Abheek Barua: Some simple fiscal arithmetic

Initiatives in tax administration seem to be paying dividends

There appears to be some confusion, at least in some sections of the financial markets, about the impact of the implementation of the Twelfth Finance Commission's (TFC's) recommendations on government debt and interest rates.

These recommendations, for those who have missed this bit of news, seek to increase both the states' share of tax revenues and other transfers from the Centre to the states.

They have been cleared by the Cabinet and are likely to be implemented in the 2005-06 Budget due at the end of this month.

As a result, there would be an effective transfer of resources from the Centre to the states estimated at Rs 26,000 crore, or 1 per cent of GDP.

One view is that if one takes a closer look at the financial engineering behind this restructuring of public finances, there is, prima facie, reason to believe that such a move could actually be quite benign or even mildly positive for interest rates.

In order to understand the underlying analytics of this argument, it might be useful to view the central and state governments as a consolidated entity, the government.

This entity runs an aggregate budget deficit of roughly 9.5 per cent of GDP. Of this, the Centre accounts for 4.5 per cent of GDP and the states 5 per cent.

This deficit is financed through borrowing from the economy's pool of savings.

If one abstracts from other changes in taxes and expenditure growth (holds the aggregate deficit constant at 9.5 per cent) and focuses entirely on this change in resource distribution alone, two things emerge.

The consolidated draft of the government on the nation's savings pool remains unchanged at 9.5 per cent. However, the Centre runs a bigger deficit per cent and borrows more.

States lower their deficit and borrow less.

In short, under the new dispensation the government borrows the same amount but the proportion of loans raised by the Centre and states is different.

The Centre enjoys a better credit rating than the states since it issues paper that is, by definition, risk-less. Hence the appetite for its debt paper is stronger than state governments' paper.

Thus, the same demand on the country's savings pool is associated with the supply of larger proportion of better-rated bonds. The "weighted average credit rating" of the debt issues improves without a change in amount raised.

Given this enhanced credit rating, the debt market should be willing to fund the deficit at a lower interest rate.

There are a couple of problems with this simple argument if one gets to the nitty-gritty of the governments' market borrowing programme in India.

First, states fund only a small fraction (about 30 per cent) of their deficit from the market. Thus, if the current regime had continued, states would have borrowed only Rs 7,800 crore of this Rs 26,000 crore additional deficit.

The rest would be funded through things like small savings and loans from the Centre. This is the effective reduction in states' market borrowing under the new TFC scheme.

However, going by what finance ministry officials have been saying, states will be asked to borrow Rs 15,000 crore from the market instead of taking central loans.

Thus, there would an additional supply of Rs 7,200 crore (Rs 15,000 crore"�Rs 7,800 crore) of state debt paper on account of the new dispensation alone.

By lending less to states, the Centre saves on capital expense by Rs 15,000 crore. Thus, the net increase in central government deficit is Rs 11,000 crore (Rs 26,000 crore"�Rs 15,000 crore).

Going by past patterns, the Centre would fund about 70 per cent through market borrowing. Thus, there would be an increase of Rs 7,700 crore (70 per cent of Rs 11,000 crore) of additional debt paper coming from the Centre.

If you put the two together, the TFC recommendations, along with increased state borrowing from the market, would result in Rs 14,900 crore (Rs 7,200 crore+Rs 7,700 crore) of additional market borrowing on account of the change in resource allocation and patterns of funding.

This amount is not be sneezed at. If global liquidity continues to tighten and private sector investments continue to be robust, these additional borrowings could play a key role in pushing interest rates up.

Over the longer term, however, a rise in the supply of paper from the states would help develop the market for state debt. State revenues have improved tangibly since 2000.

For the technically-minded, the ratio of states' own tax revenues to GDP has increased fairly significantly. In 2000, states went in for uniform floor rates on sales taxes and effectively put an end to the strategy of attracting investment by offering sales tax breaks.

The end of these somewhat ruthless tax wars appears to have paid off in raising tax buoyancy. The implementation of VAT this year could lead to temporary revenue losses but in the medium term, the effect of expanding the tax net should dominate.

Greater dependence on market resources might just induce the much-needed expenditure discipline. Were this to happen, the rating of state debt might improve significantly.

Even if the TFC recommendations do not make a substantive impact on interest rates, there are a couple of factors that point to an imminent rise.

For one, US interest rates seem set to go up further as the Fed tries to put the lid on inflation and bolster household savings.

Secondly, domestic demand for retail loans shows no sign of flagging and Indian companies are likely to expand capacity in a fairly big way next year through borrowing from banks.

Can the government do something to make sure that the rate increase does not spin out of control? For one, a reduction in the fiscal deficit based on a credible tax and spend strategy for the coming year would go a long way in easing the debt market's worries.

This is not impossible. If the trend for the first nine months of 2004-05 is any indication, the fiscal and revenue deficits are likely to be quite a bit lower than last year.

At the end of December, the fiscal deficit stood at Rs 90,239 crore, compared to Rs 92,435 crore in December 2003. The corresponding numbers for the revenue deficit are Rs 62,969 crore and Rs 72,999 crore, respectively.

This improvement has to some extent been driven by considerable buoyancy in direct tax (corporate and income tax) collection.

This seems to suggest that initiatives aimed at improving tax administration such as the introduction of the tax information network (TIN) in January 2004 are paying off.

If these administrative changes are extended to indirect taxes, things like excise collection that have remained sluggish this year could also improve sharply.

The intra-year borrowing and cash management strategy of the RBI would also make a difference. Over the past couple of years, the RBI has followed a successful strategy of building cash buffers in periods of easy liquidity and falling back on these buffers in periods when yields have nudged up.

Thus, the central bank (that acts as the government's investment banker) has avoided fresh government debt issues in periods of tight liquidity.

Thus, how the government borrows from the market next year could be as important as how much it borrows.

(The author is chief economist, ABN-Amro India. The views here are personal)