Too early to celebrate

Wonders will never cease. Only a few years ago, the finances of state governments looked as if they could never be brought out of crisis. Today, they are looking better than the central government's finances. As the Reserve Bank's study of state finances shows, the gross fiscal deficit of the states has come down to 3.2 per cent of GDP, and the revenue deficit to 0.5 per cent. This has happened because the states have done an admirable job of improving revenue. Indeed, the fiscal performance has been better than budget estimates, which is a most unusual achievement.

What has made this dramatic turnaround possible? The answer is the changed incentives structure. The Twelfth Finance Commission told the states that their loans from the Centre would be written off if they improved their budgetary performance. That was a powerful incentive for states that are stuck with massive interest and repayment obligations, and it worked like a charm. Another noteworthy feature is the sharp build-up of surplus cash balances with the states. These surpluses have been invested in 14-Day T-Bills. This surplus is due mainly to the large automatic inflow of small savings, tax devolution and, of course, Finance Commission grants. The buoyancy in tax revenue has been the icing on the cake.

It now remains to be seen if the states will continue to perform well, or slip back into old habits, ironically because of the 'moral hazard' problem inherent in offering incentives of the kind that the Finance Commission did. Such incentives work, but only at the cost of encouraging profligacy in the future. Once the loans have been written off, there is no percentage left in continuing to be fiscally responsible. Everyone knows that politics at the state level is fiercely competitive, and electoral promises are oriented towards giveaways of one kind or another. The danger of fiscal slippage therefore becomes very real.

There is also the problem posed by the huge variation in the fiscal performance of the states. There are too many fiscally weak states even today. And it is no coincidence that the politics in those states is very fragmented and therefore governance is weak. It is difficult to see such states catching up with the fiscally strong states. The target-oriented path that the Finance Commission has suggested is important in this context. However, the states will have to take care that they don't cut back on much-needed expenditure in areas like irrigation, health and education.

Unfortunately, the option of reducing the wage bill is not open to them. In each of these three vital areas, the wage bill in every state varies between 80 and 97 per cent of the budget allocated to these departments. This factor assumes great importance in the context of the new (sixth) Pay Commission, which has been set up and which is due to submit its report late next year. Given how government salaries have shrunk in relation to total expenditure, the fiscal effect of a new Pay Commission award may not be quite as devastating as it was the last time round, but since general elections will be round the corner, populism could rule and the pay hikes ordered could go well beyond the Pay Commission's award, as happened in 1996-97. So while there is cause for satisfaction at the progress achieved so far, it is early to celebrate success.