The Death Of Fiscal Federalism

Jayati Ghosh

THE crippling role of the debt burden in affecting the finances of state governments in India is now well known. It is widely recognised that the large overhang of debt of almost all state governments has implied such large interest payments that the States are effectively crippled with respect to the ability to undertake important socially necessary expenditure. Since the States are dominantly responsible for most of the types of public expenditure which affect the day-to-day life of the people, ranging from law and order and basic infrastructure to health, sanitation and education, the fiscal crisis of the States has meant that these expenditures have been very adversely affected in most parts of India.

RESTRUCTURING DEBT OF THE STATES

The need to restructure the debt of the States has been widely accepted, for several reasons. The first is the adverse impact on expenditure noted above. The second is the fact that for some years now, the States have been paying higher interest rates for a variety of reasons discussed below. The rules imposed by the Reserve Bank of India, which require case by case permission to States for accessing commercial debt in they are running revenue deficits, have also operated to make borrowing difficult and have driven several States to high-conditionality debt from multilateral agencies such as the World Bank and the Asian Development Bank.

The Twelfth Finance Commission (hereafter TFC) specifically addressed this issue, as one of its terms of reference specified that “the Commission may, after making as assessment of the debt position of the States as on March 31, 2004, suggest such corrective measures as are deemed necessary, consistent with macroeconomic stability and debt sustainability.”

The high interest payment obligations of States is one of the principal reasons for the tremendous pressure on their finances. Some attempt to reduce this pressure has been made since September 2002 under the debt-swap scheme of the central government, under which “high-cost debt” (i.e. carrying an interest rate of 13 per cent or above) on state plans or small savings could be exchanged for market borrowings and small savings securities, which at that point carried interest of around 7 per cent.

Until March 2005, around Rs 103,000 crore of state government debt was swapped under this scheme. This reduced the average interest rate paid by States to some extent, and also changed the composition and maturity profile of the debt, but not the overall stock of the debt. However, the rather limited nature of the swap has limited the beneficial effects for the States.

The TFC has introduced a package for debt reduction with two main components. The first is the consolidation of all State debt outstanding to the Centre on March 31, 2004, at an interest rate of 7 per cent to be repaid over 20 years. The second, and much more problematic, proposal is a new debt relief scheme linked to the reduction in the revenue deficits of States.

Under this scheme, the repayments due on Central loans from the current year to 2009-10 (after consolidation) will be eligible for write-off, but the amount of write-off of repayment will be linked to the absolute amount by which the revenue deficit is reduced in each successive year over the entire period. A pre-condition for eligibility to this scheme is the enactment of fiscal responsibility legislation: thus the scheme will be available to States only from the year they “qualify” by bringing in such a law. In turn, States would increasingly seek market borrowing or borrowing from other sources than the Centre, in line with another recommendation of the TFC, that the Centre stop acting as an intermediary for debt taken on by the States.

The rationale for these oppressive conditions is stated as follows: “As the states are increasingly exposed to the markets for borrowing, their fiscal position would be increasingly assessed by the markets. They may be forced to pay higher than average interest rates to cover additional risk if the public finances are not evaluated to be robust by the assessment of the market. We are relying therefore on two mechanisms for fiscal correction: self-evaluation under the Fiscal Responsibility Act and exposure to the market.” (page 84)

As it happens, the role of the Centre as creditor to the States has already declined quite sharply over the past five years, and the value of the central loans outstanding has fallen both in nominal value terms and as a share of the total outstanding debt of the States. This has not meant that the debt burden of States has been very much reduced – a significant number of states still have debt-GSDP ratios of more than 40 per cent and interest payments amounting to more than 28 per cent of revenue receipts.

FISCAL RESPONSIBILITY LEGISLATION

Not content with requiring that states enact fiscal responsibility legislation as a precondition for availing of debt relief, the TFC has also specified what such legislation should provide for “at a minimum”! This includes the following features:

• eliminating the revenue deficit by 2008-09

• reducing the fiscal deficit to 3 per cent of GSDP or its equivalent defined as a ratio of interest payments to revenue receipts

• bringing out annual reduction targets of revenue and fiscal deficits.

In addition, the TFC states that, “States should follow a recruitment and wage policy, in a manner such that the total salary bill relative to revenue expenditure net of interest payments and pensions does not exceed 35 per cent.” The TFC even demands withdrawal of reduction of the public sector: “In the period of restructuring, that is 2005-10, state governments should draw up a programme that includes closure of almost all loss making SLPEs (state level public enterprises).”

NOT RECOGNISING SOCIO-ECONOMIC REALITY

The problematic theoretical framework and lack of recognition of socio-economic reality that are embedded in these conditions are truly disturbing. The macroeconomic problems with a rigid fiscal responsibility framework that specifies what are finally only arbitrary limits to revenue and fiscal deficits are now well known across the world and are even becoming evident in India within the first year of such legislation been enacted.

These rigid numerical constraints are not just awkward and unnecessary but also pro-cyclical, since they operate to intensify and prolong slumps and even convert them into depressions. They are also foolish, since they can prevent important and socially necessary public expenditure which is required to improve current welfare and future growth prospects. There is no reason to keep capital expenditure within some predetermined numerical limit, since even debt sustainability depends upon the relation between the interest rate and anticipated return from public investment. So restricting capital account deficits to 3 per cent of GSDP makes little sense.

In addition there is the issue of social returns, which appear to be completely ignored by the TFC. In requiring the States to keep the salary bill within a prespecified limit, and demanding the closure of loss-making public enterprises, the TFC is ignoring the social role that can be played by public employees and even loss-making public enterprises that fulfill some social functions.

Let us consider what precisely such conditions will entail for the state governments. Remember also that the revenue raising capacity of the States is limited, more so since the Centre has taken upon itself all power to tax service sector incomes. If revenue deficits are to be progressively reduced and brought down to zero, this necessarily means that revenue expenditures will have to be cut.

In most states, by far the largest item of expenditure on the revenue account is in fact that for salaries. It is completely wrong to see these as unnecessary or unproductive expenditures, since these are for who are to provide the important public services that everyone acknowledges to be essential. Since state governments are responsible for almost all of the expenditures that affect the quality of life of ordinary citizens on the ground, from infrastructure and sanitation to health and education, preventing expenditure on wages and salaries for those who would perform these functions is bizarre in the extreme.

The role of the Finance Commission, as envisaged by the Constitution, is to deal with and prevent state governments from running up large revenue deficits, by ensuring a distribution of fiscal resources between Centre and States that would allow the States to fulfill their social and constitutional responsibilities within their means. However, successive Finance Commission have failed to achieve this. And a substantial part of the problem is that the Centre itself has failed on the revenue mobilisation front, especially since the early 1990s, such that central transfers to the States have been falling as a share of GDP.

INADEQUATE REVENUE GENERATION

In this context, instead of confronting this problem and addressing the central issues of inadequate revenue generation by the Centre and its adverse implications for state finances, what the TFC has done is effectively to sound the death knell of fiscal federalism. State governments are to be forced into the same neo-liberal economic policy straitjacket that the Centre has chosen to function within. They are to be prevented from exercising their own options with respect to how much revenue and capital spending they can undertake; they are to be limited in terms of how many people they can employ and how much they can be paid; they are to close down loss-making state-owned enterprises even if these are contributing to the public good; they are to be forced to turn directly to unintermediated market borrowing or accessing loans from multilateral institutions that also carry similar conditionalties, and so on.

ATTACK ON FISCAL AUTONOMY OF STATES 

All in all, this amounts to a direct attack on the fiscal autonomy of states, and therefore in effect a betrayal of the spirit of the Constitution, which recognises the possibility of different economic approaches by different state governments.

It is ironic --- but also alarming --- that the social and political fallout of such apparently “technocratic” decisions is not recognised. Depriving people of necessary public services and reducing the possibilities of sustained development are not only likely to make those at the helm of particular state governments unpopular. They are also likely to increase disaffection with the entire national supposedly federalist system and thereby encourage extremely dangerous separatist tendencies.

The evident reaction of people in many parts of the European Union to a similar project should provide a telling example. The “Growth and Stability Pact” which specified similarly foolish fiscal constraints upon EU member governments has created higher unemployment and levels of economic activity well below potential, and has led to a popular backlash which is increasingly questioning the entire project.

The reason is that the policies – and even the proposed Constitution - were seen as driven by corporate interests and operating against the interest of people and the broader social good, which cannot be calculated in terms of market principles. Policy makers in India should take note: there is no reason why such policies should not lead to similar backlash in our own federal structure.