State of progress

One of the reasons for India's dramatic economic upswing of the past four years has been the structural improvement in public sector savings. From being a negative saver (i.e. borrowing to spend) of amounts adding up to 2 per cent of GDP in 2001-02, the public sector saved as much as 2.2 per cent of GDP in 2004-05""a positive swing of more than 4 per cent of GDP that has contributed enormously to the sharp increase in savings and investment rates for the economy as a whole. At an incremental capital-output ratio of 4:1, a 4 percentage point improvement in the investment rate should increase annual GDP growth by 1 percentage point.

The credit rating agency Fitch's India arm has now put out two papers to show that state governments have contributed to this turnaround, for their finances have been on the mend over this period. In 2005-06, the states' own tax revenue to GDP ratio was 6.2 per cent, up from 5.3 per cent in the period 1995-96 to 1999-00. While the overall economic buoyancy helped, since central transfers by way of tax sharing rose, interest payments also declined thanks to the debt-swap that the Centre offered once interest rates dipped. But the more upbeat message in the Fitch report is the increased buoyancy in sales taxes (the mainstay of all state government finances) now that VAT has been implemented. The Finance Commission has pushed the envelope further and, in return for more debt and interest rate relief, most states have now agreed to mirror the Centre's fiscal correction plan by putting in place their own "fiscal responsibility" targets, mandating elimination of the revenue deficit by 2008-09 and lowering of the fiscal deficit to 3 per cent of GDP by 2009-10. It helps that, like the Centre, 15 states have already subscribed to the new defined-contribution pension scheme in place of the old defined-benefit one for new employees (this will limit the long-term damage by way of pension pay-outs); the decision to index pensions to prices and not to real wages is also a major step.

That said, there is a mismatch between state revenue and expenditure. Over the past two decades, the states' share of total government expenditure has averaged 57 per cent, compared to a 39 per cent share in revenues. Cross-country studies show that revenue hikes don't do the trick, and sustained improvement in the indebtedness of states cannot take place without expenditure compression. State governments clearly have a large role to play in this, given that cost-recoveries in sectors like education and health are around 2-5 per cent of costs. In power, while the ratio is better (20 per cent), the much larger outlays here make the problem a much bigger one. The big killer (and an issue on which the states are helpless) is the Centre's announcement of a new Pay Commission, whose recommendations will probably be accepted by the government just before the elections. The last commission resulted in a 60 per cent hike in the salary bill of the central and state governments and, by 1999-2000, Fitch says, it almost bankrupted as many as 13 state governments. So while it is true that state governments need to remain committed to expenditure contraction and fiscal correction, it is equally true that a problem lurks round the corner.