State Fiscal Reforms in India: Progress and Prospects

1. State Fiscal Reforms in India:Progress and Prospects November 23, 2004

2. Background and context • Bank’s 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”

3. Structure of the Presentation • Introduction • Expenditure Restructuring • Reforms to Improve Expenditure Quality • Tax Reforms • The borrowing and grant regime. • Scenarios and conclusion

4. A. INTRODUCTION

5. 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.

6. Average real per capita income growth

7. 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.

8. State deficit and debt levels

9. State- level debt/GSDP: poor and other states

10. 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.

11. Aggregate expenditure trends for India’s states as a percentage of GDP

12. 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.

13. But fundamental concerns remain. • The primary deficit has fallen, but revenue and fiscal deficits remain stubbornly high. • Debt levels continue to increase: India’s 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.

14. Trends in state deficits

15. State fiscal deficit: poor states and others

16. 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.

17. B. EXPENDITURE RESTRUCTURING

18. 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.

19. Starting Basic Salary of a Primary School Teacher

20. 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

21. 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.

22. 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.

23. C. REFORMS TO IMPROVE EXPENDITURE QUALITY

24. Improvements in customer satisfaction with various services in Bangalore over a 10-year period.

25. 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

26. 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.

27. D. REVENUE REFORMS

28. Trends in states’ own revenues as a percentage of GDP

29. Revenue Reform Objectives • To increase revenue • To broaden the tax base • To simplify the system and reduce corruption

30. 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, India’s indirect tax system will still be very complex. The ultimate goal should be a unified centre-state VAT.

31. 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 S&R • Transport tax: cars and 2-wheelers are undertaxed relative to buses • Non-tax revenues have stagnated and need more policy attention from government.

32. 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.

33. E. BORROWING and GRANT REGIME

34. 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.

35. Resources other than own-revenue used by states to finance expenditure

36. 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.

37. 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.

38. 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.

39. 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.

40. P.C. revenues for the major states, 2001/02 (normalized)

41. 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.

42. Transfers from GoI to the poor states as a percentage of total transfers

43. 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

44. 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

45. F. SCENARIO AND CONCLUSION

46. 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 O&M. • 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 O&M.

47. 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

48. 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.

49. 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-oriented. • 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.

50. Thank you!