For a new fiscal covenant

A concept paper from the Planning Commission suggests the waiver of all Central loans granted to the States. In a political context that demands a sharp increase in developmental expenditure, this may be a vital plank on which to build a new fiscal covenant between the Centre and the States.

in New Delhi

NEW beginnings in politics normally signal new beginnings in economics. But with the financial markets, rather than public welfare, being the final arbiter of sound economic policy, there is a powerful incentive for the newly installed Ministry to emphasise elements of continuity rather than change. Where the need for change is conceded, it is to underscore the new intent to provide larger investments in social and physical infrastructure that would be of direct benefit to the poor.

When he is able to turn his attention away from the health of the financial markets, even the most vocal proponent of reforms would concede that the plummeting levels of investment in agriculture have been a source of serious distress in the rural areas. Neither is he likely to dispute seriously the proposition that outlays in essential social services - health and education primarily - are far short of what they should be. Despite all the fatuous talk of private sector initiatives making good the serious lacunae in the welfare sectors, the realisation is now dawning across a broad political spectrum, that there is no substitute for public outlays in these areas.

The figures here are compelling. In the year 2002-03, total developmental expenditures by all State governments amounted to Rs.246,000 crores according to their budget estimates. Under every single head of developmental expenditure, it is clear, the greater responsibilities devolve upon the State governments rather than the Centre. The simple fact then is that increasing developmental outlays involves raising the fiscal capacity of the States.

Yet the reality here is rather grim. Ever since they moved from a fiscal surplus to deficit in the late-1980s, the States have had to earmark an increasing share of their total expenditure for non-developmental purposes. In 1990-91, well under 25 per cent of total State government expenditures went into non-developmental heads. By 2002-03, this proportion had increased to over 37 per cent. A major contribution to this increase, that is, about half of it, came from interest incurred on loans - as a proportion of total expenditure, these payments increased from under 10 per cent to over 16 per cent. N.J. Kurian, who recently retired as an Adviser on Financial Resources in the Planning Commission, estimates that the interest burden has since gone up rapidly, indicating the potential for a rapid meltdown of State finances.

Another major source of deterioration of State finances has of course been the implementation of the Fifth Pay Commission recommendations on compensation for public servants. But this was a one-time shock to which the fiscal apparatus adjusted within a few years. A more durable source of instability comes from pensions, which are entirely paid out of revenues. As demographics change, life expectancies increase and increasing numbers of government employees retire, State governments have had to brace themselves for a relentless increase in the pension burden. Tentative efforts have recently been set under way, to compel new entrants into the workforce to opt for "defined contribution, variable return" pension schemes. Although a number of State governments have made such efforts, their returns are only likely to accrue when recent recruits into the service begin retiring, conservatively speaking, 25 years from now.

Demography holds the key to the increase in pension payments. And a feature that has mitigated this burden on State finances in recent times has been the moderation in the numbers retiring from active service. Since public sector employment as a whole, including the State, Central and enterprise sectors, have been stagnant for well over two decades, the number of people retiring from service has also reached equilibrium. This has afforded the States' revenue collection effort an opportunity to catch up with the galloping burden of pensions. And indeed, in a mere three years since 1997-98, when the Pay Commission recommendations were implemented, pension payments as a proportion of State revenues and expenditures had begun to decline. Interest payments, in contrast to all other major items of expenditure of the State government, have the property of increasing on an accelerating scale. As the fiscal deficit widens, the rate of borrowing every year increases, leading to higher interest payments in all succeeding years.

This widens the fiscal deficit still further, necessitating still higher borrowings. In 1999-2000, a measure was set in motion to moderate the rapid rise of State government debt. Small savings collections until then used to be channelled to the States by the Centre as part of its aggregate lending programme. A new accounting procedure introduced that year allowed State governments to issue special securities to a newly designated agency called the National Small Savings Fund (NSSF), to meet a part of their borrowing requirements. In the space of that year, the States' collective dependence on Central loans fell from between 40 to 50 per cent of the gross fiscal deficit to an average of about 14 per cent. In 2002, a scheme enabling States to use a portion of their small savings accruals to retire a portion of their loans from the Centre was introduced.

Since the pool available under the NSSF is fixed, this means that States would have to divert a portion of the receipts that would otherwise have been used to fund the fiscal deficit into retiring existing debt. This was a recipe for acute liquidity problems. Unsurprisingly therefore, recourse to this facility has been limited. And with the difference in interest rates being only one percentage point between borrowings from the Centre and the NSSF, the magnitude of the relief obtained by State governments has not been very significant.

Kurian's estimate is that about 40 per cent of the total debt burden of the States is in liabilities to the Centre. Though there have been efforts to mitigate the burden in recent years, there has been no fundamental rethink on the processes of federal transfer. For instance, Kurian points out that the loan component of Central assistance for State plans still stands at 70 per cent. This is in accordance with the D.R. Gadgil formula adopted in 1969, when plan expenditure of the States used to be distributed in the 70:30 ratio between capital and revenue components. With more assets coming into existence since then and increasing portions of Plan spending going into their upkeep, the ratio between capital and revenue expenditure in the States now stands at 40:60. Capital assets were expected in the early years to yield a return on investment rather than be a sponge of limitless capacity absorbing State revenues. But the situation is quite contrary to this expectation. To remedy this and return their capital assets to a semblance of viability, the State governments need the kind of breathing space that is not available under the currently prevalent, straitened fiscal circumstances.

A recent study of fiscal transfers in a federal context, by C. Rangarajan, Chairman of the Twelfth Finance Commission, has found that substantial loan transfers from the federal Centre to the States is a practice unique to India. The universal practice otherwise is to transfer as outright grants or to devolve increasing fiscal powers to the federating units. A further irrationality in India has been the increasing spread between the rate at which the Centre raises its loans and the interest that it charges the States. The gap now is of the order of five percentage points - States pay on average, 10.5 per cent as interest to the Centre, when the rate payable on borrowings from the market is no more than 5.5 per cent. This has provided an incentive for several States to directly tap the market.

Although Article 293 of the Constitution specifically prohibits any borrowing by the States without the concurrence of the Centre, a way has been found around this through the device of the "special purpose vehicle" (SPV). These entities, floated with the intent to develop a particular sector, have become an increasingly important source of borrowings for the State government. But with the underlying assets being unprofitable, typically in the irrigation, power or road transportation sectors, servicing these loans has become an increasingly onerous task. This is especially so since few norms are in place regulating market borrowings by the State, with the Centre preferring to avert its supervisory gaze from the practice of borrowing through SPVs.

Critical situations call for critical thinking that goes beyond established parameters. Kurian has proposed in a paper circulated within the Planning Commission just prior to his retirement that all Central loans to the States should be written off as a one-time measure. With this, the practice of issuing loans from the Centre to the States would itself be ended. With appropriate revisions in the Gadgil formula, all federal transfers would then take the form of grants.

It has been estimated that once relieved of interest liabilities on Central loans, State revenue budgets would rapidly regain a semblance of balance. The capital budget would of course have to be financed through borrowings, by the States from other sources. There is legitimate reason for worry that the poorer States may not be able to raise market finance on the strength of their balance sheets. But this is where the Centre could conceivably play a remedial role through standing guarantee. In an environment of cooperative federalism, appropriate norms should not be difficult to evolve.

A complete loan waiver would entail a loss to the Centre on its capital budget. But this would be completely offset by lower borrowings since loans to the States would be ended. In the final reckoning, the net loss would only be of the order of Rs.15,000 crores on the revenue budget of the Centre, which is the interest it earns every year from the States. This would have to be made good through an additional taxation effort. Since the so-called process of reforms was instituted in 1991, successive governments at the Centre have promised that tax rate cuts are not a source of worry, that indeed, lower rates will lead to higher receipts because of the growth effect and the higher degree of compliance that is induced. This has been the underlying assumption of fiscal policy over the last 12 years.

Needless to say, the reality has been that tax receipts of the Central government have at no time responded to the stimulus of lower rates and have indeed, been a near-disaster area. If early prognoses have not been borne out, there are possibly two explanations: either the initial reading of the Indian fiscal scenario was askew, or the Centre has been completely remiss in enforcing the administrative measures necessary to make tax buoyancy a reality. Either way, the political change that has recently been effected at the Centre, which is, by all readings, a decisive vote against the direction that economic reforms have taken thus far, is perhaps the appropriate juncture to begin remedying the situation