State Fiscal Reforms in India: Progress and Prospects

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State Fiscal Reforms in IndiaProgress and
Prospects

• November 23, 2004

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Background and context

• Banks first state report in 1996 on Orissa.
  Since then, it has authored 12 fiscal/economic
  reports on 9 states prepared 8 SALs in 5 states.
• This stock-taking report looks for feasible
  solutions across states. It aims to share lessons
  of state-level fiscal reforms to date and
  suggests what more can be done.
• It has a developmental focus.
• Unlike our state reports, it also looks at
  cross-state/GoI issues the rules of the games

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Structure of the Presentation

• Introduction
• Expenditure Restructuring
• Reforms to Improve Expenditure Quality
• Tax Reforms
• The borrowing and grant regime.
• Scenarios and conclusion

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A. INTRODUCTION
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State coverage

• Focus is on the 16 large, general category states
  (93 of the population)
• Within that, special focus on the 7 poorest
  states p.c incomes of less than Rs 10,000
  Bihar, Chattisgarh, Jharkand, Madhya Pradesh,
  Orissa, Rajasthan, UP.
• The average per capita income in the poor states
  has fallen from 71 in 1980/81 to 54 of the
  All-India average in 1999/2000.

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Average real per capita income growth
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The state-level fiscal crisis of the 1990s

• A slow secular deterioration in state fiscal
  performance over the 80s and 90s was catalysed
  into a crisis by the Fifth Central Pay Commission
  Pay Awards.
• A sharp increase in spending alongside declining
  revenues led to much higher deficits and debt
  accumulation.
• Off-budget liabilities also increased sharply.
• Poor states saw the worst deterioriation.

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State deficit and debt levels
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State- level debt/GSDP poor and other states
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The fiscal deterioration had a negative
developmental impact

• Once one adjusts for the large increases in
  interest and pension payments, and for the large
  real salary increase, aggregate spending has
  continued the downward trend in state
  expenditure/GDP observed during the early
  nineties.
• Real growth slowed or halted in priority spending
  areas such as education and health.
• The quality of spending worsened as expenditures
  became more salary-intensive, especially in the
  poorer states.

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Aggregate expenditure trends for Indias states
as a percentage of GDP
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Recent years have shown signs of improved fiscal
performance.

• The intensified revenue effort appears to be
  paying off.
• The wage bill is being restrained.
• Interest rates are falling also through
  debt-swap scheme
• Liquidity has improved
• There are success stories Haryana Karnataka.

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But fundamental concerns remain.

• The primary deficit has fallen, but revenue and
  fiscal deficits remain stubbornly high.
• Debt levels continue to increase Indias states
  are the most highly indebted in the world.
• Poor states are showing fewer signs of recovery.
• Reform fatigue yet without further
  comprehensive reforms, the situation will only
  deterioriate.

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Trends in state deficits
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State fiscal deficit poor states and others
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There is a broad consensus on reform objectives

• To meet pressing developmental challenges, states
  need to
• spend more in priority areas.
• spend more effectively.
• To finance the required spending increases, while
  at the same time reducing the deficit, states
  need to
• restructure expenditure
• reform tax policy and administration
• This report asks what needs to be done by the
  centre as well as the states to achieve these
  objectives.

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B. EXPENDITURE RESTRUCTURING
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Salaries

• Salaries make up 30 of spending.
• A policy of hiring and and real wage restraint
  can deliver significant fiscal gains 2 of GDP
  in the next 10 years.
• On pay restraint
• Most public sector employees are overpaid
  relative to their private sector counterparts.
• Another cross-the-board pay increase would undo
  whatever progress has been made in recent years.
• Central leadership is key but states also have a
  role different states offer different terms to
  both existing and new employees
• On hiring restraint.
• VRS has not worked, but hiring requirements can
  be temporarily offset by attrition-led downsizing
  in other areas.

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Starting Basic Salary of a Primary School Teacher
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Pensions

• Growth in the pension bill can be contained by
  parametric and structural reforms.
• Parametric reforms (to current Defined Benefit
  (DB) scheme)
• As per RBI report
• Crack down on abuse
• Structural reforms (switch to Defined
  Contribution (DC) scheme)
• Short-term fiscal cost for long-term gain
• NPC of DC to government is two-thirds of DB scheme

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Subsidies

• Though subsidies are the normal focus of
  expenditure restructuring reforms, success on
  this front is much more difficult.
• The failure of reform in the agricultural segment
  of the electricity sector illustrates the
  difficulties.
• There are no assured paths to success, and
  institutional experimentation is needed.
• Instilling commercial discipline into subsidized
  sectors is a sine qua non. In some areas,
  privatization might be the only way to do this.
• The aim should be to manage and control rather
  than eliminate subsidies.

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Public enterprise reforms

• PE reforms will not provide large, immediate
  fiscal gains, but will prevent the need for
  budgetary support to loss-makers and the future
  build up of liabilities.
• Political commitment and institutional capacity
  are critical to success.

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C. REFORMS TO IMPROVE EXPENDITURE QUALITY
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Improvements in customer satisfaction with
various services in Bangalore over a 10-year
period.
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5 ways to improve the quality of expenditure

• 1. Agency specific reforms, incl. an increased
  role for the private sector.
• 2. Strengthening the enabling environment
• Promoting citizen demand,
• Increasing transparency
• controlling transfers
• Establishing/strengthening anti-corruption
  agencies
• 3. Improving public expenditure management
• Budgeting realistically and implementing the
  budget as announced,
• Enhancing departmental accountability and
  flexibility.
• Strengthening budgetary controls over open-ended
  obligations and capital projects,
• Tightening accounting and auditing arrangements

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Quality of expenditure (cont.)

• 4. Capacity building is critical for reforms and
  performance.
• 5. Improving the quality and increasing the
  quantity of productive expenditure go hand in
  hand it is not one or the other.

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D. REVENUE REFORMS
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Trends in states own revenues as a percentage of
GDP
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Revenue Reform Objectives

• To increase revenue
• To broaden the tax base
• To simplify the system and reduce corruption

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VAT the most important revenue reform

• The introduction of VAT should be on the basis of
  floor rather than uniform rates to avoid loss of
  revenue, preserve tax autonomy, and minimize need
  for compensation.
• It would be better if all states introduced VAT
  at the same time, but no single government should
  have a veto.
• Eliminating the tax on inter-state exports should
  be done regardless of VAT introduction
• Taxation of services should be transferred to the
  states, and integrated with the VAT.
• Even after state-level VAT introduction, Indias
  indirect tax system will still be very complex.
  The ultimate goal should be a unified
  centre-state VAT.

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Other revenue reforms

• The professions tax can be viewed as an income
  tax supplement potentially important, but
  currently neglected.With an increase in the
  constitutional ceiling and better administration,
  tax take could increase from 0.1 to 0.9 of GDP.
• Well-known reform formula for SR
• Transport tax cars and 2-wheelers are undertaxed
  relative to buses
• Non-tax revenues have stagnated and need more
  policy attention from government.

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Tax administration

• Tax administration reforms are probably more
  important than tax policy reforms both to
  increase revenue and to reduce corruption -- but
  have received less attention.
• Reducing discretion and official-taxpayer
  interaction functional CTD organization
  self-assessment with risk-based audit
  computerization citizen feedback.
• Modernizing field enforcement and check posts.
• Crack-down on evasion in excise.
• Strengthening inter-jurisdiction revenue
  coordination.

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E. BORROWING and GRANT REGIME
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Borrowing current situation recent trends

• Trends in composition of resource transfers over
  the 90s have been adverse for the states, who
  have received a greater share of their transfers
  in the form of debt, and a smaller share as
  grants.
• The strengths of the sub-national borrowing
  regime are its ban on offshore borrowing, and
  limited history of bailouts. The weaknesses are
  the looseness of overall central control, and
  absence of market-based discipline, leading to
  excessive debt accumulation by states.

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Resources other than own-revenue used by states
to finance expenditure
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Reforms to the borrowing regime

• The most important reform would be to introduce
  an aggregate borrowing cap and allow for greater
  flexibility over choice of borrowing instruments
  within that cap.
• GoI has begun to move in that direction. Next
  steps could include
• Formalizing the cap methodology, and publishing
  the individual, annual caps with the budget
• Requiring all states to get credit-rating and to
  go to the market on their own at least if they
  want additional market access.

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Debt restructuring debt relief

• Debt-restructuring is consistent with shifting to
  flexibility within a cap.
• Debt relief (HIPS) is more problematic
• Problems of moral hazard
• Creditor more indebted than debtor.
• Goals of debt relief can be achieved by cash
  grants
• Any shift to debt relief should be accompanied by
  irreversible, structural changes in the borrowing
  regime.

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Legislation to control borrowing

• India has gone down the autonomous route to
  FRAs in a federation (US, Canada, Australia),
  rather than the coordinated route (Brazil)
• 5 states have passed FRAs. Experience so far is
  mixed.
• For FRAs to work, there needs to be buy in
  internal commitment and external pressure.
• GoI can play a critical role here by monitoring
  state performance against their own fiscal
  responsibility legislation.

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Grants current situation and recent trends

• Federal transfer system is progressive, but only
  moderately so.
• It is becoming more progressive over time.
• Opinions are divided on how to reform the grant
  regime it is also institutionally complex there
  are various reform options reforms will in any
  case be incremental.

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P.C. revenues for the major states, 2001/02
(normalized)
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State revenues before and after transfers (formal
and FCI), 2000/01
Note Per capita subsidy implicit in Food
Corporation of India procurement of food produce
(from World Bank, 2004e) added to formal
transfers from GoI.
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Transfers from GoI to the poor states as a
percentage of total transfers
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Possible policy reforms to the grant regime

• De-link block grants and loans
• Eliminate hidden transfers (e.g. farm
  procurement, CST)
• End reliance on projected deficit levels for FC
  grants (gap-filling).
• Introduce a Representative Tax System to provide
  a revenue floor.
• Rationalize CSSs.
• Strengthen reform-linked schemes.
• Reforms to increase GoI tax/GDP ratio

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Institutional reforms

• Make Finance Commission a permanent body.
• Give central agency mandate to collate and
  improve state-level fiscal data
• Overhaul role of Planning Commission.
• Make role of external funding agencies consistent
  with fiscal federal reforms e.g. use donors to
  facilitate state reforms

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F. SCENARIO AND CONCLUSION
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Reform scenario results

• The scenarios conducted show that it is possible
  with the reforms presented in the report to
  eliminate the state-level revenue deficit by
  2007/08 while protecting/enhancing capex and
  non-wage OM.
• The scenario results suggest four points
• The situation today is more favourable than 5
  years ago.
• State-level fiscal adjustment and empowerment can
  be achieved as a joint centre-state project.
• Achievement of fiscal adjustment for the poorer
  states is possible only with successful central
  tax reforms.
• Esp. for poorer states, revenue balance implies
  large primary surplus, and more scope for
  increasing capex than non-wage OM.

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Conclusion the report in 13 messages

• EXPENDITURE
• A policy of hiring restraint (zero net hiring)
  and real wage restraint can deliver significant
  fiscal gains.
• Growth in the pension bill can be contained by
  parametric and structural reforms.
• There are no sure paths to subsidy reduction, but
  better subsidy management and more commercial
  discipline in subsidy-receiving sectors are
  critical.
• The quality of spending can and must be improved

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Conclusion (cont).

• REVENUE
• VAT introduction should be voluntary, and on the
  basis of floor rates.
• Tax base of the states should be increased by
  service taxation and enhancement of the
  professions tax limit.
• Tax administration reforms are more important
  than tax policy reforms, though they have
  received less attention.

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Conclusion (cont.)

• TRANSFERS loans grants
• States should be given more borrowing flexibility
  within firmly established global caps.
• Reforms to the grant system should aim to make it
  both more progressive and more performance-oriente
  d.
• In a fiscally stressed system, an increase in the
  GoI tax/GDP ratio is critical, especially for the
  poorer states.
• INSTITUTIONS
• A central agency should be given the mandate to
  collate and improve state-level fiscal data.
• The plan-non-plan distinction should be
  abolished.
• Adoption of fiscal responsibility legislation by
  all states,and its monitoring by GoI and external
  agencies, will provide important institutional
  backing for state-level fiscal reforms.

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Thank you!