res brief 13thfc

8/6/2019 Res Brief 13thFC

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Published 8 March 2010

Project on

MONITORING AND ANALYSIS

OF BUDGETS IN

MAHARASHTRA STATE

RESEARCH

BRIEF - 2

THE 13th FINANCE COMMISSION:

FISCAL ROADMAP OR FISCAL ROADBLOCK?

R. Ramakumar

“The overall approach of the Commissionis to foster ‘inclusive and green growthpromoting fiscal federalism’. This is the vision underlying the Commission’srecommendations on inter-governmentalfiscal arrangements and on the road mapfor fiscal adjustment.”

(13th Finance Commission, 2010)

The Context

An important event that preceded thepresentation of Union Budget 2010-11 was thesubmission of the report of the 13th FinanceCommission (FC). The fiscal roadmap to belaid out by the 13th FC for the period between

2010-11 and 2014-15 was keenly watched fortwo reasons. First, the FC recommendations were to determine the extent to which fiscalstimulus packages could be continued at theState-level. In the wake of the globalslowdown, the central government hadallowed State governments to exceed thetargets set for revenue and fiscal deficit in

2008-09 and 2009-10. Secondly, given theemphasis laid by the UPA-II government on“inclusive growth,” the fiscal freedom providedby FCs to States was seen as critical. In India,about 80 per cent of the social sectorexpenditure is undertaken by the States.

On both these counts, the 13th

FC report,chaired by Vijay Kelkar, comes as a dampener.It closes the possibilities of autonomous fiscalexpansion at the State-level, arguing that the“exceptional circumstances of 2008-09 and2009-10” are behind us. Further, the nature of recommendations of the 13th FC is such thateven the existing space available for States todecide on spending priorities is shrunk.

For a worthwhile discussion of the proposalsof the 13th FC, it is necessary to delve brieflyinto certain historical features and imbalancesin Indian federalism.



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Finance Commissions in India

India is often described as “a union of nationalities”. Yet, under the IndianConstitution – based broadly on theGovernment of India Act of 1935 – majority of

powers are vested with the Centre, and Statesdo not have significant room for independentinitiatives. Scholars have referred to theConstitution in diverse ways: “quasi-federal”,“federal in form, but not in intent” and“appearing to be a fundamentally federalconstitution with a unitary garb”. The sphereof economic relations between the Centre andthe States best reflects the unitary spirit of the Constitution. While the Centre is thedominant entity with respect to the control of finances, the States have a large share of

responsibilities over spending fordevelopment.

As the Constitution envisaged, the sharing of receipts between Centre and States was to begoverned by a statutory body called theFinance Commission. Each FC was to have afive year term and envisaged as anindependent body that would lay downprinciples governing primarily (a) transfer of tax resources between the Centre and States,and (b) the sharing of resources between

States.

Over the years, as eminent scholars like I. S.Gulati argued, “the Indian fiscal model madethe States more dependent on the Centre” forbudgetary and institutional transfers.1 InAshok Mitra’s words, fiscal centralisationresulted in “the Centre being the dispenser of monetary and fiscal bounty and the Statesqueuing up for benediction”.2 There was littleprogressiveness in the patterns of inter-temporal changes in either the FC transfers or

1 I. S. Gulati (1988), “The Indian Federal Fiscal Model: ACase of Increasing Centralisation”, Social Scientist, 16(2), February. Elsewhere, Gulati observed that in thisprocess, “many State subjects…became Concurrent, if not Central subjects”. See I. S. Gulati (ed.) (1987),Centre-State Budgetary Transfers, Oxford UniversityPress, New Delhi.

2 See Ashok Mitra (1975), “Will Growth and CentralisedArrangements do?”, Kale Memorial Lecture, GokhaleInstitute of Politics and Economics, Pune.

their outcomes.3 For instance, the fiscaltransfer model was unsuccessful in reducinginter-State disparities in development.4 AsAmaresh Bagchi argued, one of the failures of the Indian fiscal model was that there werelarge “inefficiencies created by the Centre’s

attempt to take on too much and manage theeconomy at the micro level”. 5 In other words,the strong centralising tendencies within theIndian federal structure were militatingagainst the idea of efficiency itself, in additionto the idea of equity.

However, the 13th

FC report puts aninteresting spin onto this history of centralising tendencies. It has argued that“there is a marked tendency towards stabilityin the relative share of Centre and States in

respect of aggregate transfers”, and considersthis trend as “remarkable”!

State Finances: The Crisis of the 1980s

It was the progressive deterioration in thefinances of States from the mid-1980s that setthe context for a new phase in Centre-Stateeconomic relations in the 1990s. Two factors were pivotal in precipitating the fiscal crisis of States.

First, after the mid-1980s, and especially after1990-91, the rates of interest on borrowings of States from the Centre increased sharply dueto interest rate deregulation under economicreforms. The coupon rates of Stategovernment securities were raised sharply bythe RBI from 1990-91 onwards. The weightedaverage of coupon rates, which was 11.5 percent in 1990-91, reached its historic peak of 14

3 See I. S. Gulati and K. K. George (1978), “Inter-State

Redistribution through Institutional Finance”,Economic and Political Weekly, August.

4 See Raja Chelliah and colleagues (1980), Trends andIssues in Federal Finance , Allied Publishers, New Delhi;and John Toye (1981), Public Expenditure and IndianDevelopment Policy, Cambridge University Press,Cambridge.

5 See Amaresh Bagchi (2001), “Fifty Years of FiscalFederalism in India: An Appraisal”, Kale MemorialLecture, Gokhale Institute of Politics and Economics,Pune.



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

Centre States Difference between States and Centre

Source: Chandrasekhar and Ghos h (2005a).

per cent in 1995-96. In the same period, theinterest rates on small saving borrowings of States also increased from 13 per cent in 1990-91 to 14.5 per cent in 1992-93, and remainedstable till 1997-98.

The rates of interests that States had to paythe Centre were clearly usurious, much higherthan the growth rate of the GDP and thus, asure recipe for a financial crisis. Even thoughthe interest rates started falling after the late-1990s, the financial burden that the longperiod of high interest rates placed on Statefinances was significant. The interestpayments of States increased from Rs 8,655crore in 1990-91 to Rs 21,932 crore in 1995-96and Rs 62,489 crore in 2001-02. As a ratio tototal revenue receipts, interest payments

amounted to 13 per cent in 1990-91, 16 percent in 1995-96 and 24 per cent in 2001-02.

Ironically, in the period that the Centre wasraising the rates of interest on States’borrowings, the rates of interest on theCentre’s borrowings were not only lower inlevels, but were also rising at a much slowerrate (see Figure 1). The result was that thedifferential between the rates of interest facedby the Centre and the States widened

significantly in the 1990s, which continuedinto the 2000s. In fact, the differential in every year in the 2000s was higher than thedifferential for any year between 1980 and2000. The average rate of interest of States’borrowings was above 10 per cent even in

2004, while that of the Centre had dippedbelow 7 per cent.

Secondly, there was an additional shock toState finances in 1997-98, when therecommendations of the Fifth Pay Commission were implemented. This measure sharplyraised the revenue deficits of States after1997-98. In just one year, the revenue deficitof States more than doubled – from 1.1 percent in 1997-98 to 2.5 per cent in 1998-99.

The rise in interest burden and higher salarypayments constituted the two proximatefactors responsible for the deterioration of State finances in the 1990s. The commonoutcome of these two factors was a sharp risein the debt burden of States. As a ratio toGDP, the total outstanding liabilities of Statesincreased from 21 per cent in March 1997 to26.1 per cent in March 2000 and 33.2 per centin March 2004.



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Economic Reform and Centre-State EconomicRelations

The solutions offered by the Centre to theproblem of State finances were closely linkedto the objectives of fiscal reform. Fiscal reform

was characterised by restraints on governmentexpenditure relative to the size of theeconomy. It was firmly believed in the neo-liberal circles that “there is an innate synergybetween acceleration of GDP growth and fiscalconsolidation”.6 The Centre recommended thateach State should drastically cut its revenueand fiscal deficits over a specified time frame.There were two separate, and complementary, ways in which the fiscal reform programme was “incentivised” by the Centre for theStates.

First, the Centre began to use theconstitutional body of Finance Commissions toforce the States to accept the fiscal reformprogramme. Secondly, central transfers toStates were explicitly linked to successes infiscal compression and the passage of fiscalresponsibility legislations (FRLs).7

From the 11th FC onwards, extra-constitutionalpowers were given to the FCs through theissue of additional terms of reference. These

FCs chose to have a narrow definition of “constitutional transfers” to mean only thedivisible pool. It was argued that other grantsand benefits were over and above the“constitutional transfers”, and thus could betied to specific conditions. In fact, underArticle 275 of the Constitution, the FC has nopowers to impose conditionalities on resourcetransfers to States. Yet, in the report of the 11th FC, about 15 per cent of the revenue deficitgrants was explicitly linked to the progressachieved in the implementation of the fiscalreforms programme (that even included the

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

forced reduction of food and fertilisersubsidies as well as privatisation of the powersector).

The 12th FC recommended a fiscalrestructuring plan for each State, according to

which (a) the revenue deficit had to beeliminated by 2008-09; and (b) the fiscaldeficit had to be brought down to 3 per centin 2008-09. All States had to enact a FiscalResponsibility and Budgetary Management(FRBM) Act to make these targets legallybinding. The 12th FC also recommended ageneral scheme of debt relief and a loan write-off scheme. However, the benefits of boththese schemes were to be made available toonly those States that had passed FRBM Acts.Thus, the passage of FRBM Acts became an

indicator of progress achieved by States infiscal consolidation.

In this way, the Centre has been progressivelyreducing the space available to States forevolving autonomous policies; it has actuallybeen forcing the States to follow theprinciples of “sound finance”. Even if a State wanted to borrow more to invest in social andeconomic services, it had to pay a penalty byforegoing a part of central transfers, which areconstitutionally obligatory.

Fiscal Compression under FCs

It would be instructive to look at certaintrends in the finances of States till 2009-10,the year that coincides with the end of the 12

th

FC period and the first UPA government(2004-09). Given the penalties involved, Stateshad moved fast in this period to meet thedeficit reduction targets (Figure 2). Therevenue deficit for all States declined from 2.9per cent in 1999-00 to (-) 0.2 per cent (i.e., arevenue surplus) in 2008-09. Similarly, thefiscal deficit for all States declined from 4.7per cent in 1999-2000 to 2.6 per cent in2008-09, far ahead of the targets set.



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The sharp contraction of deficits was achievedby the States by cutting expenditures acrossthe board.8 If we compare the averages for2000-05 and 2005-10, the total expenditure of States fell from 17 per cent of the GDP to 15.9per cent of the GDP (Table 1). Both revenueand capital expenditure of the States fell inthis period: as a ratio to GDP, while revenueexpenditure fell from 13.3 per cent to 12.4 per

cent, capital expenditure fell from 3.6 per centto 3.5 per cent.

As revenue expenditure has been the majortarget of FRBM Acts and the 12th FC, we couldcompare the composition of revenue

8 For an analysis till 2005-06, see R. Ramakumar(2008), “Levels and Composition of Public Social andEconomic Expenditures in India, 1950-51 to 2005-06”,Social Scientist , 36 (9/10).

expenditures of States between 2000 and 2010

(Table 2). As a ratio to GDP, bothdevelopment expenditure and non-development expenditure of States fellbetween 2000-05 and 2005-10. Withindevelopment expenditure, the expenditure on‘Education, Art, Sports and Culture’ fell from2.5 per cent to 2.2 per cent. The expenditureon ‘Medical and Public Health’ stood stagnant

at 0.5 per cent in both the periods. In other words, the period covered by the 12th

FC (alsoof the first UPA government) was one wherethe efforts to raise expenditures in educationand health, as a ratio to GDP, received amajor setback.

Table 1 Trends in Expenditures of all State Governments, 1980 to 2010, as % of GDP

PeriodRatio to GDP (%) of

Revenue expenditure Capital expenditure Total expenditure1980-85 10.6 4.5 15.11985-90 12.2 3.9 16.1

1990-95 12.7 3.2 15.91995-00 12.4 2.5 14.92000-05 13.3 3.6 17.02005-10 12.4 3.5 15.9

Source: Reserve Bank of India, State Finances: A Study of Budgets of 2009-10, 2010.

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

Revenue deficit Fiscal deficit

Source: Reserve Bank of India.



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The expenditure on ‘Economic Services,’ as aratio to GDP, also declined from 2.9 per centto 2.8 per cent. Within ‘Economic Services’,the expenditure on ‘Agriculture and AlliedSectors’ declined from 0.7 per cent of theGDP to 0.6 per cent of the GDP. The

expenditure on ‘Rural Development’ stoodstagnant as a ratio to GDP in this period.

The objective of fiscal consolidation has to bea reduction of expenditures on unproductiveitems, including interest payments. However,the extent of fiscal compression forced on theStates by the 12

thFC was such that States

slowed down the growth of expendituresacross the board. Thus, even though interestpayments fell in ratio to GDP, developmentexpenditure also fell in ratio to GDP between

2000-05 and 2005-10. It is a paradox then thatthe 13

thFC has termed the fiscal consolidation

efforts of the 12th FC as “sterling”.

The data presented in Table 2 are averages forthe period between 2005 and 2010. However,because the Centre had relaxed the FRBMprovisions for 2008-09 and 2009-10, States

had been able to raise expenditures in thesetwo years. The Centre allowed additionalmarket borrowings for States to the upperlimits of 3.5 per cent of the GSDP in 2008-09and 4 per cent of the GSDP in 2009-10.

All States did not undertake explicit fiscalstimulus measures at the State-level. Onlythree States – Kerala, West Bengal andHaryana – had explicit stimulus packages. In2009-10, Kerala announced a stimulus package worth Rs 10,000 crore. About 80 per cent of this expenditure was capital expenditure, andspent in infrastructure development. WestBengal announced a stimulus package of Rs5,106 crore in February 2009, which was to bespent on housing, rural power supply,healthcare and education. Haryana also

announced a stimulus package worth Rs 1,500crore in 2009-10, focusing on infrastructurespending.

Even in those States that did not have explicitstimulus measures, the increased expenditures were, on the whole, capital expenditures. Forall States, the aggregate capital outlay in the

Table 2 Composition of Revenue Expenditures of State Governments, Selected Items, 2000 to 2010,as per cent to GDP

Sl No. Item Ratio to GDP (%) in the period2000-05 2005-10I Development Expenditure 7.3 7.2

A Social Services 4.4 4.4

A.1 Education, Sports, Art & Culture 2.5 2.2A.2 Medical & Public Health 0.5 0.5A.3 Family Welfare 0.1 0.1A.4 Water Supply & Sanitation 0.2 0.2A.5 Housing 0.1 0.1A.6 Urban Development 0.1 0.3A.7 Welfare of SCs, STs & OBCs 0.3 0.3A.8 Social Security & Welfare 0.2 0.4

B Economic Services 2.9 2.8

B.1 Agriculture & Allied Activities 0.7 0.6B.2 Rural Development 0.5 0.5

II Non-Development Expenditure 5.8 4.9

A Interest Payments & Debt Servicing 2.8 2.2B Pensions 1.2 1.2

TOTAL REVENUE EXPENDITURE 13.3 12.4

Source: Reserve Bank of India, State Finances: A Study of Budgets of 2009-10.



8

In the debates on State finances in India, animportant point that is missed is that thereduction of revenue and fiscal deficits of States were achieved by force, and it does notnecessarily reflect a healthier state of theirfinances. A healthier state of finances would

have been one where, along with reducingnon-development expenditures, developmentexpenditures are raised substantially. On theother hand, over the 12

thFC period, States

achieved fiscal consolidation by simply cuttingdown spending on vital sectors. In therecommendations of the 13th FC also, there isnothing that would avoid such a responsefrom States.

Most importantly, the effort to eliminaterevenue deficit by 2011-12 would mean that

revenue expenditures on social sectors –essential in maintaining a minimum level of quality of social services – would be cut bythe States. Incidentally, this was precisely thepoint that the Planning Commission raised inits draft approach paper to the 11th five yearplan in 2006. As most of the 11th plan schemesin education, health, drinking water and ruralinfrastructure belonged to the revenue-development expenditure category, theCommission argued that “the very thrust of the approach to the 11th Plan…may be defeated

if the FRBM discipline is insisted upon”.

9

The13th

FC is totally silent on this issue, and opensthe door for another round of massive cuts inrevenue expenditures by the States.

The 13th FC also appears to believe that byreducing revenue expenditures, States canraise capital expenditures substantially. It ishere that the aversion of the FC to fiscaldeficit is revealed fully. It recommends that“any State that has a revenue surplus along with a higher fiscal deficit should compress itscapital expenditure, or alternately, increase itssurplus on the revenue account”. In essence,the FC is recommending not just a cut incapital expenditure, but also a squeeze of revenue expenditures to reduce fiscal deficit.

9 Government of India (2006), Towards Faster andMore Inclusive Growth: An Approach to the 11th Five Year Plan , Planning Commission, June, New Delhi.

Further, due to the presence of a third andnew target for States in the form of areduction in debt/GDP ratio, any newborrowal of States would be spent not oncapital expenditures, but to repay old loans.Such a bizarre status is likely to continue until

the debt/GDP ratios are reduced to 25 percent of the GDP by 2014-15.

In Conclusion

The grave state of finances has seriouslyundermined the ability of State governmentsto meet obligations in social and economicservices. The roots of the crisis in Statefinances have to be traced to the post-independence evolution of Centre-State

economic relations in India. Historically, there was a gross inadequacy in the volume of resource transfers from the Centre to theStates. On the other hand, the autonomy of State governments in policy making has beenincreasingly eroded in the period of economicreforms. In this period, the Centre has beenforcing the hands of States, using statutorybodies like the FCs, by linking resourcetransfers to successes with fiscal adjustment.Given such constraints, most States have fallenin line with the mainstream neo-liberal ideas

of fiscal contraction.

The 13th

FC was supposed to act as a neutralumpire between the Centre and States in theallocation of resources in a democraticmanner. However, it has ended up furthereroding the autonomy of States in economicpolicy making.

Evidently, the period of UPA-II is unlikely tobe different from that of UPA-I in the sphereof public expenditure. Thanks to the 13th FC,there would be one more round of expenditure cuts by States in the social andeconomic sectors, leaving all the promises of enhanced public spending hollow.



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This ‘Research Brief’ was prepared at the School of Social Sciences as part of the project titledMONITORING AND ANALYSIS OF BUDGETS IN MAHARASHTRA STATE, internally funded bythe Research Council of the Tata Institute of Social Sciences, Mumbai. Corresponding email:[email protected].

Research Briefs are envisaged to be short and structured summaries on important research andpolicy issues. The opinions and comments in the research briefs are the personal views of theauthors, and do not reflect the official positions of the institutions with which they are

associated.

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res brief 13thfc

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