Finances of State Governments –2007- 08: Highlights*

This article presents the highlights of the State Governments budgets for 2007-08. A detailed analysis is presented in “State Finances: A Study of Budgets of 2007-08” that was released in December 2007¹ .

The State Governments presented their budgets for 2007-082 in an environment of growing recognition to pursue fiscal correction and consolidation. The progressive enactment of Fiscal Responsibility Legislation (FRL) by twenty-six States so far ushered in a rule-based fiscal regime for the State Governments. The efforts of the State Governments towards reducing fiscal imbalances were aided by larger devolution and transfers from the Centre based on the recommendations of the Twelfth Finance Commission (TFC) along with the improvement in tax buoyancy on the strength of macroeconomic  fundamentals. Furthermore, all States excepting Uttar Pradesh have implemented Value Added Tax (VAT) in lieu of sales tax, which has been an unqualified success in raising the tax revenue for the States.

The State Governments while presenting their budgets for 2007-08 have taken into account the priorities as laid out in the Eleventh Five Year Plan (2007-12). In order to ensure quality of human resource development, social sector expenditure is proposed to be raised by higher allocations in 2007-08. In view of the priority given to infrastructure development in the Eleventh Five Year Plan, the State Governments have envisaged implementation of various projects, especially power and roads. Many State Governments have proposed to implement the infrastructure projects through the framework of public-private partnership (PPP). The State Governments have also undertaken development of urban infrastructure under the Jawaharlal Nehru National Urban Renewal Mission (JNNURM).

The State Governments in their budgets for 2007-08 proposed various policy initiatives to carry forward the process of fiscal correction and consolidation through measures aimed at augmenting revenue and improving expenditure management. To augment their revenues, the State Governments announced measures for enhancing resource mobilisation through simplification/rationalisation of tax structure, better enforcement and tax compliance. Some States proposed to review the user charges on power, water and transport. By adopting an outcome-oriented budgetary framework, some States have emphasised on translation of outlays into defined outcomes through monitorable performance indicators. A few States also proposed a comprehensive review of the functioning of the State PSUs and their restructuring. In order to restore financial viability of electricity boards, some States have signed Memorandum of Understanding (MoU) with the Central Government for bringing reforms in the power sector. Some States have proposed to introduce “Gender Budget” to ensure empowerment and active participation of women in various development schemes.

The Government of India has taken initiatives to provide support to the State Governments in their developmental role by announcing measures in the area of education, health, social security, agricultural insurance, etc. The Reserve Bank, on its part, has been advising the State Governments on several issues, besides providing support in the form of ways and means advances (WMA)/ overdraft (OD) and raising of market borrowings. The Reserve Bank aided the State Governments in organising prepayment of high cost debt, introduction of non-competitive bidding in the auctions of State Government securities and investment of cash balances.
The fiscal and institutional reforms aimed towards fiscal correction and consolidation coupled with the implementation of recommendations of TFC and improvement in tax buoyancy on the strength of macroeconomic fundamentals have contributed in bringing about substantial improvement in the consolidated fiscal position of the State Governments since 2005-06. The reform measures initiated by the State Governments, Central Government and the Reserve Bank to strengthen the reform process at the State level are presented next. This is followed by a discussion of 2005-06 (Accounts), 2006-07 (Revised Estimates) and 2007-08 (Budget Estimates). A discussion on fiscal transfers to State Governments is provided as a special theme. Concluding observations are provided at the end.

Policy Developments

Policy Initiatives of State Governments

The State Governments, in their budgets for 2007-08, have remained committed to carry forward the process of fiscal correction and consolidation and have announced several policy measures aimed at revenue augmentation, expenditure management and institutional development. The States have also undertaken the development of urban infrastructure under JNNURM. The States have also proposed to implement infrastructure projects through the PPP framework.

In their budgets, the State Governments in general have placed emphasis on improving tax administration by simplification of rules and procedures, rationalisation of tax rates and making the system of tax collection easy and transparent to ensure better tax compliance. All the State Governments, except Uttar Pradesh, and both the Union Territories (UTs) with legislature, i.e., NCT Delhi and Puducherry, have implemented VAT. A few States have proposed a reduction in certain taxes aimed at providing incentives to specific sectors/industries. In order to provide a boost to the tourism industry, Gujarat and West Bengal have announced reduction in the rates of luxury tax. Haryana has announced tax relief on energy saving devices to encourage conservation of power in the State. The State Governments have also placed emphasis on the need to enhance their non-tax revenues.

State Governments have continued their efforts to place emphasis on expenditure management and containment of non-plan revenue expenditure. While several States had already imposed ban over recruitments and creation of new posts, Nagaland has proposed a voluntary retirement scheme and ban on creation of new posts. The State Governments have highlighted the need to reduce salary expenditure and proposed measures to reduce administrative expenditure. While aiming at expenditure prioritisation, the State Governments have proposed several developmental schemes for the weaker sections of the society. Several State Governments, including Andhra Pradesh, have proposed insurance schemes for the poorer sections of population and tribal groups. Chhattisgarh has proposed an insurance scheme for farmers to provide protection against losses due to natural calamities, while Goa has proposed to provide insurance cover against accidental fire hazards to small and marginal farmers. Several State Governments have announced expansion in coverage under pension schemes and increase in rates of pension rates for senior citizens, widows and disabled persons (Himachal Pradesh, Karnataka, Sikkim, Tamil Nadu and West Bengal).

During past few years, the State Governments have adopted various institutional measures, which were oriented towards further strengthening of fiscal discipline, such as legislation in respect of guarantees and fiscal responsibility. Three State Governments, viz ., Jammu and Kashmir (August 2006), Mizoram (October 2006) and Jharkhand (May 2007) enacted FRL encompassing targets on various fiscal parameters, thus taking the total number of States that have enacted FRL to twenty-six. The States have also implemented measures like introduction of new pension scheme (NPS), setting up of consolidated sinking fund (CSF) and guarantee redemption fund (GRF) and placing ceiling on guarantees. Most of the State Governments have proposed setting up of committees/institutions/schemes for targeted purposes, such as agricultural technological management authority (Bihar), knowledge incentive scheme (Chhattisgarh), women employment exchange (Gujarat), rural development (Haryana and Uttar Pradesh), streamlining of exemptions given to industries (Jammu and Kashmir), etc. Some States have also proposed to introduce insurance schemes in pursuance of a new scheme called Aam Admi Bima Yojana (AABY) announced in the Union Budget 2007-08. Few States would explore the possibility of linking their existing schemes with the AABY. A number of State Governments (Assam and Chhattisgarh) have decided to implement the recommendations of the Vaidyanathan Committee to strengthen the cooperative banks. Several State Governments have proposed for a greater role of the local bodies.

The State Governments have proposed several schemes particularly directed towards education, health and employment. Almost all the State Governments have proposed to set up (upgrade) new (existing) schools/colleges/ universities towards providing basic as well as advanced education facilities to wider sections of populations in their respective States. State Governments have announced extension of the employment guarantee schemes to cover more districts. The State Governments have also announced initiatives to improve irrigation facilities and supply of drinking water in rural as well as urban areas. The West Bengal and Tamil Nadu Government have announced measures to revise and revitalise the tea gardens of their States. Some States (Punjab, Sikkim, Tripura) have also placed emphasis on horticulture and floriculture projects.
Initiatives of the Government of India

The Government of India aids the reform process of the State Governments through various measures. The progress of eight flagship programmes under Bharat Nirman would continue to aid the development process in the State Governments. In the Union Budget 2007-08, the Government of India outlined several initiatives to assist the State Governments in their developmental and social role. The Centre has integrated the polio eradication programme into the National Rural Health Mission (NRHM). To make a beginning towards introducing a social security scheme for unorganised workers, the Union Government has proposed to extend death and disability insurance cover through Life Insurance Corporation of India (LIC) to rural landless households under a new scheme called “Aam Admi Bima Yojana”. In order to revive and replicate a programme called ‘Training and Visit’, in which the agricultural extension workers worked side by side with the farmers during the Green Revolution of the 1960s, the Ministry of Agriculture will draw up a new programme in consultation with the State Governments. The Centre has announced a scheme for the modernisation and technological upgradation of the coir industry with special emphasis to major coir producing States such as Kerala, Karnataka, Tamil Nadu, Andhra Pradesh and Orissa. The Union Budget based on the mutual agreement between the Centre and the States proposed to phase out the Central Sales Tax (CST), commencing with a reduction of the CST rate from 4 per cent to 3 per cent from April 1, 2007. In the spirit of ongoing cooperative fiscal federalism between the Centre and the States, the Union Budget announced that the Empowered Committee of State Finance Ministers would prepare a roadmap for introducing a national-level Goods and Services Tax (GST) with effect from April 1, 2010.

Reserve Bank’s Initiatives

The Reserve Bank as the banker and manager of public debt to the State Governments has been sensitising the State Governments on fiscal issues. In this direction, the Reserve Bank has been organising a bi-annual Conference of State Finance Secretaries since 1997 to establish a consultative approach to issues pertaining to the finances of State Governments.

Faced with the accumulation of surplus cash balances and a negative spread earned on the investment of such balances, some State Governments had approached the Reserve Bank to arrange for the buy-back of their outstanding State Development Loans (SDLs). Accordingly, the Reserve Bank formulated a general scheme for the buy-back of SDLs with the concurrence of the Government of India. With a view to widening the investor base in SDLs, the Annual Policy Statement of April 2006 had proposed to extend the facility of non-competitive bidding (currently limited to Central Government dated securities) to the primary auction of SDLs. Necessary provisions of the Scheme on “Non-Competitive Bidding Facility” have been incorporated in the Revised General Notification issued by all the State Governments in July 2007. The scheme will be operationalised shortly. The Reserve Bank in its Annual Policy Statement for 2006-07, had proposed to constitute a Standing Technical Committee (STC) “under the aegis of the State Finance Secretaries Conference with representation from the Central and State Governments and the Reserve Bank to advise on the wide-ranging issues relating to the borrowing programmes of Central and State Governments through a consensual and co-operative approach”. The STC was constituted in December 2006. In the context of the back-to-back transfer of external assistance to the States, the Reserve Bank organized a workshop on the management of foreign exchange risk in May 2007 for the benefit of State Government officials. The States have also proposed alternative mechanisms for providing for foreign exchange risk by setting aside funds in their budgets, where the Reserve Bank is expected to play a role in managing these funds on the lines of CSF. These proposals were discussed at the 20th Conference of the State Finance Secretaries, held in August 2007. In the 19th Conference of State Finance Secretaries held on January 24, 2007, the provision for payment of brokerage and commission by the State Governments to the banks/other eligible entities for issuance of SDLs through auction method was reviewed. In terms of General Notification issued by all the State Governments in July 2007, payment of brokerage/commission to banks/other eligible entities was discontinued in case SDLs are issued through auction method. In the Annual Policy Statement of April 2007, it was proposed that, with a view to building up a critical mass and thereby improving the secondary liquidity of such securities, reissuance of SDLs may be introduced in consultation with the State Governments. The feasibility of introducing the system of re-issue of SDLs is being examined taking into account the responses received from State Governments.

Accounts: 2005-06

The key deficit indicators of the State Governments, viz., Revenue Deficit (RD), Gross Fiscal Deficit (GFD) and Primary Deficit (PD) recorded significant reduction when the revised estimates (RE) of 2005-06 translated into accounts. RD and GFD witnessed sharp declines of Rs.12,813 crore (64.6 per cent) and Rs.22,338 crore (19.9 per cent) respectively, between 2005-06 (RE) and 2005-06 (Accounts). Primary deficit also registered a sharp reduction of Rs.19,070 crore (75.9 per cent). In 2005-06 (Accounts), RD, GFD, and PD, relative to GDP, were placed at 0.2 per cent, 2.5 per cent and 0.2 per cent as against 0.6 per cent, 3.2 per cent and 0.7 per cent, respectively in the revised estimates. The correction in the revenue account in 2005-06 (Accounts) was largely due to a sharp reduction in the revenue expenditure, mainly non-interest revenue expenditure which fell by Rs.22,928 crore (6.1 per cent) (Table 1).
The developmental expenditure in revenue account declined substantially by Rs.17,160 crore accounting for 65.5 per cent of the fall in revenue expenditure. The non-developmental revenue expenditure also registered a decline by Rs.9,296 crore in 2005-06 over 2005-06 (RE). The revenue receipts declined by Rs.13,384 crore on account of a decline in States’ own tax revenue and grants from the Centre, which was partly compensated by increase in States’ share in Central taxes and their own non-tax revenue. There was a decline in capital outlay by Rs.6,207 crore (7.4 per cent), which was higher in magnitude than the fall in capital expenditure. The decline in capital outlay was particularly in respect of sectors such as rural development (15.4  per cent), special area programmes (41.3 per cent), transport (7.9 per cent) and irrigation and flood control (2.3 per cent). Thus, despite a decline in revenue receipts by 0.4 per cent of GDP, the overall correction in the key deficit indicators was on account of compression of developmental expenditure (both revenue and capital) by 0.6 per cent of GDP.

Revised Estimates: 2006-07

The trends in the revised estimates of 2006-07 vis-à-vis  the budget estimates (BE) revealed that there was a decline in RD from 0.2 per cent of GDP in budget estimates to 0.1 per cent of GDP in the revised estimates. On the revenue account, there was a substantial increase in revenue receipts of Rs.22,654 crore (4.5 per cent) in 2006-07 (RE) over 2006-07 (BE), which more than compensated for the increase in the revenue expenditure by Rs.19,872 crore (3.8 per cent). The marked rise in revenue receipts by 0.6 per cent of GDP was mainly on account of increase in States’ own tax revenue and share in Central taxes, accounting for 39.7 per cent and 27.9 per cent of the increase in revenue receipts, respectively. The developmental component of revenue expenditure increased by 0.5 per cent of GDP on account of higher expenditure on energy, natural calamities, education,

rural development and transport and communication. The GFD increased by Rs.7,160 crore (6.7 per cent), notwithstanding the decline in RD, due to higher provision for capital  outlay by Rs.10,399 crore (11.0 per cent). The rise in capital outlay was mainly in respect of economic services such as irrigation and flood control, transport, energy and urban development (Table 2) (Also see Statements 1 and 2).

Budget Estimates: 2007-08

During 2007-08, the consolidated fiscal position of State Governments is slated to show improvement in terms of the major deficit indicators. A noteworthy aspect is that the consolidated revenue

balance is envisaged to turn into a surplus of Rs.11,973 crore (0.3 per cent of GDP) in the budget estimates (BE) for 2007-08 from a deficit of Rs.5,566 crore (0.1 per cent of GDP) in 2006-07 (RE). It is pertinent to note that the revenue surplus has been budgeted one year in advance of the FRL stipulations and TFC recommendations. Consequent upon the budgeted revenue surplus, the GFD would decline by Rs.5,590 crore (4.9 per cent) to Rs.1,08,323 crore (2.3 per cent of GDP). Similarly, the PD is budgeted to decline by Rs.12,561 crore (69.0 per cent) to Rs.5,648 crore (0.1 per cent of GDP) in 2007-08 (Table 3).
The correction in the revenue account during 2007-08 has been envisaged to be

achieved primarily through enhancement in revenue receipts by 14.2 per cent on top of the 23.3 per cent growth recorded in the previous year. The increase in revenue receipts during 2007-08 is budgeted to be contributed by own tax revenue (49.1 per cent), share in Central taxes (27.2 per cent), grants from the Centre (19.1 per cent) and States’ own non-tax revenue (4.7 per cent). Revenue receipts as a ratio to GDP have been estimated to increase by 0.2 percentage points to 13.1 per cent in 2007-08, contributed mainly by own tax revenue and devolution and transfers from the Centre. States’ own tax revenue as a percentage of GDP is estimated to rise marginally during 2007-08, maintaining the upward trend witnessed since the mid-1990s. The revenue from VAT/sales tax, which accounts for nearly half of States’ own tax revenue, are budgeted to increase by 15.7 per cent in 2007-08, while taxes on property and capital transactions would rise by 18.3 per cent, respectively. On the other hand, the growth in States’ own non-tax revenue is budgeted to decelerate to 6.3 per cent during 2007-08 from 16.1 per cent in the preceding year (Statement 3). Gross devolution and transfer of resources (i.e., shareable tax revenue, grants and loans and advances) from the Centre to the State Governments are estimated to increase by 17.3 per cent to Rs.2,68,422 crore during 2007-08 as compared with 28.0 per cent growth recorded in the previous year. As a ratio to GDP, gross devolution and transfer from the Centre would improve to 5.8 per cent in 2007-08 from 5.5 per cent in the previous year. It may be stated that gross devolution and transfer from the Centre would finance 35.0 per cent of the aggregate disbursements of the State Governments during 2007-08 as compared with 33.3 per cent in the preceding year. In terms of recommendations of the TFC, the States are receiving a higher share in shareable Central taxes and larger grants from the Centre. Simultaneously, the Central plan loans to the States are phased out (see Statement 4).

The improvement in revenue account would also be facilitated by deceleration in revenue expenditure to 10.8 per cent during 2007-08 from 22.6 per cent growth in the previous year. The budgeted increase in revenue expenditure during 2007-08 would be primarily contributed by non-interest revenue expenditure (87.9 per cent). Within revenue expenditure, developmental expenditure (economic and social services) would decelerate to 11.3 per cent after recording a sharp increase of 26.0 per cent in the previous year. Non-developmental expenditure would also decelerate to 9.5 per cent (from 17.6 per cent in previous year) on account of deceleration in expenditure on administrative services, pensions and interest payments (Statements 5 and 6).

Capital receipts are budgeted to increase by 12.4 per cent during 2007-08 against the decline of 12.9 per cent in the preceding year mainly on account of sharp increase in budgeted amount of market borrowings. It is pertinent to note that the State Governments have budgeted both special securities issued to NSSF and recovery of loans and advances at lower levels by 4.1 per cent and 45.9 per cent, respectively (Statement 7). The total capital expenditure of the State Governments, on the other hand, is budgeted to increase by 13.9 per cent during 2007-08 as compared with an increase of 22.1 per cent in the previous year. Enhancement in capital outlay would account for 66.3 per cent of the increase in capital disbursements in 2007-08, primarily representing developmental outlays in economic services. As a ratio to GDP, capital outlay would increase to 2.6 per cent from 2.5 per cent in the preceding year.

The share of social sector expenditure (SSE), including expenditure on social services, rural development and food storage and warehousing, in total expenditure (TE) by the State Governments, which showed a declining trend in the first half of this decade, witnessed an improvement during the recent years. From an average of 32.5 per cent during 2000-05, the ratio of SSE-TE increased to 33.7 per cent in 2005-06 and further to 35.5 per cent 2006-07 (RE). SSE-TE ratio is budgeted at 35.9 per cent in 2007-08. SSE as a ratio to GDP would be maintained at 5.9 per cent in 2007-08 as in the previous year. The proportion of operations and maintenance expenditure in total revenue expenditure, by and large, exhibited a gradual decline over the years. On the other hand, share of wages and salaries in revenue expenditure increased over the second half of the 1990s, but declined to 27.8 per cent in 2006-07 (RE) from the peak level of 39.1 per cent in 2000-01.

The trend in major deficit indicators reveals significant improvement witnessed in recent years after recording progressive deterioration from the second half of the 1990s (Table 4) (also see Annex 1). However, the marked improvement in consolidated fiscal position does not reveal the wide variation that exists across the States.

During 2007-08, twenty States have presented revenue surplus budgets. However, fifteen States have budgeted for higher GFD in 2007-08 over the previous year. Only a few States account for a major part of the envisaged overall correction. State-wise analysis of the fiscal correction process indicates that the non-special category States would account for 85 per cent of the correction in the revenue account and 73 per cent of the correction in GFD during 2007-08.

The decomposition of consolidated GFD of all State Governments based on their budget documents reveals that the surplus in the revenue account would finance capital expenditure in 2007-08, while RD formed 4.9 per cent of GFD in the previous year. Accordingly, the share of capital outlay in GFD would move up from 92.1 per cent to 109.7 per cent over the year.  Securities issued to NSSF would continue to be the major financing item of GFD, though its share would come down due to the expected decline in net collections in keeping with the recent trends and the policy decision to reduce the minimum obligation of the States to borrow from the NSSF to 80 per cent of net collections from 100 per cent. Market borrowings would correspondingly finance a higher share of GFD during 2007-08 at 24.3 per cent compared with 16.8 per cent during the previous year (Table 5).

A perusal of Union Budgets in conjunction with State Budgets for last three years reveals that States have generally overestimated grants-in-aid from the Centre while the amount of shareable Central taxes have been underestimated in the State Budgets. So far as, financing of GFD is concerned, the flows from NSSF, which have been generally underestimated in State Budgets, have been overestimated in the State budgets in 2007-08. Loans from the Centre have been generally overestimated in the State budgets. In view of the underestimation of the shareable taxes from the Centre to the tune of Rs.6,267 crore in the State budgets of 2007-08 and overestimation of grants by Rs.17,737 crore, the level of revenue receipts would differ from those budgeted by the State Governments. The RD and GFD would, therefore, be somewhat higher than those budgeted by the State Governments. With regard to financing of GFD, both loans and advances from the Centre and loans against Securities issued to the NSSF have been overestimated by Rs.3,501 crore and Rs.6,689 crore respectively, in the State budgets of 2007-08. Thus, the financing pattern of GFD gets distorted due to such overestimation/underestimation of the budgetary heads of State Governments as compared with that of the Union Budget. 

Outstanding Liabilities and Market Borrowings

The large and growing GFD of States, particularly since the latter half of the 1990s, led to accumulation in the outstanding debt of the State Governments. The loans from Centre, which accounted for a significant share of States’ debt over the years, have shown a decline. On the other hand, the share of market borrowings and NSSF has increased as compared to the 1990s. The outstanding liabilities of the State Governments as at end-March 1991 were placed at Rs.1,28,155 crore (or 22.5 per cent of GDP). The debt-GDP ratio, which was at a low of 20.9 per cent as at end-March 1997, rose sharply to 32.7 per cent as at end-March 2006 but declined to 30.8 per cent as at end-March 2007. The outstanding liabilities of State Governments are budgeted at Rs.13,78,663 crore as at end-March 2008 with the debt-GDP ratio placed at 29.8 per cent (Statement 8 and Annex 2).

The share of market borrowings in the aggregate outstanding liabilities of State Governments gradually moved up from 12.2 per cent at end-March 1991 to 14.8 per cent at end-March 2000 to 20.7 per cent at end-March 2005. The declining trend in share of high cost market loans of State Governments continued during 2006-07. As at end-March 2007, the share of outstanding market borrowings with interest rate of 10 per cent and above declined by nearly 5 percentage points to 27.5 per cent from 32.2 per cent as at end-March 2006. The net allocations of market borrowings to the State Governments, as per Reserve Bank records, have increased steadily. Additional allocations which witnessed a decline till 2006-07, have increased during 2007-08. The net allocation under market borrowing programme for State Governments is placed at Rs.28,811 crore during 2007-08, an increase of 67.1 per cent over the previous year. Taking into account repayments of Rs.11,555 crore and additional allocation of Rs.5,625 crore, the gross allocation amounts to Rs.45,990 crore, higher by 72.9 per cent over the previous year. During 2007-08 (up to November 30, 2007), the States have raised market borrowings amounting to Rs.30,875 crore (or 67.2 per cent of gross allocation) through auctions with cut-off rate in the range of 8.00-8.90 per cent. The weighted average interest rate on market borrowings which had declined since the mid-1990s up to 2003-04, firmed up to 8.39 per cent during 2007-08 (up to November 30, 2007) in line with that of the Central Government securities, reflecting the general upward movement in interest rates. In 2007-08 so far (up to November 30, 2007), the entire amount of market borrowings was raised through the auction route as in 2006-07, indicating State Governments’ intention to raise market borrowings based on their improved financial condition (Table 6).

Liquidity Position and Cash Management

Based on the recommendations of the Advisory Committee on Ways and Means Advances and Overdrafts to the State Governments (Chairman: Shri M.P.Bezbaruah), a revised WMA Scheme for State Governments was put in place with effect from April 1, 2006. Accordingly, the aggregate Normal WMA

limit was increased by 10.5 per cent to Rs.9,875 crore for the year 2006-07. The State-wise limits of Normal WMA were reviewed towards the end of the year. It was perceived that the extant Normal WMA limits were adequate, inter alia, on account of (i) low utilisation of WMA by the State Governments during 2006-07; (ii) acclimatisation of the State Governments to the changes in the fiscal environment as envisaged by the TFC, thereby signaling the end of the transition; and (iii) expected persistence of comfortable liquidity position of the State Governments during 2007-08. Accordingly, it was decided to retain the extant State-wise Normal WMA during 2007-08.

During 2006-07, the average utilisation of normal WMA, special WMA and overdrafts by the States remained low. There was a reduction in the number of States that availed WMA during 2006-07 (8 States as compared with 12 States in 2005-06). Similarly, there was a reduction in the number of the State Governments availing overdraft during 2006-07 (two States as compared with eight States in 2005-06). This reflected improvement in the overall cash position resulting in build-up of high level of surplus cash balances by most of the State Governments. The utilisation of WMA and overdraft (average of daily outstandings) by the States at Rs.904 crore during 2007-08 (up to November 30, 2007) was, however, substantially higher than that of Rs.246 crore in the corresponding period of the previous year. During 2007-08 (up to November 30, 2007), seven States availed of WMA for a period of 1-155 days, of which three States resorted to overdraft for a period ranging between 3-65 days. The higher utilisation of WMA reflects temporary mismatches between receipts and expenditure in respect of a few States notwithstanding maintenance of high level of surplus cash balances by a number of State Governments.

An issue that has a bearing on the liquidity and cash management by the State Governments relates to their surplus cash balance. The buoyancy in small saving collections over the last few years and the automatic channelisation of these funds to the States has meant that State Governments’ borrowings are more than the amount required for financing their GFD. This gets reflected in large surplus cash balances maintained by most of the State Governments in the form of investments in 14-Day Intermediate and Auction Treasury Bills, which at the consolidated level stand at Rs.62,996 crore (as on November 23, 2007). The States get a lower rate of return on these investments than the cost of borrowings for these resources, thus having an adverse impact on the revenue account.

Special Theme: Fiscal Transfers to the State Governments

Fiscal transfers play an important role in a federal structure of Government by addressing the imbalances between the national and sub-national governments arising on account of the allocation of functions and financial resources to different levels of Government. Under the federal system in India, while the State Governments have a major responsibility with regard to provision of economic and social infrastructure, their own resources fall far short of the requirements, necessitating fiscal transfers from the Centre to the States.

In a federal set-up, fiscal transfers take place through tax devolution and grants, which are supplemented by loans from the Centre to the States. In line with the practice followed in other federal countries, fiscal transfers in India are guided by the principle of “equalisation”, which neutralises deficiency in fiscal capacity across States but not in revenue effort. The normative approach to fiscal transfers neutralises adverse incentives as States are assessed in terms of revenues that they ought to raise given their respective capacities. Similarly, expenditures are assessed on the basis of needs consistent with an average or minimum acceptable level of service and the relevant cost norms and not driven by the past history of expenditures. The objective of fiscal transfers is to correct the vertical and horizontal imbalances. Vertical imbalances arise because higher resources have been assigned to the Central Government while State Governments are entrusted with larger responsibilities. Horizontal imbalances arise on account of different fiscal capacities and needs of the States as also the differences in the costs of providing the services. Transfers from the Central Government to the State Governments taken together are aimed at correcting vertical imbalances. The allocation of transfers among the State Governments aims at correcting horizontal imbalances. In the present scheme of transfers, tax devolution plays a dual role of correcting vertical as well as horizontal imbalances, while grants-in-aid are mainly targeted towards achieving a degree of equalisation. Apart from statutory grants under the recommendations of the Finance Commission (FC), there are plan grants covering Central assistance for State plans as decided by the Planning Commission (PC), as well as plan grants given by the Central Ministries for implementation.

Gross devolution and transfers (GDT) comprising share in Central taxes (SCT), grants-in-aid (GIA) and loans from Centre (LFC) have increased steadily over the years, but for the decline in a single year during 1999-00 (Table 7). Componentwise, the shares of SCT and GIA in GDT have moved up in recent years with phasing out of LFC to the States in terms of recommendations of the TFC. GDT is budgeted to be 5.8 per cent of GDP in 2007-08. On an average, the ratio of GDT to GDP during the first three years of Twelfth FC (2005-08) was higher at 5.5 per cent than the Eleventh FC period (5.2 per cent). GDT constituted around 33 per cent of aggregate disbursements and aggregate receipts of the States during 2005-08. The GDT as percentage of GDP witnessed a decline in the 1990s and early 2000s coinciding with the period of Tenth FC and Eleventh FC. During the period of Twelfth FC so far, the compound annual growth rate (CAGR) of GDT at 22.5 per cent was substantially higher than during previous three Finance Commissions (Annex 3).

The FC transfers comprising SCT and statutory grants and grants for natural calamities, on an average, account for

around two-thirds of total current transfers to the States. In terms of GDP, the FC transfers were 3.3 per cent of GDP during the Twelfth FC period, which is the highest ever FC transfers since the Ninth FC. This is because along with SCT, there is substantial increase in the grant component in terms of recommendations of the TFC. It may be recalled that the Twelfth FC recommended a greater role for grants in overall FC transfers on the following grounds: (a) grants are determined in absolute terms and the amounts are, therefore, known; (b) grants can be targeted better; and (c) in determining grants, better account can be taken of cost disabilities and redistributive considerations that are not adequately captured in the tax devolution formula. Accordingly, the Twelfth FC allowed increase in share of grants in total FC transfers to 18.87 per cent during the award period 2005-10, from 8.96 per cent during Tenth FC period and 13.47 per cent during Eleventh FC period. Data for 2005-06 to 2007-08 indicate that, on an average, share of grants in FC transfers was 15.2 per cent while that of tax devolution was 84.8 per cent. Other current transfers from the PC and the Ministry of Finance also witnessed significant increase relative to GDP during the Twelfth FC (Table 8).

During the period from Ninth to Eleventh Finance Commissions, revenue receipts of the State Governments before transfers averaged 7.0 per cent of GDP, while revenue receipts after transfers averaged 11.3 per cent of GDP. In the first three years of the Twelfth FC, revenue receipts before and after transfers have averaged 7.5 per cent and 12.7 per cent of GDP, respectively. Higher devolution and transfer of resources to the State Governments has facilitated the fiscal correction and consolidation process particularly in achieving substantial improvement on the revenue account (Table 9).

On the capital account, transfers from the Centre in the form of loans facilitate financing of GFD of the States. Historically, loans from Centre were the largest source of financing GFD till 1998-99. There has been a steep reduction in importance of net LFC in GFD financing – from an average of 48.7 per cent during 1990-95 and 39.7 per cent during 1995-00 to 4.6 per cent during 2000-05 and further to 2.6 per cent during 2005-08. The decline in LFC to the State Governments, however, was compensated by higher open market borrowings and negotiated loans. The changing milieu of financing

pattern of GFD of States also reflects the changes in the accounting norms in respect of small savings on account of institution of NSSF effective April 1, 1999. The collections under NSSF, which are passed on to the State Governments against issue of Special State Government Securities, have turned out to be a buoyant source of funds during past few years. Before institution of NSSF, small savings were treated as loans from Centre to the State Governments. The introduction of DSS for the period 2002-03 to 2004-05 also significantly reduced the importance of LFC as a financing item of the GFD.

To sum up, with the change in accounting framework of small savings and constitution of NSSF with effect from April 1, 1999 and abolition of Plan loans from the Centre to the States from 2005-06 in line with the recommendations of Twelfth FC, the share in Central taxes and grants-in-aid remain two major components of gross devolution and transfer from the Centre to the States. The gross devolution and transfer from the Centre to the State Governments, comprising share in Central taxes, grants-in-aid and loans from the Centre has reached the average level of 5.5 per cent of GDP during the first three years of Twelfth FC (2005-08) as compared with the average level of 5.2 per cent during Eleventh FC period. The higher devolution of Central taxes and transfer of grants during the first three years of the award period of Twelfth FC apart from the buoyant own tax revenues of the States has facilitated improvement in fiscal position of the State Governments.

Concluding  Observations

An assessment of the fiscal position of the State Governments indicates visible improvement in the key deficit indicators in the recent years. Reflecting this, in the revised estimates of 2006-07, the consolidated RD and GFD of States, as ratios to GDP, have been placed at 0.1 per cent and 2.8 per cent, respectively. Continuing with the fiscal correction process, the State Governments have budgeted for a further reduction in GFD as a ratio to GDP to 2.3 per cent during 2007-08. The reduction in GFD is based on a turnaround envisaged in the revenue account, which is budgeted to generate a surplus of 0.3 per cent of GDP. It is significant to mention that the State Governments have budgeted a consolidated surplus on the revenue account after two decades. In this context, it may also be mentioned that several State Governments have achieved the targets of reduction in RD and GFD ahead of the path of restructuring recommended by the TFC and their own FRL.

The key factors that have enabled the improvement in fiscal position of the State Governments are: (i) a rule-based process of fiscal correction and consolidation adopted under the FRL by a majority of State Governments; (ii) buoyancy in States’ own tax revenue; (iii) expenditure management by the State Governments, and (iv) high current transfers from the Central Government. Higher devolution and transfer of resources to the State Governments has facilitated the fiscal correction and consolidation process particularly in achieving substantial improvement on the revenue account. Higher devolution and current transfers to the poorer States as a ratio of their GSDP also reflect the principle of equalisation.

Given the importance of revenue augmentation in sustaining fiscal correction, the State Governments have announced measures for mobilisation of additional resources through simplification/ rationalisation of tax structure, better enforcement and tax compliance. The States have made commitments to contain non-plan revenue expenditure and introduced new pension schemes to contain future pension obligations. The State Governments have also taken into account the priorities laid down in the Eleventh Five Year Plan (2007-12) in the State Budgets for 2007-08. Accordingly, allocations for the social sector and rural infrastructure are proposed to be raised by the States.

The overall improvement in the consolidated fiscal position of the State Governments, however, does not reveal the wide variation that exists in fiscal performance across the States. The State-wise analysis reveals that fiscal correction has not been uniform across States, notwithstanding a strong commitment by almost all State Governments to carry forward the process of fiscal correction and consolidation. Only a few States account for the major part of the overall correction. State-wise analysis of the fiscal correction process indicates that the non- Special Category States would account for 85 per cent of the correction in the revenue account and 73 per cent of the correction in GFD. With TFC recommending a uniform target oriented fiscal restructuring path to be attained by all the States by end of 2009-10, the fiscally weak States may initiate measures to catch up with the fiscally sound States within the timeframe.

While the State Governments have achieved noticeable improvement in their fiscal position in the recent years, they would have to strive to make the fiscal consolidation durable through strengthening the revenue flows into the budget while placing emphasis on targeting expenditures to meet the developmental objectives. The strength in overall macroeconomic conditions has resulted in higher own revenue receipts and greater fiscal capacity for the States. The buoyancy in revenue mobilisation also needs to be channelised for productive expenditure and investment. It is crucial to ensure that the process of fiscal correction does not adversely affect capital outlay and expenditure on social sectors.

The high level of deficit of State Governments in the past resulted in accumulation of high level of debt by the State Governments. In case of several States, the present level of debt- GSDP ratio is perceived to be alarmingly high. Furthermore, there are concerns about the ability of the State Governments to service their debt obligations. The TFC had emphasised the need to determine borrowing limits for each State taking into account borrowings from all sources including small savings and States’ public accounts and reserve funds. In ensuring debt sustainability in terms of a stable debt to GSDP ratio, given the growth rate and the rate of interest, the status of primary balance is of crucial importance. Despite an improvement in the number of fiscal parameters, the primary balance of many of the States, and consequently at the consolidated level, continues to be in deficit. However, due to higher economic growth and the favourable interest rate environment in the recent years, the debt to GDP ratio of the States has been contained from rising. It may be mentioned that the State Governments have budgeted ratio of interest payment to revenue receipts for 2007-08 at 16.9 per cent against the TFC target of 15 per cent for the year 2009-10. The State Governments may make efforts through fiscal restructuring to contain their debt at sustainable level.

With a view to improving monitoring and evaluation of programmes, the State Governments may consider strengthening their evaluation capacity with a focus on outcome. They may aim at a system which is responsible and responsive for improving the efficiency and effectiveness of spending.

With fiscal transparency gaining critical importance, the State Governments may need to make efforts to enhance transparency by providing adequate details in their budgets on items such as outstanding and contingent liabilities, subsidies, etc. In addition, public dissemination of fiscal data on a more frequent basis, say quarterly basis, may be considered. With large deviation observed between budget estimates and the accounts data, particularly in the revenue account of the States in the recent years, it would be useful to improve the entire budget estimation process and methodology. In view of the constitution of the Sixth Pay Commission in October 2006 to examine the pay and pension structure of the Central Government employees, it is important to note that the State Governments have by and large followed the Central Pay Commission award to improve the pay structure of their employees. Several State Governments have constituted their own Pay Commissions. The State finances experienced deterioration in the latter part of 1990s subsequent to adopting the recommendations of the Fifth Pay Commission for their employees. The States, therefore, need to base their decisions relating to salary levels after due consideration to their fiscal capacity, employee strength, size of population and the required complementary expenditure for productive employment.

To conclude, the improvement in the fiscal position of the State Governments has resulted from buoyancy in their tax revenues along with higher current transfers from the Centre. The State Governments would, however, have to devise strategies for augmenting resource mobilisation from non-tax sources of revenue. With regard to expenditure management, the State Governments may emphasise improvement in effectiveness of service delivery mechanism. The States would also need to make continuous efforts towards ensuring the channelisation of resources to meet the development needs in line with the priorities laid down in the Eleventh Five Year Plan, while initiating steps to bring down the levels of non-developmental expenditure.