The improvement in State finances during 2004-05 and 2007-08 was the outcome of a confluence of
factors. While the rule-based fiscal policy adopted by most of the States improved fiscal discipline, the
correction in State finances was aided by high growth and the resultant increase in the buoyancy of the
States’ own tax revenues as well as Central transfers and the implementation of VAT during this period.
With the overall macroeconomic slowdown and the implementation of the Sixth/State(s) Pay Commissions
during 2008-09 and 2009-10, State finances suffered a setback but needed to revert to a fiscal consolidation
path. The higher devolutions recommended by the Thirteenth FC will benefit State finances. Factors
likely to have significant implications for fiscal consolidation at the States’ level include implementation
of GST, pace of economic recovery, States’ own efforts towards mobilising non-tax revenues and
prioritisation/rationalisation of expenditure. To make credible progress towards fiscal consolidation, States
need to amend their FRBM Acts and workout a fiscal reform path. States also need to review their tariff
policies especially those relating to the power and irrigation sectors. For the successful implementation of
GST, the Centre and the States need to agree on certain issues and equip themselves with administrative
capacity and IT infrastructure. Better allocation of expenditure along with improved transparency and
accountability through stricter audit procedures is also necessary to ensure quality in fiscal management.
States need to put in place the effective forecasting and monitoring mechanism for their cash inflows and
outflows so that a need-based approach is followed for market borrowings and the interest cost of cash
surpluses is minimised. The strengthening of State Finance Commissions is essential to ensure the allocation
of resources to local bodies, keeping in view their developmental role for the purpose of inclusive growth.
1. Introduction
2.1 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 rate
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.
Against this background, this chapter highlights
some immediate as well as medium-term issues and challenges that State governments confront at
this stage. While an immediate challenge is to revert
to the rule-based 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.
2. Revised Fiscal Roadmap for States
2.2 During 2008-09 and 2009-10, the experience
of fiscal authorities at the Central and sub-national
levels showed that the crisis can be dealt with better
when adequate fiscal space is available to them. In
the Indian context, the fiscal consolidation process
undertaken during the pre-crisis period provided
fiscal headroom to initiate stimulus measures not
only by the Central government but also by a number
of State governments. Many State governments
announced tax cuts and increased expenditure to
provide a boost to their State economies. Although
there was some deterioration in key fiscal indicators
at the State level in 2008-09 and 2009-10, the overall
fiscal position of States remained under control.
Looking forward, an important issue in the context
of State finances is to resume the rule-based fiscal
policy from 2010-11 onwards, supported by the
evidence that appropriate fiscal rules can facilitate
swifter fiscal consolidation. For instance, State
finances, which had witnessed a deterioration during
the low growth phase of 2000-01 to 2002-03,
improved significantly from 2004-05, following the
implementation of rule-based fiscal framework,
supported by growth acceleration during this period.
2.3 Taking into account the deterioration in State
finances in the recent past, the Thirteenth FC has
outlined a fiscal roadmap for both the Centre and the
States in the medium term. For State governments,
the Thirteenth FC has adopted a differential approach,
instead of prescribing a uniform roadmap, based on
the past fiscal performance of States (till 2007-08),
which prescribes different timelines for different
groups of States2 . The States would need to show
credible progress in their finances as some of the
benefits recommended by the Thirteenth FC are linked
to their fiscal performance. For instance, the release
of State-specific grants would depend upon
compliance to the fiscal reform path worked out by
the Thirteenth FC.
2.4 Progress along the lines of the fiscal
roadmap prescribed by the Thirteenth FC would
largely depend on (i) the overall macroeconomic
performance of States, (ii) devolutions from the
Centre and (iii) the efforts by States to mobilise own
revenues effectively and compress the least
productive revenue expenditure. It may be noted
that there was a substantial rise in revenue
expenditure of States in 2009-10 on account of
fiscal stimulus measures and the phased
implementation of the recommendations of the
Sixth/State Pay Commissions (CPC/SPCs). The
Thirteenth FC has recommended that States should
avoid structural shocks emanating from payment
of arrears on account of upward revision of salaries
under the Pay Commission awards by making the
pay award commence from the date of acceptance.
However, this would require that both the Centre
and the States initiate the process of setting up their
respective Pay Commissions well before the expiry
of the previous Pay Commission(s). In addition, the
States would also need to identify items of revenue
expenditure which can be compressed without
hampering the growth process. To make non-tax
revenues a more durable source of revenue, States
need to study the commercial viability of certain
State-provided services, viz., power and irrigation,
in a medium to long-term perspective.
3. Implications of Recommendations of the
Thirteenth FC
2.5 The Thirteenth FC has continued with the
incentive-linked approach followed by the Twelfth
FC. The incentive framework has been
recommended for general performance grants,
special area performance grants and State-specific
grants, and also for extending the benefit of interest
relief on NSSF and the write-off. With the enactment
of the FRBM Act,3 West Bengal and Sikkim may
also benefit from the extension of the debt
consolidation facility as recommended by the Thirteenth FC. Besides these, the Thirteenth FC
has identified reforms in areas pertaining to
accounting, budgeting, transparency and
disclosures, tariffs and user charges of services
provided by State governments. The implementation
of these recommendations would accelerate the
fiscal reform process at the State level.
2.6 Another notable change suggested by the
Thirteenth FC is with regard to the horizontal
distribution formula. Recognising the differences
in the tax base of different States, the Commission
has emphasised the adoption of ‘fiscal capacity
distance’, instead of ‘income capacity’, as one
criterion for inter se distribution of shareable union
taxes. Therefore, States with a lower tax base and
a lower per capita income would get a larger share.
The criterion neutralises to some extent the fiscal
disadvantage of special category States in terms
of tax capacity. This bodes well for ensuring
horizontal equitable distribution of shareable
taxes.
2.7 Taking cognisance of the fact that the
buoyancy of Central taxes has been higher than
that of State taxes, the Thirteenth FC has also
recommended (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. Following the treatment of
proceeds of services tax as part of the divisible pool
and increasing the importance of taxes on services,
the States may further benefit in terms of higher
devolution. In short, the Thirteenth FC
recommendations are likely to supplement States’
efforts towards fiscal correction and consolidation.
4. Introduction of Goods and Services Tax
2.8 One upcoming tax reform that has
implications for the tax structure at the States’ level
is the proposed introduction of GST. The underlying
objective of GST is to eliminate the cascading effect
of some taxes, rationalise the cost structure, and
reduce the effective tax rates on most goods while also aiming to reduce transactions and payment
costs. This could enhance the competitiveness of
Indian industry and trade. With the introduction of
GST, there would be a major reshuffle in the tax
bases of both the Centre and the States. Various
Central and State indirect taxes are likely to get
subsumed under GST. The Central GST portion
may subsume Central excise duty and additional
excise duties, service tax, additional customs duty
(countervailing duty) and all surcharges and
cesses, etc. Similarly, the States’ GST is expected
to subsume value added tax, entry tax (not levied
by local bodies), luxury tax, taxes on lottery, betting
and gambling, entertainment tax (unless levied by
local bodies), advertisement tax, State excise
duties, and all State cesses and surcharges insofar
as they relate to supply of goods and services.
2.9 There was some initial consensus on basic
issues like dual GST rate on goods for an initial
two years with a convergence to a single rate in
the third year. In fact, the dual structure of GST is
considered desirable for preserving India’s federal
structure. In addition, there have been other issues
with regard to the design of GST which seemed to
have been delaying the implementation of GST.
These issues mainly pertained to the power to
determine the tax rate structure, dispute resolution
mechanisms, compensation structure (if required),
inter-State transactions and information systems.
However, the areas of divergence between the
Centre and the States on GST seem to be
narrowing down. Accordingly, as a step towards the
roll-out of GST, the Central government has
introduced a Constitutional Amendment Bill for GST
on March 22, 2011. This Bill, apart from providing
the list of Central/State taxes to be subsumed,
confers simultaneous power upon Parliament and
the State Legislatures to make laws governing
goods and services tax. The Bill also proposes
levying of Integrated GST on inter-State
transactions of goods and services. In addition, the
Constitutional Amendment Bill attempts to provide
clarification on some of these issues. As per the
Bill, the proposed Central and State goods and
services tax would be levied on all transactions
involving supply of goods and services except those that are exempt or kept out of the purview of the
goods and services tax4 . The Bill also envisages
the setting up of a Goods and Services Tax Dispute
Settlement Authority, which may be approached by
the affected Government (whether the Centre or a
State) seeking redressal for any loss caused by any
action due to a deviation from the recommendations
made by the Goods and Services Tax Council or
for adversely affecting the harmonious structure
and implementation of the goods and services tax.
2.10 With introduction of GST system, the vertical
imbalance is expected to reduce, as States will have
the power to tax the services sector which is the
largest and a growing sector of the Indian economy.
Nonetheless, the revenue implications are likely to
vary across States. Since States still do not have an
accurate assessment of their respective tax bases, it
is difficult to infer the revenue implications for States.
It may, however, be noted that with the introduction of
VAT, the tax-GDP ratio at the State level improved
significantly. One important issue to be finalised is the
compensation structure in case of revenue loss to
States. Since the GST rates being discussed are
higher than initially envisaged and that recommended
by the Taskforce of the Thirteenth FC, the issue is
whether the Centre should fully compensate States
in case of revenue loss. Harmonising the GST laws
at the State level would also be important in order to
ensure reduced compliance costs and increase
efficiency in tax collections
2.11 The implementation of GST also involves other
issues such as enhancing administrative capacity and
improving the IT infrastructure of States to ensure
better compliance with the expanded tax base. An
Empowered Group (Chairman: Nandan Nilekani) with
representation from the Centre and States has been
constituted to assess the IT infrastructure needs at
the Centre and State levels. Adequate IT infrastructure
is a pre-requisite for the successful implementation
of GST as it would enable seamless GST registration
and electronic filing of returns and payment of taxes.
Being a destination-based tax, accurate determination
and efficient transfer of input tax credits across tax jurisdictions need to be ensured in the case of inter-
State transactions. Some progress seems to have
been made in this regard as key business processes
of registration, returns and payments are in advanced
stages of finalisation. As indicated in the Union Budget
2011-12, National Securities Depository Limited
(NSDL) will set up a Pilot portal in collaboration with
eleven States prior to its roll out across the country
by June 2011. There are other practical challenges
with regard to (i) distinguishing between goods and
services, (ii) taxation of bundled or composite supplies
comprising both goods and services and (iii) taxation
of software and telecom services. Similarly, in view of
the large list of exempted goods and a three-way
classification of rates, viz., lower rates for basic goods,
standard rate for all other goods and a single rate for
services, disputes relating to classification and
valuation cannot be ruled out. There needs to be a
clear policy on the treatment of such issues.
Nevertheless, the successful implementation of GST
is crucial for States to benefit from such reforms and
make smooth progress towards fiscal correction.
5. Expenditure Management
2.12 In the context of State finances, the quality
of expenditure has always been an important issue.
At present, revenue expenditure accounts for
around 80 per cent of States’ aggregate
expenditure, which is in the nature of current
consumption rather than investment and has
implications for the growth prospects of States. It
may be argued that revenue expenditure is not
altogether unproductive and vice versa for capital
expenditure. Nevertheless, States need to identify
unwarranted items of revenue expenditure which
have low growth and welfare implications.
2.13 Expenditure reforms are an important driver
of the Thirteenth FC’s approach to the fiscal
roadmap for the future. The major thrust of the
proposed expenditure reforms is to improve the
supply of public goods, which is also inclusive,
through a reduction in the existing untargeted and regressive subsidies. The Commission also
recognises the need to improve transparency and
accountability by putting in place stricter audit
procedures in general and operational audit, in
particular, for proper assessment of the ‘efficiency
and effectiveness’ of various items of expenditure.
It has also suggested that ‘institutional deepening’
through the creation of local body ombudspersons,
fiscal councils and independent evaluation
organisations would help in better expenditure
management. States could encourage the use of
innovative measures that can reduce cost and also
improve the quality of public services. The efficient
allocation of public expenditure is crucial not only
for setting the pace of fiscal consolidation at the
State level but also for raising their economic
potential over the medium term.
6. Surplus Cash Balances
2.14 State governments have been parking their
large cash surplus balances in market instruments
like 14-day intermediate treasury bills (ITBs) since
2004-05. Although States’ average investment in
14-day ITBs showed a sharp decline in 2008-09
and 2009-10 due to fiscal stress, States tended to
accumulate large surplus cash balances towards
the last quarter of these years. As on March 18,
2011, States’ investment in 14-day ITBs stood at
`1,20,318 crore as compared with `93,776 crore
as at end-March 2010. Apart from the improved
macroeconomic situation which had positive
implications for State finances, the accumulation
of large surplus cash balances indicates that some
States tended to borrow more than their fiscal
deficit. Taking note of this situation, the Thirteenth
FC has highlighted that while States require some
cushion for smoothening expenditure at the
implementation level, the accumulation of cash
beyond a level reflects inefficiency, leading to an
avoidable interest burden.
2.15 Given the fact that States still have ample
surplus cash balances and the GFD-GSDP ratio is
envisaged to be lower in the coming years, it is
essential that States adopt a need-based approach
to their market borrowings. The Thirteenth FC has
also suggested that there should be a directed effort by States with large balances towards utilising their
existing cash balances before resorting to fresh
borrowings. States may consider using their surplus
cash balances for bullet repayments of market
borrowings raised for debt swaps during the period
2002-2005, which are likely to become due during
the next few years. Further, State governments
need to have an effective forecasting and
monitoring mechanism for their cash inflows and
outflows. Effective cash management is possible
only if State governments develop the skills and
capacity to record, monitor, and project short-term
inflows and outflows. States should encourage coordination
among State entities that collect revenue
and expend funds. Better timing of decisions
involving major expenditures and rationalising the
number of bank accounts may also help them use
cash surpluses more efficiently.
7. Disclosure and Dissemination in
State Budgets
2.16 With the enactment of Fiscal Responsibility
Legislations (FRLs), there has been some
improvement in the fiscal transparency at the States’
level. However, there are still issues with regard to
lack of availability of information, inconsistency in
the available information and lack of uniformity in
data reporting by the State governments. There are
considerable discrepancies in the methodology in
some State budgets. To make an objective
assessment, it is important that the budget
documents provide accurate information in a
transparent manner. For instance, many of the State
governments do not publish data on outstanding
liabilities, contingent liabilities and off-budget
borrowings in their budget documents, despite the
recommendations of various committees. The data
on wages and salaries and ‘operations and
maintenance’ are spread over a number of heads in
the State budgets, such as administrative services,
economic services and social services. Thus, from
the State budgets, it is difficult to make out the extent
of funds spent on wages and salaries and operations
and maintenance expenditure.
2.17 There are several inconsistencies in the
budget documents of State governments. For instance, GSDP data which is used to calculate
key fiscal indicator ratios are at times inconsistent
with the GSDP estimates given in the budget
documents of some States. Similarly, the formats
in which the State governments disclose
information on key items are not uniform.
Therefore, States which lack disclosure and
transparency standards need to gradually improve
them, keeping in view the best benchmarks set
by some other States.
8. Strengthening the State Finance
Commissions
2.18 With an increasing emphasis on
decentralisation through greater devolution of
powers, functions and authority to local bodies, it
becomes important to strengthen the State Finance
Commissions (SFCs). The SFCs can play an
important role in ensuring allocative efficiency of
resources transferred from the States to local
bodies in the form of compensations and transfers.
It is also essential to strengthen the SFCs to make
their functioning more predictable while ensuring
transparency in the process of implementing their
recommendations. The Thirteenth FC has
suggested that the Central Finance Commission
and the SFCs could be constituted simultaneously.
2.19 Under Article 243-I of the Constitution, the
SFCs are supposed to be appointed at the end of
every fifth year. This is to ensure that all State
government transfers to local bodies are governed
by the mandate of the current SFC. However,
considerable delays have been observed in
submission of reports by the SFCs in some States.
State governments also take their own time to
finalise ‘Action Taken Reports’. In some States, the
lag between submission and the Action Taken
Report is unduly long. In some States, the SFCs have not even been constituted while other States
are exempted under Article 243M from setting up
an SFC. While setting up an SFC, the State
Government should emphasise that the report of
the Commission should be adequately analytical.
One of the major challenges that the SFCs face is
the lack of credible data that is comparable across
local bodies. This limits their effective use by SFCs
to work out a sound distribution framework across
the local entities of the State. Thus, local bodies
should gradually move towards sound budgetary,
accounting and auditing practices so that their
resource requirements are assessed in a better
manner by the SFCs.
9. Conclusion
2.20 To conclude, a major issue at the present
juncture is to make credible progress towards fiscal
consolidation at the States’ level. Even though the
States’ fiscal performance to a large extent depends
on macroeconomic conditions, they need to explore
sources of non-tax revenues and review their policies
towards user charges in certain highly subsidised
sectors. In the current phase of fiscal correction, the
focus has to be on expenditure-related reforms to
improve the productivity of public expenditure which
can contribute to the sustained fiscal position of State
governments. Going forward, the implementation of
GST would assume significance in determining the
revenue position of States. States should prepare
and put in place adequate infrastructure to effectively
capture the tax base once GST is implemented.
States also need to strengthen the SFCs by asking
them to use an analytical approach to issues
pertaining to local bodies. Timely submission of
reports by the SFCs and finalisation of action taken
by the State Government should be ensured so that
the recommendations made in the Report do not
become outdated and irrelevant with time.
2Under the revised roadmap, 24 States would need to achieve either revenue balance or surplus by 2011-12 and maintain it thereafter;
while the remaining four States would have to achieve the same by 2014-15. All special category States with fiscal deficit of less than 3
per cent of GSDP in 2007-08 could incur a fiscal deficit of 3 per cent in 2011-12 and maintain it thereafter. Manipur, Nagaland, Sikkim
and Uttarakhand would need to reduce their fiscal deficit to 3 per cent of GSDP by 2013-14. Jammu and Kashmir and Mizoram need to
limit their fiscal deficit to 3 per cent of GSDP by 2014-15
3For details of FRBM Acts in West Bengal and Sikkim, see Chapter III.
4Items which are proposed to be exempted or outside the purview of GST include crude petroleum, high speed diesel, natural gas, motor
spirit (petrol), aviation turbine fuel and alcoholic liquor for human consumption. States will have the authority to levy tax on these items. |