State of solvency

A lot of attention has been focused on central government finances and the ability of the government to adhere to the rather strict requirements of the Fiscal Responsibility and Budget Management (FRBM) Act. Somewhat further away from the limelight are state government finances. Till a couple of years ago, they were generally seen to be in a complete mess. However, without too much fuss, significant improvements have taken place in the last two years. A report released by the Reserve Bank of India last week, "State Finances: A Study of Budgets 2006-07," quantifies the rather sharp reduction that has taken place in aggregate state public finance deficits in the revised estimates of 2005-06, a trend that has persisted in the budget estimates for the current year. Given the overall buoyancy in the economy this year, it is highly likely that most, if not all, states will achieve or exceed their budget targets. With the high probability that the central government will also do better than its Budget estimate of the fiscal deficit this year, the combined fiscal deficit, a persistent sore point in the eyes of global rating agencies and investment banks, gives every indication of falling off the list of macroeconomic threats.

The report indicates that the aggregate fiscal deficit of states was 3.2 per cent of GDP, while the revenue deficit was 0.5 per cent in the revised estimates of 2005-06. In the budget estimates for 2006-07, these ratios came down to 2.8 per cent and a minuscule 0.1 per cent, respectively. Since state governments are also bound by the same targets as the Centre as per the recommendations of the Twelfth Finance Commission (TFC)""a cap of 3 per cent on the fiscal deficit and zero revenue deficit""it would appear that they have, in the aggregate, virtually achieved these targets three years ahead of schedule. Of course, the targets apply to individual states; as of now, about half the states are some way from targets on both parameters. However, the trend towards improvement is broad and unambiguous. Three factors have contributed to the rather rapid turnaround in state finances. First, the TFC required all states to legislate on fiscal responsibility, or face certain penalties. Most states have complied, certainly with the minimum requirements; others have gone further in imposing legislative or administrative ceilings on specific kinds of commitments by the state government. This has clearly imposed a transparent and non-negotiable constraint on state finance ministers. Second, most states have experienced significant revenue buoyancy over the last couple of years. Macroeconomic conditions have no doubt helped, but a significant contributor to this trend has been the implementation of the value added tax (VAT) by most states in 2005.

The incentive-related benefits of VAT appear to be kicking in and revenues have increased more than expected in many cases. Third, though this is a somewhat weaker force and one that is more varied in its impact across states, governments appear to have had some success in improving cost recovery across a range of public services. This third factor clearly needs to be consolidated, but taken together, the three represent a healthy combination of governance, revenue and expenditure improvements, which bodes well for sustainability. Challenges remain, of course, but the report suggests that some major hurdles have been crossed and the FRBM and TFC targets are well within reach.

There are three risks to bear in mind from now on: a sharp increase in interest rates would raise the cost of the large public debt; a Pay Commission award, once announced and implemented, would raise the cost of government pay and pensions by 1 percentage point of GDP; and the unfolding of the UPA's new spending programmes could outstrip revenue growth.