Confused picture

The year 2005-06 is going to be a challenging year for everybody dealing with public finance, be it politicians, bureaucrats or analysts. Two fundamental changes are going to take place in the scenario.

The Value Added Tax (VAT) is supposed to be implemented by states from April 1. The recommendations of the 12th Finance Commission are to take effect for a five-year period beginning on the same day.

These two factors are going to impact the entire budgeting process that state governments will go through for the year. And, these changes are taking place against a backdrop of strong pressures to increase the degree of fiscal discipline exercised by the central as well as state governments.

The governments of some states, notably Andhra Pradesh, Madhya Pradesh and Gujarat, presented their budgets last week, ahead of the Union Budget.

These plans provide some indication of the respective governments' grasp and understanding of the changed fiscal environment. On account of the VAT, the Centre has assured states compensation for revenues lost in the transition period.

Despite the well-known 'moral hazard' problem associated with such an assurance (the states have no reason to collect revenue if there is a Central guarantee), it might be kick-starting a process that has been in perennial danger of stalling, and so would have done its job.

However, for states that presented their budgets before the compensation formula is known, this poses a problem.

The budget speech made by the finance minister of Andhra Pradesh, for instance, refers to the impending implementation of the VAT and calls upon the Centre to provide adequate compensation, but there is no reference to any estimate of the shortfall he expects to deal with.

Revenue growth projections are quite rosy, with the state's own tax revenues estimated to grow by about 15.4 per cent over the revised estimates for 2004-05, to almost Rs 20,000 crore.

If this is without any expected compensation, it should be music to the ears of the central government. However, it also leaves open the possibility of a significant re-working of the budget numbers once VAT is in play and the compensation formula is announced.

On the issue of fiscal discipline, there seems to be some moral hazard kicking in as well. The Finance Commission's recommendations bring parity to the constraints faced by the central and state governments, by making some significant debt relief provisions contingent on an elimination of revenue deficits by 2008-09.

Further, these constraints must be formalized in a legislation enacted by the state assembly. Notwithstanding the eventual impact of this measure, the fact is that states have a bit of a reprieve in starting to reduce deficits.

For 2005-06, Andhra Pradesh shows a revenue deficit of Rs. 1,401 crore, which is only marginally lower than the previous year. Madhya Pradesh shows one of Rs. 1,186 crore.

Given the mess that state finances are believed to be in, a great deal would be achieved in terms of clarity and control if there were some consistency in the assumptions and timing of central and state budgets.

This is particularly so in a time of dramatic change.