrowing ceilingin 2006-07 should have been Rs 4,672 crore.

The implications of the reduction of borrowing ceiling toRs 4,672 crore in 2006-07 in order to stick to the fiscal correctionpath would have been calamitous to the state government. Itwould have meant a drastic reduction in the plan outlay and asevere cut in social sector and welfare expenditures. It wouldhave also meant total disruption of the devolution of funds fromthe state government to the LSGIs, consisting of plan grants ofRs 1,400 crore and maintenance and general purpose grants ofaround Rs 650 crore.

After much pressure, the union finance ministry agreed to raisethe borrowing limit of the state to the original level. But therewas a condition. The state would have to forego the TFC-recommended incentive of debt-waiver and would not be per-mitted to raise additional loans from other sources for the shortfallin the small savings collection (which was expected to be at leastRs 1,200 crore lower than the budgeted amount of Rs 2,950 crore).It is to be remembered that the central government that swearsby the TFC has neither constituted the Inter-State Loan Councilthat it recommended nor discussed the issue in the subcommitteeof chief ministers formed by the NDC to discuss the debt burdenof states. The unilateral stand adopted by the central governmentis a serious challenge to the spirit of fiscal federalism in India.

It is very evident that a mechanical implementation of the fiscaladjustment programme would result in severe compression ofsocial and developmental expenditure in Kerala and derail thedemocratic decentralisation process in the state. In the revisedbudget for 2006-07 presented by the LDF government, an al-ternative adjustment programme that postponed the revenuedeficit target to 2009, with no drastic expenditure compressionmeasures and focus on raising the tax-GSDP ratio, has beenmooted. With this objective in mind, a number of measures forincreasing the tax revenues, primarily to check evasion, and alsoan increase in the VAT rates on non-necessities were introduced.The average sales tax rate on such items in the pre-budget periodwas about 22 per cent in Kerala. It has been conclusively shownthat, as far as Kerala was concerned, the revenue neutral VATrate was not 12.5 per cent but above 18 per cent. Therefore, aposition was adopted that the VAT rates must be conceived ofas floor rates and not as uniform rates.

Further, whether the revenue deficit of the state is reduced asper the revised budget for 2006-07 would be conditional ongreater devolution from the centre. With revenue deficit understrict control, the alternative adjustment programme does not seeany particular merit in mechanically adhering to a ceiling forthe fiscal deficit. This position has been made amply clear inthe response note of the Kerala State Planning Board to the


Eleventh Plan Approach Paper of the Planning Commission[State Planning Board 2006].

IVSumming Up

Public expenditure by states on social and economic services,a crucial necessity for fulfilling the basic needs of people, is lowin India by any standard and needs urgent enhancement. How-ever, in the 1990s and 2000s, the ratio of revenue expenditureby all states to the GDP has stagnated, if not declined. At thesame time, all states together have an investment outstanding ofover Rs 64,000 crore in the treasury bills of the centre. Thenwhy do the states not spend this money? The union financeminister has concurred in the Parliament that much more needsto be invested in education, health care, the mid-day meal scheme,rural roads and urban development. The problem, according tohim, is that states are “unable to spend” because they do not havethe “absorptive capacity”. Our position in this paper has beenthat this is a false and misleading argument.

States do not spend because there are legal constraints onspending. The finance ministry and the successive finance com-missions have forced the states to pass fiscal responsibilitylegislations in their assemblies. As per these legislations, stateshave to eliminate the revenue deficit and reduce the fiscal deficitto 3 per cent of the GSDP by 2008-09. In line with these targets,the revenue deficit and fiscal deficit of states declined sharplyin the 2000s. This decline in revenue deficit was achieved bykeeping the revenue expenditure to GDP ratio stagnant, evenwhile there was an increase in revenue receipts to GDP ratio ofstates. The states could have raised revenue expenditures bymaking use of the increased receipts, and still kept the revenuedeficit constant. This, however, would have been contrary to thetargets set for the elimination of revenue deficit by 2008-09. Eventhe increased capital receipts – in the form of NSSF borrowings– were not routed to revenue expenditures because of the fearof rising revenue deficit. The cash surplus phenomenon, thus,is a perverse outcome of the FRBM Acts.

The case study of Kerala in this paper sharply brings out theadverse implications of mechanically designed fiscal adjustmentprogrammes in the context of long-term commitments to socialspending and exogenous changes like pay revisions. Going bythe provisions of the FRBM Act, Kerala would have to sharplycut plan expenditures, reduce social spending and curtail devo-lution to local self-governments.

The Planning Commission has already taken a position againstthe lack of flexibility in the FRBM Act provisions. Demands formore flexibility are also fully endorsed by international expe-riences with fiscal responsibility legislations. As we have argued,the FRBM Act has to go off the rule book or drastically amended.This demand is today in the centre stage of centre-state relationsin India.

Email: [email protected]@tiss.edu

Notes[For helpful comments and discussions on an earlier draft, we thank AmiyaKumar Bagchi, Prabhat Patnaik, S L Shetty, Pallavi Chavan and Jose Cyriac.]

1 One argument has been that it is the centre that provides tax incentivesto investors in small saving accounts. However, this is argument not

tenable, as the loss to the centre due to tax incentives affects the receiptsof states as well through the lower share in taxes devolved.

2 In this paper, we have not undertaken an analysis of capital expendituresof states.

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