4.44 The inability to raise user charges has been relatively more pressing for States than the Centre. The States account for nearly three-fourth of total spending on social services, and more than half of the total spending on economic services provided by the Government sector. User charges recovered from such services are much lower as compared with spending on such accounts. Our estimates of user charges for various services rendered by the State Governments indicate that cost recovery for education during the 1990s has been lowest at 1.2 per cent, followed by health (4.7 per cent) and irrigation (8.5 per cent), without any firm indication of improvement during the reform period.⁶

4.45 Apart from low user charges on the services rendered by the Government, the sluggishness in non-tax revenue also follows from continuing inadequate returns on public investment. The outstanding investment in Central PSUs amounted to Rs.3,03,400 crore as at end-March 2000. The State Governments’ investment amounted to nearly Rs.75,000 crore in statutory corporations and another Rs.42,000 crore in the Government companies as at end-March 1999. In the case of Central PSUs, although returns on capital employed have improved from a low level of 2.5 per cent in the 1980s to 2.8 per cent in the early 1990s and further to around 5.0 per cent in the latter half of the 1990s, dividends from PSUs remain inadequate to finance future investment opportunities through internal finance (Chart IV.6). Beside operational inefficiency, the poor returns on investments in, both, Central and State PSUs also reflect the limitations of pricing policies as well as heavy implicit and explicit subsidies (Box IV.1).

4.46 In the case of State-level enterprises, returns do not cover even a fraction of their cost of funds (Government of India, 2000c). Capital invested in SEBs account for the bulk of investments made by the State Governments. Although the Electricity (Supply) Act, 1948 requires SEBs to earn a minimum yield of 3 per cent on their net fixed assets, they have rather registered a persistent negative return over the years (Box IV.2). The State Road Transport Undertakings (SRTUs), the other segment attracting major public investments, have also been a drag on the State budgets.

4.47 In addition to States’ own tax and non-tax revenue, the resource base of State Governments also includes transfers from the Central Government in the form of devolution of Central taxes and grants-in-aid and contribution. Both forms of transfers to States have decelerated over time. Although successive Finance Commissions recommended devolution of higher amounts through either upward revisions of the coverage of the shareable items, or by increasing the magnitude of the States’ share (Tenth Finance Commission, 1994), the quantum of funds transferred to States as a ratio to GDP has been lower in the 1990s as compared to that of the 1980s, reflecting sluggishness or lower buoyancy of Central taxes (Chart IV.7). The Centre-State tax sharing system has been pointed out as one of the factors having disincentive and efficiency reducing effects on tax collection (Srinivasan, 2000). The main argument here is that the Centre’s efforts in collecting income tax, which is to be shared, would be less vigorous than in the case of custom duties, which accrue fully to the Central Government. The argument, however, does not receive support from the observed recent trends. Buoyancies of direct taxes estimated above showed marked improvement while that of custom duties slumped sharply during the reform period. Moreover, changes in the transfer formula by the Eleventh Finance Commission, 2000, has further reduced this possible bias, as all the taxes have become shareable with effect from 2000-01.

4.48 To sum up, the sluggishness in Central Government revenues was largely the result of lower buoyancy of indirect taxes caused by cut in tax rates without adequate expansion in the tax base. The inadequate growth in States’ revenue, on the other hand, was the result of their inability to levy appropriate user charges and tax the services sector, combined with lower Central transfers due to falling tax buoyancy.

4.49 Government consumption and investment spending constitute an important part of aggregate demand in the economy. It influences growth through several channels. An increase in public spending on physical capital could positively influence the long-term growth. The impact of such spending in human capital formation could be larger but benefits require longer gestation period. So is the case with Government spending on research and development (R&D). As such, any programme of stabilisation-cum-adjustment, has to give considerable attention to the expenditure side of fiscal restructuring. It is important to plan expenditure reduction while improving quality of public spending to aim simultaneously at supporting growth with equity and improving fiscal balances. In India, expenditure/GDP ratio of the Centre had risen from about 12.3 per cent in 1970-71 to around 20 per cent in the latter half of the 1980s. This had placed a difficult burden on budgetary balances. With a view to narrowing down the fiscal gap, particularly by bridging the revenue deficit, a cut in current expenditure was considered essential.

4.50 The steps taken to compress expenditure led to a reduction in the size of overall public expenditure as a ratio to GDP in the initial years of the 1990s. The combined expenditure of Centre and State Governments as a ratio to GDP declined from 28.8 per cent in 1990-91 to 25.1 per cent in 1996-97. However, the trend reversed and the expenditure to GDP ratio once again began to follow an upward movement after 1996-97 and reached 29.5 per cent in 2001-02. Furthermore, the efforts to augment investment expenditure by cutting consumption expenditure did not materialise. This was due to the fact that at, both, the national and sub-national levels of Government, expenditure correction was brought about mainly through cut in capital expenditure. Between 1990-91 to 1996-97, although combined revenue expenditure fell by 1.2 percentage points, it increased again by about 3.6 percentage points between 1996-97 and 2001-02. On the other hand, there was a steep fall of 2.5 percentage points in the capital expenditure to GDP ratio between 1990-91 and 1996-97, though it rose marginally by 0.8 percentage point between 1996-97 to 2001-02. Thus, since the beginning of the 1990s upto 2001-02, while the revenue expenditure to GDP ratio increased from 22.8 per cent to 25.2 per cent, the capital expenditure to GDP ratio declined from 6.0 per cent to 4.4 per cent (Chart IV.8, Table 4.7). The deterioration in capital expenditure contributed to the decline in the share of public investment from 9.3 per cent of GDP in 1990-91 to 6.3 per cent in 2001-02.

4.51 The major contributing factor imparting a downward rigidity to the revenue expenditure relates to items of committed expenditure, of which, interest payments and expenditure on wages and salaries are prominent. Interest payments as a ratio to GDP increased from 3.8 per cent in 1990-91 to 4.7 per cent in 2001-02 for the Central Government, while for the States, the corresponding rise was steeper from 1.5 per cent to 2.8 per cent (Chart IV.9). During the phase of fiscal consolidation, even though the debt to GDP ratio for the Central and State Governments fell from 61.7 per cent in 1990-91 to 56.5 per cent in 1996-97, the rise in the weighted average interest rate on Central Government and State Governments market borrowings, following the progressive alignment of coupon rates with market interest rates, led to the rise in interest payments. On the other hand, in the latter half of the 1990s, though the cost of borrowings declined consistently due to fall in market interest rates, interest payments continued to rise unabated. This essentially reflects the impact of sizeable outstanding liabilities contracted at higher interest rates during the first half of the 1990s, and also the return to rising deficit, and consequent, increase in public debt to GDP ratio to 71.1 per cent by 2001-02.

4.52 The rising wage bill has been considered as an important element in fiscal deterioration in recent years. One view is that the rise in spending on wages and salaries and pension was the prime factor for the abnormal rise in revenue expenditure during the 1990s (Acharya, 2001; Rao, 2000). The Eleventh Finance Commission (EFC), on the other hand, notes that the surge in revenue expenditure towards the late 1990s cannot be attributed only to salary and pension revision, though it led to immediate and acute fiscal stress all round (Government of India, 2000c). A similar view is expressed by Mohan (2000) who notes that, for the Central Government, spending on salaries and pension as a proportion to GDP during the 1990s was much lower than that in the 1980s.

4.53 The growth in Central Government spending on wages and salaries and pension was restrained during the period from 1990-91 to 1996-97. As a proportion to GDP, it dropped by around 0.8 percentage point. With the implementation of the Fifth Pay Commission award towards the late 1990s, the wage bill could not be kept constricted (Chart IV.10). Though the present expenditure on salaries and pensions for the Central Government employees as a percentage to GDP is still lower than it was at the end of the 1980s, the sharp rising trend is worrisome. It may be added that with downsizing of the Government as part of the reform process, the share of its wage bill in GDP should decline substantially. As liberalisation of the economy puts upward pressure on wage rates in competitive sectors that attract fresh domestic and foreign capital, preferred strategy would be to redeploy the surplus labour from the public sector to more productive sectors. This will reduce the wage bill burden in a much more meaningful way.

4.54 Downward rigidity has also been discernible in expenditure on subsidies, which is another major constituent of the revenue expenditure. Subsidies are an important policy instrument. Apart from impacting the expenditure side of the fisc, these affect domestic resource allocation, income distribution and expenditure efficiency. Subsidies can also affect international competitiveness by introducing distortions in international trade. Apart from providing implicit subsidies through under-pricing of public goods and services, Governments also extend subsidies explicitly on items such as exports, interest on loans, food and fertilisers. Owing to the conscious efforts made by the Government, total explicit subsidies of the Central Government, which constituted 2.14 per cent of GDP in 1990-91 were reduced to nearly 1 per cent by 1995-96. Cut in subsidies in the beginning of the reform period was brought about largely through the phasing out of export subsidies (cash compensatory support) which amounted to nearly Rs. 2,750 crore (0.5 per cent of GDP) in the year 1990-91. During the second half of the 1990s, the size of subsidies again started rising and increased to 1.36 per cent of GDP by 2001-02 (Table 4.8).

4.55 Details on State Government subsidies are not available in their budget documents but the indications are that the trend is similar to that of the Central Government, as reflected from the quantum of subsidies extended to some of the SEBs by the respective State Governments (Chart IV.11).

4.56 The downward inflexibility in the subsidies was essentially on account of the growing size of food subsidy, which recorded nearly a six-fold rise over the reform period. It has been observed that a sizeable proportion of food subsidy is due to the carrying cost of the food stock (Balakrishnan and Ramaswami, 2000). Thus, a significant part of subsidies goes to make up for the inefficiencies embedded in institutional arrangements meant for providing subsidy rather than benefiting the targeted group. Although subsidies are extended by the Government on the grounds that the poor are benefited, evidence shows that impact on poverty and nutritional status of the population is very limited (Srinivasan, 2000; Government of India, 1997). Expressing similar concerns, it has been stated that the argument that subsidies are meant for the poor has little basis in actual practice. The better-off sections of the society consume most of such services (Mohan, 2000). It has been shown that during 1986-87, the public distribution system (PDS) and other consumer subsidy programmes accounted for less than 2.7 per cent of per capita expenditure of the poor in rural areas and 3.2 per cent in urban areas (Radhakrishna and Subbarao, 1997). This indicates that phasing out of subsidies would have a very limited impact on the poor and less so in rural areas. However, there is a need for ensuring safety-net for the poor segment of population, whose ability to adjust to areas of work in the face of restructuring is rather limited. In order to ensure availability of food to the poor, the Government launched the Targeted Public Distribution System (TPDS) in June 1997. The Scheme was targeted to families Below Poverty Line (BPL)/ Antyodaya Anna Yojana (AAY) families in a transparent and accountable manner. The ability of the scheme to make a lasting dent on poverty would depend on the ability to create adequate entitlements through employment opportunities for the poor. Such policies would support income improvement without the burden of large fiscal subsidies.

4.57 In sum, it seems that the reversal in expenditure correction followed from the downward rigidity in consumption expenditure, particularly, in the interest payments for both the Central and the State Governments. The pay revision in the late 1990s further compounded the problem, while provision of subsidies continued to remain inefficient. In the event, capital expenditure had to bear the brunt of restraint placed on expenditure.

4.58 A major source of revenue imbalances, reflected in dissaving of the public sector is rooted in the poor profitability of the PSUs. The operations of PSUs have been on non-commercial lines. The returns on capital invested by the Government have been low. As a result, adequate resources in the form of profit and dividends are not forthcoming. With poor internal resource generation, PSUs had to depend on external financing from budgetary and non-budgetary sources.

4.59 Against this backdrop, public sector restructuring had two-fold objectives - to provide fiscal support to the Government in terms of additional resources and to improve the efficiency of these enterprises. Given the need to expand activities such as education, health and medicine, it was envisaged that substantial additional resources could be generated through a programmed disinvestment of some PSUs. With disinvestment, private shareholders are expected to enhance discipline by their monitoring. Managers, who act as agents of the shareholders, are forced to act in their interests by increasing the value of the firm. This would transform the PSUs on more efficient lines.

4.60 During the 1990s, there was a significant decline in the budgetary support available to the PSUs. Budgetary support to the total capital expenditure of Central Government PSUs declined sharply from 39.7 per cent during the Seventh Plan period to 12.7 per cent during the Eighth Plan period and further to 11.9 per cent by 1998-99 (Table 4.9). Furthermore, allocation of SLR bonds was completely phased out and the issue of tax-free and Government guaranteed bonds was also considerably reduced.

4.61 Although there is a considerable improvement as regards the direct impact of PSU operations on the budget, they continue to be a drag on the fisc. As stated earlier, the returns on the investment in these units do not cover even the cost of borrowed funds invested by the Government in these units. The profits after tax earned by PSUs on their capital are far lower than the implied average interest rate paid by the Central Government on its outstanding domestic liabilities (Table 4.10). Moreover, aggregate profitability measure is a bit misleading since it includes State oil and petroleum monopolies. Even for PSUs, which compete with the private enterprises, the returns have been generally lower than that of the competing firms in the private sector.

4.62 The programme of divestment in PSUs had slippages due to pricing problems and sluggishness of the capital market in the late 1990s. Targets set for divestments could not be achieved in most of the years (barring 1991-92, 1994-95 and 1998-99) during the decade of the 1990s (Chart IV.12). Since 1991-92, Government equity has been divested in 48 units and strategic sale was undertaken in another 16 units. Of the total amount of Rs.78,300 crore targeted to be mobilised through divestments/strategic sale, Rs.30,917 crore could be realised up to March 31, 2002. Initially the Government (with the exception of Modern Foods) sold only minority stakes in different PSUs. However, since 2000, the Government began strategic sales as these were judged to be revenue enhancing and signalled commitment to enhanced efficiency that transfer of management could bring about. To establish a systematic policy approach to disinvestments and privatisation and give fresh impetus to strategic sales of identified PSUs, the Government has established a new Department for Disinvestment.

4.63 Efforts to phase out inefficient PSUs were also made at the State level. According to available information from the Ministry of Disinvestment, 19 States have identified 290 State-level public enterprises for disinvestments; restructuring or closure has been initiated in 221 of these enterprises. So far, 69 units have been closed down, while 33 units have been privatised. It may be mentioned that an approximately 919 State-level public enterprises have run an accumulated loss of Rs.23,377 crore by end-March 2001. Furthermore, 409 out of these 919 enterprises are loss making, while 180 are non-working. The implicit subsidies in State-level enterprises are known to have risen substantially since the mid-1980s. In this context, there is a need to take the disinvestment programme for State enterprises on an accelerated footing.

4.64 As stated earlier, the growing fiscal deficit during the pre-reform period was increasingly financed through the pre-emption of institutional resources at sub-market rates by progressive increase in SLR and monetisation by the Reserve Bank. These developments eventually resulted in crowding out of private investment, growing financial repression and imposed constraints on the conduct of monetary policy. Thus, the efforts towards better monetary-fiscal coordination were aimed at elimination of automatic monetisation by the Reserve Bank and movement away from financial repression through the reduction in statutory pre-emption of banks and long-term resources to allow a level-playing field to private investors. With these underlying objectives, a series of structural and institutional reforms were initiated during the 1990s which, inter alia, included aligning coupon rates on Government securities with market interest rates, introduction of auction system, introduction of system of primary dealers and setting up of D vP system. These measures resulted in the emergence of an active, wide and deep Government securities market and paved the way for complete elimination of automatic monetisation and substantial lowering of statutory pre-emption of institutional resources by the Government.

4.65 These developments were also reflected in the structural change in the financing pattern of fiscal deficit during the reform period - with a marked shift towards market borrowings. Accordingly, the share of market borrowings, which constituted 26.9 per cent of gross fiscal deficit (GFD) in the 1980s rose sharply to 59.1 per cent in the latter half of the 1990s and financed about 70 per cent of the GFD by 2001-02. On the other hand, ad hoc Treasury Bills which financed a sizeable proportion of GFD, both in the 1980s and in the 1990s upto 1996-97, no longer exist as a financing item with their replacement by WMA in 1997-98. Similarly, the share of external finance which was around 10 per cent in the 1980s also came down sharply to an average of 2.9 per cent during 1997-98 to 2001-02. The share of other liabilities has been relatively stable and averaged around 40.0 per cent, both, in the 1980s as well as in the 1990s (Chart IV.13).

4.66 In case of State Governments, the fiscal gap is financed by way of loans from the Centre, small savings and market borrowings. Like the Central Government, the share of market borrowings in financing GFD of States has steadily increased. The financing pattern of the GFD indicates that, on an average, the share of loans from the Centre and small savings declined from 51.9 per cent and 37.1 per cent, respectively, in the 1980s to 47.5 per cent and 36.6 per cent, respectively, during the 1990s. ⁷ The share of market borrowings rose from 11.0 per cent to 15.8 per cent between these two periods (Chart IV.14).

4.67 The growing reliance on market borrowing for financing the fiscal deficit has been accompanied by restraint on reserve money growth and moderation of inflationary pressure. This has also had the effect of raising interest payments. In order for the strategy to finance fiscal deficit through borrowings at market related rates to have a favourable macroeconomic impact, some discipline on growth of the fiscal deficit is necessary.

4.68 In addition to borrowings to finance the fiscal deficit, Governments, both at the Centre and State levels, also avail WMA from the Reserve Bank to bridge short-term mismatches in revenue and expenditure. While WMA is envisaged to be a short-term funding, in many States, it is continuously rolled over. In this context, the Report of the Advisory Committee on WMA to State Governments (Chairman: C. Ramachandran) has noted that WMA has assumed the form of a long-term financing facility in many States with the progressive deterioration in their fiscal balances over the years (RBI, 2003). The Committee has recommended that States need to use the facility of WMA only for meeting the temporary liquidity mismatches rather than as a near budgetary resource.

4.69 The objective of fiscal reforms to prevent further accumulation of public debt is intimately linked to the objective of reining in the fiscal deficit. Since the public debt of the Government is broadly the accumulation of liabilities created by the Government to finance its deficit over the years, debt parameters in general move in tandem with the trends in fiscal deficit. Thus, reflecting the downward rigidity in the fiscal deficit, the objective to curtail growth of public debt was also not achieved, particularly since the mid-1990s. The outstanding debt of the Government sector as a proportion to GDP after witnessing improvement from 61.7 per cent in 1990-91 to 56.5 per cent in 1996-97 rose once again, and by the year 2000-01, the debt-GDP ratio at 66.4 per cent exceeded the level at the beginning of the reform process.

4.70 Although the primary deficit declined in the 1990s as compared to that in the 1980s, the growth in debt-service burden as a result of growing reliance on high cost market borrowings largely contributed to the downward inflexibility in the debt-GDP ratio. The weighted average interest rate on Central Government securities almost doubled from 7.03 per cent in 1980-81 to a peak level of 13.75 per cent in 1995-96. Since then the interest rates have declined gradually to 11.77 per cent in 1999-2000 and further to 9.44 per cent in 2001-02. Moreover, the higher implicit cost of borrowings through small savings and provident funds, owing to tax concessions, also placed additional burden on Government resources.

4.71 In addition to the size of debt appearing on the budget/balance sheets of the Governments, there has been a steep rise in the off-budget liabilities arising on account of guarantees extended by the Governments. The guarantees given by the combined Government rose in nominal terms from Rs.1,00,603 crore as at end-March 1993 to Rs.2,61,975 crore as at end-March 2002, though as a ratio to GDP they declined from 13.4 per cent to 11.4 per cent during the same period. The Central Government outstanding guarantees increased from Rs.58,088 crore in 1993 to Rs.95,859 crore in 2002. As a percentage of GDP, these guarantees dropped from 7.8 per cent to 4.2 per cent over the same period. Thus, in terms of contingent liabilities, there are clear signs of fiscal prudence by the Centre in the reform period. In contrast, State Governments’ (17 major States) outstanding guarantees increased sharply from Rs.42,515 crore in 1993, comprising 5.7 per cent of GDP, to Rs.1,66,116 crore in 2002, comprising 7.2 per cent of GDP ( Table 4.11).

4.72 A rise in contingent liabilities, particularly in case of State Governments, essentially reflects the practice followed by the State Governments to set up corporations to borrow from the market to undertake departmental jobs. In view of low user charges and inefficient operations of PSUs, these contingent liabilities are a potential threat to the stability and sustainability of the fiscal system.

4.73 To overcome such disquieting trends in State Governments’ finances, many States in their budgets have initiated fiscal measures such as setting up of consolidated sinking fund, guarantee redemption fund, statutory and administrative limits on guarantees and restructuring of PSUs. This follows the recommendation of the Technical Committee on State Government Guarantees (1999). Besides, some States have also taken decision to charge guarantee commission on outstanding guaranteed amount.

4.74 The conceived strategy of fiscal consolidation as reflected in various official pronouncements focused on compressing consumption expenditure and augmenting revenue. This is akin to ‘Type 1’ approach of fiscal consolidation experimented elsewhere as enumerated in Alessina and Perotti (1996). In terms of actual outcome, however, the adjustment was predominantly brought through cuts in capital expenditure. This is similar to Alessina and Perotti’s ‘Type 2’ approach, though the essential difference in the Indian case has been that household taxes have been reduced but the tax base has not widened significantly. The inability to effect a large cut in consumption component of expenditure resulted in an increasing proportion of borrowed funds being preempted by such expenditure. This could slow down future revenue growth. Inadequate returns on Government expenditure get reflected in rising debt-service obligations. This gives rise to the emergence of a vicious cycle of deficit and debt.

4.75 The detailed analysis of the fiscal performance during the reform period drew attention to the downward rigidity in current expenditure. In the face of sluggish revenue growth, this results in a persistent increase in revenue deficit. This has been a critical factor in the resurgence of fiscal deficit during the latter half of the 1990s. Although the tax reform measures initiated have imparted rationality to the tax structure, the revenue buoyancy expected through a Laffer-curve effect has not come through. This is because cuts in indirect tax rates were not accompanied by removal of concessions and exemptions. Therefore, there has been neither significant increase in the tax base nor has tax compliance improved. With the result, the improvement in direct tax collection on account of an expansion of tax base and perhaps better compliance was not adequate to compensate the drop in customs and excise duty collections. Eventually, the tax-GDP ratio suffered deterioration during the reform period. The non-tax revenue of the Centre as a proportion to GDP recorded some rise, whereas the same in the case of States registered a decline during the 1990s. Poor cost recovery for the services provided by the Governments has been responsible for this trend. Inadequate progress in public sector restructuring, specifically reflected in the inability to raise user charges and continued low returns on investments, have also resulted in stagnation in non-tax revenue at, both, the Central and State Governments level. Thus, on the whole, reforms did not result in adequate pick up in revenue growth in relation to growing expenditure requirement during the 1990s.

4.76 The faster growth in committed expenditure like interest payments, wages and salaries and subsidies has imparted downward inflexibility in revenue expenditure. More importantly, expenditure on interest payments continued to grow unabated, reflecting the impact of sizeable outstanding liabilities contracted at higher interest rates in the first half of the 1990s.

4.77 Progress towards better fiscal-monetary coordination during the reform period was an important achievement. The major policy initiative in this direction was the elimination of automatic monetisation of Central Government fiscal deficit. This, together with structural and institutional reforms undertaken by the Reserve Bank in the 1990s, has strengthened the public debt management process enabling wider market participation in the Government securities market and significant reduction in the pre-emption of institutional resources by the Government to finance fiscal gap. The Government borrowings at market related rates have intended to provide level-playing field for the private investor. It was also expected to induce fiscal discipline. The overall reform experience has been that, while the public debt management has been made market-based, fiscal deficits remain unrestrained. Market based regime with unrestrained fiscal deficit could worsen the fiscal situation. The above development unfolds certain important issues for the Indian fiscal system.

4.78 The analysis shows that the level of fiscal deficit relative to GDP in India at present is higher than not only that of most internationally comparable benchmark levels ( e.g. the Maastricht Treaty requires fiscal deficit to be 3.0 per cent of GDP) but also the levels recommended by the Eleventh Finance Commission (6.5 per cent of GDP for Government sector, 4.5 per cent for Central Government and 2.5 per cent for States). Furthermore, the present level has also exceeded the levels witnessed on the eve of the 1991 crisis. Notwithstanding these developments, most other macroeconomic parameters have been sustainable. As a result, the higher fiscal deficit has not spilled over to the external sector. In this setting, questions have been raised whether the high fiscal deficit should be a matter of much concern. A judgement on this issue over a longer horizon would have to factor in the possibility of adverse movements in the interest rates and inflation rates.

4.79 An important observation that could be made from a comparative analysis of the finances of the Centre and State Governments is that deterioration of finances during the latter part of the reform period was much sharper for the States than that for the Central Government. Although the growth of revenue for the States and the Central Government was comparable, expenditure growth was much steeper for the States than that for the Central Government. Consequently, the rise in fiscal deficit of States was sharper than that of the Central Government. Data show that during 1996-97 to 2001-02, States accounted for more than half of the rise in the fiscal deficit of the combined Government. In this context, it is important to consider whether worsening fiscal situation of States is on account of their own operations or owing to the factors such as central transfers and rising interest payments, which are not fully under their control.

4.80 Another issue which emerges in the context of downward rigidity exhibited by the fiscal deficit is the rise in debt-GDP ratio. It needs to be reviewed whether the fiscal stance and the debt accumulation process is sustainable or not. This is particularly so as the debt-servicing of market loans now accounts for more than 70 per cent of the gross market borrowings.

4.81 As stated earlier, the underlying objective of improving monetary-fiscal co-ordination by eliminating automatic monetisation and reducing pre-emption of institutional resources was to contain crowding-out arising from pre-emption of funds by the Government and, thus, allow level-playing field to the private investor. Although the Government at present borrows from the market on equal terms with private borrowers, the crowding-out effect of Government borrowings still remains a critical issue in view of the high fiscal deficit.

4.82 In the context of role of fiscal policy in reinvigorating growth, it needs to be recognised that the fiscal stance affects output itself as well as the variability of output. Imbalances between aggregate demand and aggregate supply feed back into the realised fiscal deficit. Given this simultaneity, an important question is to examine the design of fiscal policy to see whether fiscal policy automatically smoothens the business cycle or discretionary interventions are required. This aspect is usually examined by looking at built-in automatic stabilisers and by decomposing the actual fiscal deficit into a structural component (unresponsive to cycles in the economy) and a cyclical component (responsive to cycles). Previous research has shown that fiscal deficits in India have been predominantly structural with cyclical component almost negligible (RBI, 2002). This suggests that discretionary policy had an important role to play in counter-cyclical measures in the Indian context.

4.83 Of the above issues, three viz., (i) macroeconomic impact of fiscal deficit, (ii) worsening of State finances and (iii) debt-sustainability are addressed in remaining part of the section.

4.84 The high fiscal deficit and sharp increase in the size of outstanding liabilities of the Government during the 1990s did not have any adverse macroeconomic impact as witnessed in the beginning of the 1990s. This has led to the revival of the view that higher fiscal deficits should not be a matter of much concern. It is argued that fiscal deficits would be inflationary only if the system is at full employment or is characterised by supply bottlenecks in certain sectors. Given the fact that there is excess industrial capacity along with large food stocks, large foreign exchange reserves and low inflation, a monetised deficit is not only non-inflationary, but virtuous from the point of view of growth (Chandrasekhar, 2000).

4.85 At the first look, the argument appears plausible as it could be observed that the spill-over effect of the high fiscal deficit in the external sector did not occur. However, this period was marked by dampened investment demand from the private sector with recessionary conditions. The overall saving-investment gap was narrowed as a result and this was reflected in low current account deficit. Furthermore, the recessionary conditions coupled with the availability of sizeable forex reserves, large food stocks and downward trend in global prices helped in containing inflationary pressures in the Indian economy. Continuing foreign exchange inflows and the recessionary conditions enabled the Reserve Bank to move to a softer interest rate regime in spite of a rising fiscal deficit.

4.86 It has, however, been shown that while public investment spending crowds in private investment and is expansionary in nature, consumption spending by the Government causes economic contraction (RBI, 2002). In fact, considerable scepticism has been expressed towards the success of expansionary fiscal policy, which does not consider the quality of expenditure (Chelliah, 2001). The Report of the Economic Advisory Council, Government of India, 2001 stresses that a high fiscal deficit, by raising real interest rates, crowds out private investment as Government borrowing is predominantly used to finance the revenue deficits. Relying on the reduced form evidence pertaining to the 1990s, fiscal expansion in the Indian context is observed to be contractionary (Khatri and Kochhar, 2002). It may be added that fiscal consolidation in the first half of the 1990s was accompanied by high income growth. Also, a deterioration in fiscal position in the second half of the 1990s occurred along with deceleration in income growth. It has also been shown that in India, during the eleven year period since 1986-87, an increase in the Central Government’s fiscal deficit (inclusive of oil pool account) by one per cent of GDP was associated with a reduction in private corporate investment by one per cent of GDP (Srinivasan, 2000).

4.87 It needs to be recognised that the fortuitous conditions that have restricted the adverse macroeconomic impact of high fiscal deficit are transitory in nature. With a revival of economic activity, spurred by a pick-up in the private investment demand, rise in fiscal deficit could raise the saving-investment gap and eventually raise interest rate and widen current account deficit. The problem could be compounded if inflationary pressures reemerge due to buoyant economic activity or some exogenous shock. In view of this, sustainability of deficit and debt and fiscal consolidation continues to be a matter of serious concern.

4.88 The down slide in the fiscal performance of the States has assumed serious proportions. Several factors have been identified by a number of studies for the widening fiscal gap of the State Governments. Evidence set out in Box IV.3 indicates that expenditure on wages, salaries and pension, growing size of interest payments, inability to levy adequate user charges and falling buoyancy in Central transfers are the prominent reasons for the deterioration of State finances.

4.89 Analysis of the data since 1980-81 suggests that an inverse relationship prevails between cost recovery and the fiscal deficit (Chart IV.15). On the other hand, co-movements between expenditure (on both interest payments and on wages and salaries) and the fiscal deficit indicated positive relationship. A rise in interest payments or wages and salaries generally exert upward pressure on fiscal deficit. The positive relationship between interest payments and GFD was, however, not observed during the first half of the 1990s. Similarly, transfer ratio, which is defined as the proportion of total expenditure which is not met by Central transfers also exhibits a positive relationship showing that with a fall in Central transfers, the fiscal deficit of the States, in general, worsens.

4.90 Although the studies surveyed identify nearly the same set of factors, they differ in terms of the relative importance attached to each of the factor. There are large disparities across the States in terms of level of income and the tax and expenditure policies pursued by the respective Governments. Accordingly, the impact of various factors (as enumerated above) are likely to vary across the States. Any sluggishness in central transfers would impact more on the States whose fiscal conditions are weak. Similarly, the level of revenue receipts in each State would depend upon the level of income, quality of tax administration and the policies pursued by the Government regarding user charges. Therefore, recognising that there is a need to track the changes, both, over the period and across the States, a panel data exercise for the 15 major States over the period from 1980 to 2000 has been undertaken to assess the relative strength of factors affecting the State finances. The methodology and other technical details have been set out in Box IV.4.

4.91 The exercise does reveal that spending on interest payments, which had no significant impact during the 1980s turned into a prominent determinant of the fiscal deficit of States during the 1990s. On the other hand, all other factors viz., the transfer ratio, user charges and spending on wages, salaries and pension, while continuing to be significant factors determining the fiscal deficit of States in both the periods, were relatively less important (in terms of value of coefficients) during the 1990s. Notably, this finding is contrary to the general belief that rise in expenditure on wages and salaries has been the major cause for deterioration in the fiscal condition of the State Governments during the 1990s.¹²

4.92 The underlying theoretical notion of fiscal stability and sustainability is that real interest rate must not exceed the real output growth of the economy to ensure that debt/output ratio does not grow to explosive proportions. If the interest rate exceeds the output growth rate, and the larger is the gap between the two rates, the higher would be the growth in debt-GDP ratio. This would require generation of adequate primary surplus equivalent to the gap between the interest rate and the output growth rate to stabilise the debt-GDP ratio. Conversely, by this condition, even if the rate of output growth exceeds the interest rate, a large primary deficit can still lead to rise in the debt-GDP ratio. Thus, the positive differential between the output growth rate and the interest rate is not the sufficient condition for sustainability. Sufficient condition for sustainability requires that the initial debt stock equals the present discounted value of primary surpluses in the future (Blanchard, 1980). The latter condition which is popularly termed as the inter-temporal budget constraint or the ‘present value constraint approach’ ensures that the debt-GDP ratio does not grow inexorably. This approach essentially brings to the fore that it is the behaviour of the lenders to the Government that ultimately determines the sustainability of fiscal policy. The underlying notion is that, in the wake of explosive rise in debt-GDP ratio, lenders may lose confidence in the ability of the Government to honour its commitments and may become unwilling to subscribe to Government debt any more.

4.93 In the Indian context, a number of studies have empirically tested sustainability of public debt. Amongst the earlier studies, Seshan (1987) found that the internal debt of the Government that had evolved by the mid-1980s was unsustainable. Analysing the alternative modes of financing Government deficit, it was shown that while the debt financing was unsustainable, resorting to monetary financing would lead to a vicious circle of large deficit, higher monetary financing and more inflation leading again to a higher deficit (Rangarajan, Basu and Jadhav, 1989). Many other studies in the 1990s, and thereafter, also show the unsustainability of Indian public debt (Buiter and Patel, 1992; Jha, 2001).

4.94 The sustainability of the public debt in terms of both the approaches viz., accounting approach or Domar’s stability condition and the ‘present value constraint approach’ is assessed in this section. In the accounting approach, a comparison of weighted average interest rate on the Government borrowings and the GDP growth rate indicates that the differential between the two rates has narrowed down considerably. During 1990s, at least on three occasions, the weighted average interest rate on Central Government securities exceeded the output growth rate (Chart IV.16). Although these results point towards pressure on the sustainability of the public debt during the second half of the 1990s, the concomitant fall in primary deficit as a proportion to GDP has enhanced the zone of comfort.

4.95 In the second approach, the hypothesis in the tradition of Buiter and Patel (1992) was tested. The method involves discounting the nominal stock of Government debt with an appropriate interest rate and assessing the stationarity of the resultant discounted series. Since the interest rate on pubic account liabilities are not market determined, total internal liabilities excluding public account liabilities were discounted with the weighted average interest rate on Government dated securities (Chart IV.17). The discounted series was tested for stationarity by alternative tests, viz., Augmented Dicky-Fuller and Phillips-Perron Unit root tests. Both the unit root tests show non-stationarity of the discounted series (Table 4.12).

4.96 Since the above results could be biased, as they do not account for any possible structural break following reforms, unit root tests with structural break were also conducted. Three alternative models were tested: (i) change in intercept (model 1); (ii) change in intercept and in the slope (model 2); and (iii) change in slope but both segments of the trend function are joined at the point of break (model 3) (Perron, 1997). In none of the models, the discounted debt series was stationary. These results indicate that the continuation of current fiscal stance could make public debt of both the Central and State Governments unsustainable unless corrective measures are undertaken to rein in the fiscal deterioration (Table 4.13).

4.97 The analysis and assessment in the preceding sections clearly revealed that the significant fiscal consolidation in the immediate aftermath of the fiscal reforms was essentially brought about through cut in investment expenditure, as rise in committed revenue expenditure could not be curtailed. Within a short span, it became increasingly obvious that the Indian approach to fiscal correction was not sustainable. While reduction in investment spending affected future growth prospects with consequent slowdown in revenue receipts, the interest payments and public debt continued to grow, resulting in reversal of fiscal consolidation process in the latter half of the 1990s. Downward rigidity in the revenue deficit, which amounts to dissaving by the Government sector, has significant implications for the growth target of 8 per cent set in the Tenth Five Year Plan. This would require an investment rate of about 32 per cent, whereas, over the years, the investment rate has stagnated at around 24 to 25 per cent of GDP. Acceleration of saving and investment rate would critically depend upon the efforts to restore balance on the revenue account of both the layers of Governments.

4.98 The key factors underlying the growing resource gap across the States are uneconomical level of user charges particularly in the power sector, sluggishness in the Central transfers due to low buoyancy of Central taxes and the rising interest payments. Restoration of revenue balance both at the Central and the State level would require that user charges are adequately raised, the tax collection machinery is overhauled to achieve better tax compliance, returns on Government investment in PSUs are raised through appropriate pricing policies eliminating implicit subsidies and the burden on the fisc is lowered through phasing out of unviable public sector units. The introduction of VAT should eliminate the practice of competitive tax concessions, which has seriously dampened tax buoyancies.

4.99 The sizeable outstanding liabilities contracted at higher rates during the late 1980s and the early 1990s and the resultant mounting interest payments have contributed to the widening fiscal gap. The scheme of swapping States’ outstanding liabilities to the Central Government on account of small savings could make a major dent in the growth of interest payments. For the Central Government, aggressive restructuring and divestment in unviable public sector units could bring in sizeable resources to redeem a part of outstanding liabilities and consequent reduction in interest payments.

4.100 The elimination of automatic monetisation and reduction in pre-emption of institutional resources by the Government has provided a conducive environment to generate market liquidity and softening of interest rates in the economy. However, with a widening of the fiscal gap, it would be increasingly difficult to maintain a softer interest rate regime. In such an eventuality, it would not only crowd out the private investment initiative, but would also make public debt highly unstable given the level of returns on Government investments.

4.101 The institutional support in the form of fiscal rules should be the prime mover of future agenda of fiscal consolidation programme. Such fiscal rules could prescribe quantitative limits for elimination of the revenue deficit, reduction in the fiscal deficit and the public debt over a specific period in a phased manner. Advocates of expansionary fiscal policy have, however, cautioned against the stringent fiscal rules to avoid impairment of future growth prospects (Rakshit, 2001; Patnaik, 2001, Shetty, 2001). In a recessionary environment along with low inflation, growing forex reserves and comfortable level of food stocks, there is a definite role for the expansionary fiscal policy. The apprehension is that the stringent fiscal rules may hinder appropriate steps by the Government. However, it may be noted that such rules generally make a clear distinction between public consumption and public investment expenditure while envisaging a complete elimination of revenue deficit. Rule based fiscal policy would facilitate the path for durable fiscal consolidation through mandatory fiscal discipline, enhanced accountability and improved transparency in fiscal operations.

4.102 In the above context, it may be mentioned that the RBI Annual Reports 2000-01 and 2001-02 have set out a policy prescription for further fiscal consolidation. According to these Reports, the path of durable fiscal consolidation is through fiscal empowerment i.e., by expanding the scope and size of revenue flows into the Budget. Furthermore, a fiscal strategy based on revenue maximisation would also provide the necessary flexibility to shift the pattern of expenditures and redirect them productively. Revenue maximisation requires that the tax system be reformed through widening the tax base, simplification of tax rules, review of exemptions/incentives and strict tax compliance.