Finances of State Governments – 2010-11: Highlights*

The State governments presented their budgets for 2010-11 against the backdrop of a strengthening recovery and the resultant improvement in growth prospects for the Indian economy. Reflecting these positive developments, growth in own tax revenues of States was budgeted to be higher in 2010-11 than in 2009-10 (RE). In addition, the States also expect a larger devolution from the Centre in the form of share in Central taxes during 2010-11. Having undertaken massive expansion in aggregate expenditures in the previous two years in the wake of the overall macroeconomic slowdown and implementation of recommendations of the Sixth Central/State(s) Pay Commission, the States budgeted only a modest rise in their aggregate expenditures during 2010-11. All these factors augur well for the resumption of the fiscal consolidation process at the level of the States in 2010-11. The emerging pattern of expenditure showed that as a ratio to Gross State Domestic Product (GSDP), development expenditure, capital outlay and social sector expenditure were budgeted to be lower in many States, raising concerns about the quality of fiscal adjustment being undertaken at the State level. Despite the extra expenditure obligations emanating from the implementation of revised pay structures and fiscal stimulus measures, States’ debt-GDP ratio at 25.0 per cent in 2009-10 (RE) was well below the level of 30.8 per cent recommended by the Twelfth Finance Commission. In 2010-11 (BE), the aggregate debt-GDP ratio of States was likely to decline further, reflecting higher growth in nominal GDP than that in outstanding debt.

This article presents the highlights of the State Governments’ budgets for 2010-11. A detailed analysis is presented in ‘State Finances: A Study of Budgets of 2010-11’ that was released in March 2011¹.

The global crisis affected output and employment across the world. To support aggregate demand, the major advanced and emerging market economies resorted to expansionary fiscal and monetary policies. While expansionary fiscal policy played an important role in the process of global economic recovery, fiscal sustainability has since assumed significance. In India, with the unprecedented global developments in the second half of 2008-09, the Central as well as State governments adopted an expansionary fiscal stance to counter the effects of the global crisis on the Indian economy. Although only a few State governments announced expenditure-led fiscal stimulus packages, these policy measures had a discernible impact on the consolidated revenue receipts and aggregate expenditures of State governments in 2008-09 and 2009-10. Consequently, there was a marked deterioration in the major fiscal indicators of the States.

With the Indian economy showing faster recovery from the second half of 2009-10, reverting to the path of fiscal consolidation has become an immediate priority of both the Central and State governments. Recognising the need for fiscal consolidation, the Thirteenth Finance Commission (FC) has set out a roadmap for fiscal correction and consolidation in the medium-term, both for the Centre and State governments. The budgets of the State governments for 2010-11 reflected their commitment to resuming the process of fiscal consolidation. Importantly, with the enactment of the Fiscal Responsibility and Budget Management (FRBM) Acts in West Bengal and Sikkim, all the States are expected to follow a rule-based fiscal policy, albeit under the amended FRBM Acts as suggested by the Thirteenth FC.

The State governments presented their budgets for 2010-11 against the backdrop of a strengthening recovery and the resultant improvement in growth prospects for the Indian economy. Reflecting these positive developments, growth in own tax revenues of States was budgeted to be higher in 2010-11 than in 2009-10 (RE). In addition, the States also expected a larger devolution from the Centre in the form of share in Central taxes during 2010-11. Having undertaken massive expansion in aggregate expenditures in the previous two years in the wake of the overall macroeconomic slowdown and implementation of recommendations of the Sixth Central/State(s) Pay Commission (CPC/SPCs), the States budgeted only a modest rise in their aggregate expenditures during 2010-11. All these factors augur well for the resumption of the fiscal consolidation process at the level of the States in 2010-11.

The issues and perspectives are presented hereunder followed by the policy initiatives of State Governments, the Government of India, and of the Reserve Bank of India, an analysis and assessment of the consolidated budgetary position of the State Governments for the year 2008-09 (Accounts), 2009-10 (Revised Estimates) and 2010-11 (Budget Estimates). As a special theme, a brief on analysis of ‘Finance Commissions in India: An Assessment’ is provided at the end.

Issues and Perspectives

The period from 2004-05 to 2007-08 was marked by significant improvement in the consolidated position of State finances. The Twelfth FC put in place an incentive system, encouraging States to implement their own Fiscal Responsibility Legislations (FRLs) to enable them to be eligible for conditional debt restructuring and interest relief. However, the economic slowdown following the knock-on effect of the global financial crisis and the accompanying moderation in the pace of revenue growth adversely affected State finances in 2008-09 and 2009-10. After having implemented the expansionary fiscal policy to address the slowdown in the previous two years, the challenge before the State governments is to revert to the fiscal consolidation path from 2010-11 onwards. While an immediate challenge is to revert to the rulebased fiscal consolidation following the roadmap outlined by the Thirteenth FC, there is a need to calibrate the exit from the expansionary fiscal stance in a manner so that its adverse impact on growth is minimised. Another issue gaining importance from the viewpoint of State finances is the uncertainty regarding the implementation of the goods and services tax (GST) due to lack of consensus on certain issues between the Centre and the States. Given the uncertain revenue implications of the proposed introduction of GST, it is important for the States to undertake a careful management of their finances in the next few years. In the medium-term, improvement in the quality of States’ expenditure management along with a move towards fiscal transparency and adoption/ strengthening of fiscal rules needs attention.

Policy Initiatives

Macroeconomic developments during 2008-09 and 2009-10 necessitated the use of expansionary fiscal policy at the State level. The policy emphasis was on the generation of employment and tax exemptions/ reductions to boost growth prospects. In fact, a few States undertook dedicated fiscal stimulus packages aimed at higher expenditure and tax concessions. However, foreseeing better growth prospects, States presented their budgets for 2010-11 with a focus on tax-enhancing measures, while measures such as exemption/reduction in the rates of value added tax (VAT) and excise duties on certain goods were also announced to tackle the price rise in essential commodities. On the expenditure side, higher allocations were proposed for various Plan schemes (both Centrally sponsored schemes and State Plan schemes), particularly in education, health, transportation, housing and employment generation besides increasing expenditure on food security and strengthening the public distribution system (PDS). The creation of infrastructure such as roads and bridges and healthcare services as public-private partnerships (PPP) was proposed by some States. Institutional measures such as establishment/augmentation of the Guarantee Redemption Fund (GRF) and the appointment of committees/commissions to oversee fiscal parameters in the context of fiscal reforms and budget management were expected to be taken up by some States in 2010-11. This section briefly discusses policy initiatives and schemes that have been proposed by the State governments, the Government of India and the Reserve Bank that impinge on State finances.

State Governments

The broad thrust of policy proposals announced in State budgets for 2010-11 was to revert to the path of fiscal consolidation suggested by the Thirteenth FC, against the backdrop of improvement in the prevailing macroeconomic conditions and the need for steady growth.

On the revenue side, the policy measures were broadly targeted to augment tax revenues. The major tax policy initiatives include: (i) an increase in the rate of value added tax (VAT) on specific commodities such as tobacco and allied products (Arunachal Pradesh and Karnataka), (ii) the imposition of VAT on items such as compressed natural gas for use in the transport sector, Rassi, Ban & Newar, bio-inputs like fertilisers, micronutrients and plant growth promoters, kerosene stoves, lanterns and petromax and their spares, embroidery and zari items, motion picture distribution, and plastic/ glass scrap which were earlier exempted (NCT Delhi), (iii) increase in VAT rate on certain items such as diesel, desi ghee, plastic household items, plastic and tin containers including barrels, fertilisers, pesticides, weedicides, insecticides, herbicides, rodenticides and plant growth regulators, wood, timber, plywood and laminated boards, fittings for doors and windows, and furniture (NCT Delhi), and (iv) levy of surcharge on VAT (Haryana). Besides these, a few States have announced an increase in the VAT rate from 4 per cent to 5 per cent as decided by the Empowered Committee of State Finance Ministers. Apart from increasing the VAT rate, States also announced tax rationalisation measures, such as rationalising the excise duty structure (Goa and Assam), revising the Passenger Goods Taxation Act (Assam and Meghalaya), revising the entry tax rate to make it consistent with the VAT rate (Bihar), rationalising/revising the motor vehicle tax (Assam, Kerala, Manipur, Maharashtra and Mizoram), amending the VAT Act and e-services for luxury and profession tax (Maharashtra), rationalising stamp duties (Manipur) and amending/revising the Entertainment Tax Act (Orissa). Keeping in view the sharp rise in the prices of essential commodities, most States proposed exempting or reducing the VAT on certain foodgrains and goods for daily use.

Several States announced rationalisation of the stamp duty structure through measures such as reduced stamp duty rates (Karnataka, Kerala, Punjab and Uttarakhand), concession in rates (Jammu and Kashmir), exemption from stamp duty on specific transactions (Chhattisgarh and Kerala) and e- Stamping for specific purposes (Bihar). Apart from the introduction of new schemes for taxes on trades and e-Payments, e-Returns were proposed to be made compulsory in some States (Bihar). On the non-tax front, revenue enhancing measures announced by States included: (i) rationalisation of the licence fee for retail sale of liquor (Goa and Meghalaya), (ii) recruitment of talatis as a separate cadre in the revenue department to carry out revenue work such as collecting land revenue (Gujarat), (iii) disinvestment of the State PSUs (Jammu and Kashmir and Karnataka), (iv) sale of land and imposition of toll on vehicles of more than 16 tonnes weight (Karnataka), and (v) rationalisation of power tariffs and forest royalties (Manipur).

Apart from announcing tax exemption/reduction on certain items, various States proposed special allocation of resources during 2010-11 to contain rising food prices. Besides higher expenditure on food security, expenditure on socio-economic services particularly education, medical and public health, family welfare, irrigation, roads and bridges and rural development, emerged as a priority area of expenditure allocation during 2010-11, although growth in expenditure in some of these sectors was budgeted to be lower.

The policy initiatives relating to agriculture and allied activities have assumed significance in an environment of high food inflation. Himachal Pradesh, Karnataka, Maharashtra, Meghalaya, Orissa and West Bengal announced policy measures to enhance irrigation potential in order to increase agricultural productivity. The Government of West Bengal proposed that multipurpose cold storages and chain arrangements be established to ensure a fair price to farmers for their produce. To assist farmers, the State governments of Assam and Maharashtra announced that they would provide an interest subsidy on agricultural loans, while Nagaland will provide highyielding seeds and agricultural equipment to farmers. With a view to achieve self-sufficiency in foodgrain production, the Tripura government chalked out an action plan targeting higher foodgrain production in the State.

State governments attempted to promote industrial growth and industrialisation by providing the necessary infrastructure facilities and other incentives to industries within their regions. Towards this end, the major policy initiatives included the setting up of micro-level enterprises in every village (Assam), a Margin Money Grant scheme for assistance to entrepreneurs belonging to Scheduled Castes (SCs) and Scheduled Tribes (STs) (Chhattisgarh), a Venture Capital Fund and a Viability Gap Fund to raise capital (Goa), the Exclusive Entrepreneurs Development Programme for women to set up small and microenterprises and new emporiums called Haat-cumshilpgram to sell handicraft items (Goa), road networks linking ports, special economic zones (SEZs) and Special Investment Regions (Gujarat), facilitating marketing campaigns of handicrafts during the Commonwealth Games (Jammu and Kashmir), and improving infrastructure facilities to encourage the establishment of small and medium industries in every district (Karnataka). The Maharashtra government envisaged a policy for the golden quadrilateral of Mumbai-Pune- Nashik-Aurangabad as a focal point of agro-industries and industrial development. In order to enhance the competitiveness of industries, the State governments of Bihar, Chhattisgarh and Madhya Pradesh announced exemption/reduction of entry tax on raw inputs/ outputs used by industries.

The development of the social sector, particularly education, health, housing, social security, women empowerment and the welfare of SCs and STs, was emphasised by many States while presenting their budgets for 2010-11. The policy measures announced in State budgets also aimed to promote financial inclusion/banking services in States. These measures include: (i) an interest subsidy of 3 per cent for bank loans extended to self-help groups (SHGs) to increase the reach of cheaper credit to SHGs by banks (Arunachal Pradesh), (ii) strengthening Primary Agriculture Cooperatives and District Co-operative Banks as per the recommendations of the Vaidyanathan Committee (Gujarat and Karnataka), (iii) banking services at least one day in a week through branchless banking, and business correspondents and primary agricultural cooperative credit societies in villages with population up to 2,000 (Bihar) and (iv) enhancing the flow of credit to marginal farmers, especially BPL families, and providing seed capital (Meghalaya). The government of Nagaland proposed to extend the necessary assistance to set up banks in unbanked areas, while Uttarakhand proposed to establish ‘mini-banks’ in 428 villages during 2010-11. Rajasthan proposed to strengthen the co-operative movement through the Aggregate Co-operative Development Scheme.

The development of infrastructure and other services through Public Private Partnership (PPP) were another priority area in terms of States’ policy initiatives in 2010-11. This was sought to be achieved through (i) constructing bridges and citizen service centres to provide value added services to rural citizens (Andhra Pradesh), (ii) setting up an Infrastructure Development Fund (Goa), (iii) setting up an Infrastructure Development Board for financing, implementation, maintenance and operation of PPP projects (Haryana), (iv) transmission and distribution of energy and the construction of expressways (Uttar Pradesh), (v) setting up hospitals (NCT Delhi), and (vi) improving tertiary-level healthcare (Haryana).

The institutional measures adopted by State governments such as Fiscal Responsibility Legislations (FRLs), Value Added Tax (VAT), New Pension Schemes (NPS), setting up of a Consolidated Sinking Fund (CSF) and a Guarantee Redemption Fund (GRF) have helped them consolidate their finances in the past decade. The progress so far has been quite encouraging as all States have implemented VAT and also enacted FRLs. In fact, one of the major developments during 2010-11 has been the enactment of the Fiscal Responsibility and Budget Management (FRBM) Acts by the State governments of West Bengal and Sikkim, which is expected to facilitate restructuring of finances in these States, particularly in West Bengal that has chronic revenue deficits.

Government of India

Under the National e-Governance Programme, the Government of India approved a scheme to computerise State treasuries at an overall cost of `626 crore (with Central assistance of `482 crore). The scheme, to be implemented in about three years beginning in 2010-11, would support States and UTs to fill the existing gap in their treasury computerisation, upgrading, expansion and interface requirements, apart from supporting basic computerisation. It would make the budgeting process more efficient, improve cash flow management, promote real time reconciliation of accounts, strengthen the management information system, improve accuracy and timeliness in preparing accounts and bring about transparency and efficiency in the public delivery system in States and Union Territories. In this context, the detailed guidelines were communicated to all States and UTs to enable them to prepare their proposals. Two committees, viz., the Empowered Committee (EC) and the Programme Steering Committee, were constituted to implement the scheme.

The Central government announced steps towards management of food security in the country in consultation with State Chief Ministers to control food inflation in the economy. While the Direct Tax Code is to be introduced from April 1, 2012 the GST would be implemented once consensus on certain issues is achieved and the institutional setup is ready for its implementation. The government has already tabled the Constitutional Amendment Bill for GST in the Parliament on March 22, 2011. Acting on the assessment and recommendations of the Thirteenth FC, the Government of India appointed a committee to review the structure of the National Small Savings Fund (NSSF) and a Committee on revenue-deficit States to suggest ways to eliminate the revenue deficit (Kerala, Punjab and West Bengal).

Recognising that the Ladakh region of Jammu and Kashmir faces an extremely harsh climate and suffers from energy deficiency, the Government of India has proposed to set up solar, small hydro and micro-power projects. The Government of India announced a grant to the Government of Tamil Nadu towards the cost of installing a zero liquid discharge system at the effluent treatment plant in Tirupur to sustain hosiery industry without undermining the environment. A Special Golden Jubilee package was announced for Goa to preserve the natural resources of the State by restoring Goa’s beaches, which are prone to erosion, and increasing its green cover through sustainable forestry. Apart from increased plan allocation for school education in 2010-11, States were provided resources for elementary education under the Thirteenth FC grants for 2010-11. In order to encourage State Governments to create a slum-free India, the Union budget 2010-11 proposed to increase support to the States under Rajiv Awas Yojana in 2010-11. To encourage people in the unorganised sector to voluntarily save for their retirement and to lower the cost of operating the NPS for such subscribers, the Government of India announced its contribution of `1,000 per year to each NPS account to be opened during 2010-11. This initiative, Swalamban, would be available for people joining NPS with a minimum contribution of `1,000 and a maximum contribution of `12,000 per annum during 2010-11. Accordingly, an amount of `100 crore was allocated for the year 2010-11. A Mission Mode Project to computerise commercial taxes in States has been approved with an outlay of `1,113 crore, of which the Centre’s share is `800 crore; the project will lay the foundation for the launch of GST.

Reserve Bank of India

In January 2011, the Reserve Bank entered into a Supplementary Agreement under Section 21A of the Reserve Bank of India Act, 1934 with the Government of Jammu and Kashmir. Under the agreement, the Reserve Bank shall carry out the general banking business of the Government of Jammu and Kashmir and act as the sole agent for investment of Government’s funds w.e.f. April 1, 2011. On the recommendation of the State Government, the Reserve Bank has entered into an agreement with Jammu and Kashmir Bank Ltd., whereby Jammu and Kashmir Bank would act as an agent of the Reserve Bank for conduct of general banking business of the State Government.

Consolidated Fiscal Position of the State Governments

Accounts: 2008-09

The fiscal position of the States deteriorated somewhat in 2008-09 as revenue receipts were impacted by the overall macroeconomic slowdown, and revenue expenditure obligations grew with the implementation of the Sixth Central Pay Commission (CPC)/State Pay Commissions (SPCs) during the year. The fiscal outcome for 2008-09 at the consolidated level, however, turned out to be better than anticipated when the revised estimates were translated into accounts. Accordingly, the consolidated surplus in the revenue account was higher while fiscal deficit was lower in the accounts position relative to the revised estimates for the year. As a ratio of GDP, the consolidated revenue surplus improved marginally, from 0.19 per cent in 2008-09 (RE) to 0.23 per cent in 2008-09 (Accounts). The improvement in the revenue account reflected a sharper reduction in revenue expenditure than the shortfall recorded in revenue receipts in the accounts vis-à-vis the revised estimates for the year.

The reduction in revenue expenditure occurred particularly in the development component, which declined sharply in 2008-09 (Accounts) over 2008-09 (RE). The decline was seen across major categories of development revenue expenditures, viz., ‘education, sports and art and culture’, ‘medical and public health’ and ‘rural development’. Non-development revenue expenditure was also lower and contributed more than one-fourth of the decline in revenue expenditure in 2008-09 (Accounts) over 2008-09 (RE). Within nondevelopment revenue expenditure, committed expenditure comprising administrative services, pension and interest payments declined by 4.1 per cent in 2008-09 (Accounts) over 2008-09 (RE).

The revenue receipts in 2008-09 (Accounts) turned out to be lower than the revised estimates, due to a decline in transfers from the Centre and own tax revenues of States. Grants from the Centre as well as the States’ share in Central taxes declined in 2008-09 (Accounts) over 2008-09 (RE), thereby contributing around 85.3 per cent to the total decline in revenue receipts. Reflecting the impact of moderation in overall economic activity in the Indian economy, States’ own tax revenue (OTR) collections in 2008-09 (Accounts) also fell short of the revised estimates.

This was, however, partly compensated by an increase in States’ own non-tax revenue receipts (ONTR) in 2008-09 (Accounts) over 2008-09 (RE). The marginal improvement in revenue account was reflected in a decline in the Gross Fiscal Deficit to GDP (GFD-GDP) ratio, from 2.6 per cent in 2008-09 (RE) to 2.4 per cent in 2008-09 (Accounts). The decline in capital outlay to the extent of 9.3 per cent over the revised estimates led to a further decline in the GFDGDP ratio. Consequently, the consolidated GFD of the States declined in 2008-09 (Accounts) as compared with 2008-09 (RE). Reflecting the decline in GFD, the States were able to compress the primary deficit in 2008-09 (Accounts) over 2008-09 (RE) (Table 1).

Revised Estimates 2009-10

The deterioration in State finances persisted in 2009-10 as a few State governments, perceiving a further slowdown, announced dedicated fiscal stimulus measures including higher spending on infrastructure, while some other States announced tax exemptions and a reduction in their own tax rates to boost economic activities. The consolidated revenue deficit, therefore, re-emerged in 2009-10 after a gap of three years and GFD was higher in the revised estimates compared with budget estimates. The deterioration in the revenue account occurred as the marginal increase in total revenue receipts was more than offset by a surge in revenue expenditures of the States in 2009-10 (RE) over 2009-10 (BE). The revenue deficit as a ratio to GDP (RD-GDP) at 0.7 per cent in 2009-10 (RE) was marginally higher than 0.5 per cent in 2009-10 (BE).

According to the revised estimates of 2009-10, States’ tax receipts declined over the budget estimates of that year, reflecting a perceptible fall in States’ share in Central taxes and a marginal decline in States’ OTR. The sharp fall in the Centre’s gross tax revenues in the wake of the economic slowdown led to lower than budgeted transfers under the States’ share in Central taxes in 2009-10 (RE). States’ OTR also recorded a marginal decline as revenue collections from stamp and registration fees, professional tax and land revenue fell short of their budgeted levels. States’ non-tax revenues, however, rose, particularly on account of a sharp rise in the ONTR component, while grants-in-aid from the Centre increased moderately in 2009-10 (RE) over 2009- 10 (BE). The improvement in the ONTR of States over the budgeted levels reflected higher collections from education, sports, art & culture; power; irrigation and interest receipts. Consequently, as the fall in tax receipts was entirely compensated by a rise in their non-tax revenue receipts, States recorded marginally higher than budgeted revenue receipts during 2009- 10 (RE) (Table 2).

The increase in revenue expenditures of States in 2009-10 (RE) over 2009-10 (BE) was attributable entirely to an increase in development expenditure pertaining to education, sports and art & culture; relief on account of natural calamities; power; irrigation and transport & communications. The States were able to contain their non-development expenditure mainly in respect of committed expenditure (by `3,613 crore) in 2009-10 (RE) over the budget estimates. As per 2009- 10 (RE), expenditures on administrative services and interest payments were lower than their respective budget estimates. However, expenditure on administrative services was higher in 2009-10 (RE) over 2008-09 (Accounts), reflecting the impact of the increase in wages and salaries on account of the implementation of the Sixth CPC/SPCs during the year.

In view of the overall macroeconomic slowdown, the Central Government had allowed States to increase the limit of fiscal deficit to 4.0 per cent of GSDP during 2009-10. Thus, the States were allowed to raise additional market borrowings to the extent of 0.5 per cent of GSDP in 2009-10. This additional fiscal space was to be utilised for undertaking capital investments. While capital outlay and net lending of State governments remained close to their budgeted levels, the increase in GFD-GDP ratio from 3.0 per cent in 2009-10 (BE) to 3.3 per cent in 2009-10 (RE) was mainly due to an increase in revenue deficit over the budget estimate (Table 2 and Appendix Table 1).

Budget Estimates 2010-11

The deterioration in State finances during 2008-09 and 2009-10 resulting from countercyclical fiscal stimulus measures, a cyclical slowdown in growth of tax revenues mirroring the economic scenario (particularly in 2008-09) and the implementation of the Sixth CPC/SPCs led to a considerable departure from the targets envisaged under the FRLs of States during these two years. However, given the robust growth outlook for 2010-11, the States’ fiscal position was expected to improve. The commitment of the States towards reverting to the fiscal consolidation path was evident from the budget estimates of key fiscal indicators for 2010-11 (Appendix Table 2).

The consolidated revenue account of the State governments was budgeted to improve, with the revenue deficit placed lower at 0.3 per cent of GDP in 2010-11 (BE) as against 0.7 per cent in 2009-10 (RE). The improvement in the revenue account during 2010-11 (BE) reflects growth in revenue receipts, outstripping that in revenue expenditure. Revenue receipts were budgeted to show an increase mainly on account of higher growth in own tax revenues and States’ share in Central taxes in 2010-11 (BE) (Table 3).

The decline in the revenue deficit-GDP ratio in 2010-11 (BE) along with lower capital outlay as a ratio to GDP was expected to contain the GFD at 2.5 per cent of GDP in 2010-11 (BE) compared with 3.3 per cent in 2009-10 (RE).

With the revenue deficit being budgeted to decline, a notable positive feature emerging from State finances was that capital outlay would account for a higher proportion of GFD in 2010-11 (BE) compared with 2009-10 (RE) (Statement 1). It may be noted that from 2006-07 to 2008-09, States’ capital outlay was higher than GFD, indicating that not only entire borrowings but a portion of revenue receipts was also spent on capital outlays. If most States are able to achieve a revenue balance or surplus by 2011-12 as envisaged by the Thirteenth FC, it would again restore the capital outlay-GFD ratio to 100 per cent or above and, thereby, help enhance the long-term growth potential of States.

States appeared to be reasonably optimistic regarding growth prospects, as evident from the higher budget estimates of both OTR and tax devolution from the Centre during 2010-11. While the economic slowdown had moderated States’ OTR in 2008-09 and 2009-10 (RE), its impact on statutory transfer of tax revenues from the Centre to the States was more perceptible. In 2010-11(BE), States’ OTR and share in Central taxes were budgeted to increase significantly as compared with 2009-10 (RE). The increase in States’ share in Central taxes is in line with the expected buoyancy in gross tax revenues of the Centre. In contrast, growth in the consolidated non-tax revenue receipts of States was expected to decelerate during 2010-11 (BE) with the lower growth budgeted for grants from the Centre to the States and States’ ONTR as compared with 2009-10 (RE).

Revenue receipts as a ratio to GDP (RR-GDP) were budgeted to decline from 12.3 per cent in 2009-10 (RE) to 11.6 per cent in 2010-11(BE). Even though higher tax buoyancy was anticipated at the Central level and a rise in the share of States in the net proceeds of shareable central taxes has been recommended by the Thirteenth FC, transfer through tax devolution from the Centre to States as a ratio to GDP in 2010-11 was expected to remain stable at the previous year’s level.

With declining grants and stable non-tax revenue (as ratio to GDP), the overall current transfers to States are budgeted to decline by 0.4 percentage points of GDP in 2010-11 (BE). On the States’ own revenue collection front, the ratio of their OTR to GDP was budgeted to decline from 5.6 per cent in 2009-10 (RE) to 5.4 per cent in 2010-11 (BE). Nevertheless, States expected higher collections from all major taxes, viz., VAT, stamp duty and registration fees, State excise duty and property tax. States’ ONTR-GDP ratio was budgeted to remain marginally lower in 2010-11, mainly due to a decline in interest receipts and non-tax revenue from the power sector of State governments. As noted by the Thirteenth FC, the current level of recovery on loans advanced by the States is extremely poor (Appendix Table 3).

Growth in the consolidated revenue expenditure of State governments was budgeted to decelerate significantly in 2010-11 (BE) as compared with 2009- 10 (RE) mainly due to lower growth expected in development revenue expenditure (both social and economic services). All major categories of social services expenditure, viz., education, sports, art & culture, medical and public health, family welfare, social security & welfare, welfare of SC/ST & other backward classes and urban development, were expected to show lower growth in 2010-11 (BE). In economic services, the States’ expenditure on food storage & warehousing, co-operation, special area programmes, power and transport & communications sectors was budgeted to decline (in absolute terms) in 2010-11. In contrast, growth in revenue expenditure on rural development was placed marginally higher than in the previous year. Non-development revenue expenditure, contributing 37.5 per cent of total revenue expenditure, was budgeted to show a lower growth in 2010-11 mainly on account of lower interest outgo on loans from the Centre and only a modest rise in other major components of committed expenditure, viz., pensions, administrative services. Accordingly, committed expenditure as a ratio to revenue receipts was expected to decline marginally to 33.6 per cent in 2010-11 (BE) (Appendix Table 5 and 6).

At a consolidated level, States budgeted a lower growth in capital receipts for 2010-11 (BE) as compared with 2009-10 (RE), mainly on account of lower recovery of loans and advances and special securities issued to the National Small Savings Fund (NSSF). However, loans from the Centre were budgeted to increase during the same period. Similarly, States budgeted a moderate increase of 5.8 per cent in market borrowings (gross) to be raised in 2010-11 [an increase of 18.3 per cent in 2009-10 (RE) over 2008-09]. In 2009-10 (RE), small savings and provident fund collections (net) had increased significantly by 55.3 per cent, partly reflecting the impact of arrears received by State government employees. However, only a moderate decline of 7.7 per cent was expected in small savings and provident funds (net) in 2010-11 (BE). As regards the composition of capital receipts, the States’ increasing dependence on market borrowings was evident in 2010-11 as well. While loans from the Centre (gross) were budgeted to account for 6.4 per cent in 2010-11 as against 5.4 per cent in 2009-10 (RE), the share of NSSF in capital receipts was budgeted to decline marginally in 2010- 11 (BE) (Appendix Table 7).

While announcing their budgets, many State governments had proposed to undertake higher capital expenditure in 2009-10. In 2010-11 (BE), the level of capital expenditure was expected to record only a modest growth as compared with 2009-10 (RE). While States budgeted lower growth in capital outlay for development activities (1.6 per cent as against 12.0 per cent in 2009-10), the same for non-development activities was expected to be much higher at 58.0 per cent as against 25.5 per cent in 2009-10 (RE), although it accounted for merely 6.3 per cent in capital outlay. Similarly, loans and advances by the State governments were budgeted to decline by 14.5 per cent in 2010-11. In short, lower resource availability for development activities, as evident from the pattern of capital expenditure in 2010-11 (BE), raises concerns about the quality of fiscal adjustment being undertaken by the States.

A trend analysis shows that the composition of transfers from the Centre to States largely depends on the macroeconomic situation in the Indian economy. Based on the cyclical behaviour of tax devolutions and grants-in-aid, it is found that the former moves positively with GDP while the latter is associated negatively. Such a trend was observed during 2008-09 and 2009-10 (RE) when tax devolution from the Centre was substantially lower (in terms of growth as well as a ratio to GDP) than during the upswing period, which to some extent was compensated through higher grants from the Centre. With growth recovery in 2010-11 (BE), States expected to receive higher resources through tax devolution (in absolute terms) while their dependence on grants was expected to diminish (in terms of GDP). Gross transfers from the Centre (i.e., shareable taxes, grants-in-aid and loans from the Centre) were budgeted to decline from 5.5 per cent of GDP in 2009-10 (RE) to 5.1 per cent in 2010-11 (BE) mainly due to expected decline in grants as a ratio to GDP (Appendix Table 4).

Given the development needs of States, it is important to examine the trends in development as well as social sector expenditure of States. The pattern of aggregate expenditure of States in 2010-11 (BE) showed a decline in the share of development expenditure in total expenditure following a sharp decline in the share of development capital outlay, particularly in the case of economic services, viz., food storage and warehousing, co-operation and power projects. States’ loans and advances for development purposes were also budgeted to decline in absolute terms in 2010-11 with a corresponding decline in their share in total development expenditure. A major portion of development expenditure continued to be expended through the revenue account of States (Appendix Table 5).

A gradual rise in the share of social sector expenditure in the aggregate expenditure of States was evident in recent years, which, however, was expected to rise marginally in 2010-11 (BE). The ratio of social sector expenditure to GDP (SSE-GDP) was, however, likely to decline in 2010-11 (BE) as compared with 2009-10 (RE). Notwithstanding a decline in SSE-GDP ratio in 2010-11 (BE), education, sports, art & culture, medical and public health continued to be priority areas for State governments.

The consolidated revenue deficit, which reemerged at the State level in 2009-10 (RE) after a gap of three years, contributed around one-fifth of the GFD. Since the revenue deficit was budgeted to decline in 2010-11 (BE), its share in GFD would also decline accordingly. Capital outlay would continue to be the dominant component in States’ GFD in 2010-11 (BE). With the phasing out of loans from the Centre as recommended by the Twelfth FC and a decline in collections under NSSF, market borrowings have become a major source of financing the GFD in recent years. A similar trend was observed in 2010-11 (BE), as a major portion of the GFD would be met through market borrowings, followed by small savings and provident funds.

Outstanding Liabilities and Market Borrowings of State Governments

An inter-temporal comparison shows that the consolidated outstanding liabilities of States as a ratio to GDP steadily increased from 1997-98 to 2003-04. With the debt relief mechanism prescribed by the Twelfth FC, which incentivised adherence to a rulebased fiscal regime, the States were able to contain the magnitude of outstanding liabilities to 26.6 per cent of GDP by 2007-08. The declining trend in the debt-GDP ratio persisted from 2008-09 to 2010-11. The additional expenditure obligations emanating from revised pay structures and expansionary fiscal policy measures announced by a number of State governments led to higher levels of debt in 2008-09 and 2009-10, which grew by 10.7 per cent and 11.4 per cent in 2008-09 and 2009-10, respectively, compared with an increase of only 7.0 per cent in 2007-08. In spite of higher levels of outstanding debt in 2008-09 and 2009-10 (RE), the aggregate debt-GDP ratios of States recorded a decline during the same period. Importantly, the aggregate debt-GDP ratio at 25.0 per cent in 2009-10 (RE) was well below the level of 30.8 per cent recommended by the Twelfth FC. In 2010-11 (BE), the outstanding debt- GDP ratio of the States was likely to decline further to 23.1 per cent. States were allowed to raise additional market borrowings to the extent of 0.5 per cent of GSDP each in 2008-09 and 2009-10 which were to be utilised for undertaking capital investment. Accordingly, the GFD-GSDP target was relaxed from 3.0 per cent to 3.5 per cent in 2008-09 and further to 4.0 per cent in 2009- 10. States seem to have resorted to this additional provision of borrowings in 2008-09 with incremental market borrowings at the consolidated level relative to GDP turning out to be higher at 0.8 per cent. Although the incremental market borrowing-GDP ratio at the consolidated level declined slightly during 2009-10, the incremental market borrowings were higher in absolute terms. Notwithstanding the increase in market borrowings in 2008-09 and 2009-10, the consolidated debt-GDP ratios of State governments declined as the share of other debt components fell and nominal economic growth turned out to be higher than that in outstanding debt (Appendix Table 8 and Statement 2).

The composition of States’ outstanding liabilities has witnessed a noticeable change in recent years. With the increasing emphasis on financing GFD through market borrowings, its share in outstanding liabilities of State governments has increased gradually, while the dependence on loans from the Centre declined sharply from 1999-2000 onwards. In 2009-10 (RE), market borrowings emerged as a dominant component with a share of 31.5 per cent in total outstanding liabilities of the State governments, which was expected to further increase to 35.6 per cent in 2010- 11 (BE). In contrast, the share of the special securities issued to National Small Savings Fund (NSSF) has declined persistently since end-March 2008. The Special securities issued to NSSF expected to account for around one-fourth of the total outstanding liabilities as at end-March 2011. The share of high-cost debt instruments, i.e., public account items like ‘small savings’ and ‘State provident fund’ in total outstanding liabilities has remained in the range of 12.1-12.3 per cent since 2005-06. Considering the burden arising as a result of the high effective rate of interest on NSSF loans taken by States till 2006-07, the Thirteenth FC has recommended interest relief on these NSSF loans, with a precondition relating to the enactment of the FRL.

As already mentioned, there has been greater reliance on market borrowings by State governments to meet their resource requirements. This was evident during 2008-09 and 2009-10 when States had to undertake counter-cyclical measures in the wake of the impact of the global economic downturn on domestic economic activity. The higher amount of market borrowings raised during this period was facilitated by additional provisions allowed by the Centre (Table 4). As a result, the outstanding stock of State Development Loans (SDLs) recorded an increase of 34.6 per cent and 28.6 per cent in 2008-09 and 2009-10, respectively, compared with an increase of 23.0 per cent in 2007-08. The interest rate profile of outstanding stock of SDLs shows that the share of high-cost market loans (interest rate over 10 per cent) declined further during 2009-10. The share of outstanding stock of SDLs with interest rates of 10 per cent and above declined sharply from 10.1 per cent as at end-March 2009 to 4.7 per cent as at end-March 2010. However, the share of outstanding SDLs with interest rates ranging between 8-10 per cent increased from 34.4 per cent at end-March 2009 to 44.8 per cent at end-March 2010, which indicates that incremental debt was raised at somewhat higher cost in 2009-10.

Keeping in view the surplus cash position of the State governments, the WMA limits of State governments have been left unchanged since 2006-07. Accordingly, the aggregate normal WMA limit for States for 2009-10 was `9,925 crore and the limit had been retained for 2010-11. The rate of interest on normal and special WMA and OD continue to be linked to the repo rate. Most State governments have accumulated sizeable cash surpluses in recent years, which reflected, inter alia, the fiscal consolidation process undertaken since 2005-06. The temporary setback to fiscal consolidation in the wake of the global crisis, however, did not impact the surplus cash position of the States, as the liquidity pressures remained confined to a few State governments. The position in respect of outstanding WMA/OD remained relatively comfortable during 2009-10. Although the dependence of most of the States on WMA/OD remained moderate in 2010-11, two chronic revenue-deficit States, viz., West Bengal and Punjab, depended heavily on WMA/OD to meet their temporary resource gaps in the months of October and November 2010.

Since the middle of 2004-05, most States have tended to accumulate sizeable cash surpluses. Despite expenditure pressures on account of pay revisions and fiscal stimulus measures undertaken in 2008-09 and 2009-10, most States continued to accumulate surplus cash balances which they invested in 14-day Intermediate and Auction Treasury Bills (ITBs and ATBs), although temporary dips were observed in some months. Monthly data shows that a major portion of cash surpluses is carried forward by the State governments into the next year. As on March 18, 2011 the investment in 14-day ITBs by the State governments stood at `1,20,318 crore, which has significant implications for monetary policy. Importantly, since mid-June 2010, States’ investments in ATBs have shown substantial increases, reflecting its positive return differential over ITBs.

Special Theme – Finance Commissions in India: An Assessment

In December 2009, the Thirteenth FC submitted its Report recommending (i) a rise in the share of net proceeds of shareable taxes from 30.5 per cent (Twelfth FC) to 32 per cent for the award period of 2010-11 to 2014-15, and (ii) a rise in the indicative ceiling on all revenue account transfers to the States from 38.0 per cent to 39.5 per cent of the Centre’s gross revenue receipts. In addition, the Thirteenth FC also, inter alia, recommended a revised fiscal map for the Centre and the States. In order to assess the evolving role of Finance Commissions in the context of Centre- State finances, the topic on ‘Finance Commissions in India: An Assessment’ was chosen as a special theme.

Examining the role of various FCs, it was observed that apart from the constitutional tasks of deciding the proportion of tax revenue to be shared with the States and the principles governing the grants-in-aid of the revenues of the States, the scope of the FCs has broadened over time as they were assigned several other issues on government finances, particularly those relating to augmentation of State Consolidation Funds to supplementing the resources of local bodies and debt-related issues. The approach of successive FCs, however, varied as they addressed concerns raised by States from time to time regarding the composition of the divisible pool of Central taxes and inter se distribution criteria. Recent constitutional changes have simplified the sharing arrangement of the divisible pool of Central taxes by clubbing all shareable Central taxes and excise duties. While determining the formula for horizontal distribution of inter se shares of States, various FCs attempted to correct the differentials in revenue capacity and cost disability factors inherent in the economies of States, and foster fiscal efficiency at the State level. However, differences have been noticed in selection, definition and weight of variables that have been used by FCs to prescribe the devolution formula for Central taxes. More recently, the Thirteenth FC has placed greater emphasis on fiscal capacity distance and fiscal discipline, which is expected to facilitate greater convergence among the States. In the context of grants, there has been some shift from a gap-filling approach to a normative assessment of resource requirements and expenditure. The pattern of transfers through the FC channel showed that the share in Central taxes has persistently been the predominant component of revenue sharing since the First FC.

Using the framework provided by Rangarajan and Srivastava (2008)² to separate the vertical, horizontal and residual components of per capita FC transfers to the States, an attempt was made to assess the degree of equalisation achieved across the States since the Tenth FC. It was found that equalisation component of transfers was highest in the case of Eleventh FC as the gap between recommended and benchmark transfers was minimum.