Physicians, heal thyself

While it is obvious that the profligacy of state governments is largely to blame for the fiscal mess they are in today, a point not made so eloquently or even frequently is that the central government is just as responsible for the sorry state of the states' affairs.

The Reserve Bank of India's latest Bulletin brings this out forcefully when it points out that gross central transfers to states, including Plan and non-Plan loans, dropped quite sharply, from 6.8 per cent of GDP in the first half of the 1990s to barely 5.7 per cent of GDP last year, and may drop further this year to 5.5 per cent.

This means the states have not been getting something approaching Rs 45,000 crore that they would have got, if the level of fiscal transfers had been constant in relation to GDP.

What this implies in turn is that much of the fiscal correction achieved by the Centre since the early 1990s has been through the simple process of squeezing the states.

It should cause no surprise therefore that the states' fiscal situation has got worse, not better.

The reduction in transfers may not have been through devious intent. Indeed, what usually happens is that the states calculate their share of central revenues, based on the Budget numbers, and plan expenditures accordingly.

However, in the majority of years, the Centre's tax revenues have fallen short of Budget estimates, leading to a shortfall in state transfers as well.

However, since by this stage it is too late for states to reduce their expenditure for the year, they end up with larger deficits than planned in their own budgets""causing increased indebtedness, which in turn creates fresh problems because of the interest burden.

While it would be foolish to ignore the shortfalls in the states' own tax and non-tax collections, clearly the problem of the central tax shortfall is an issue of serious concern as it comprises a significant portion of the states' revenue source.

The problem gets more acute since, as the Kelkar report on the achievability of the FRBM targets pointed out, the buoyancy of various central taxes such as excise duties is significantly below one""that is, even when industrial production picks up as it has this year, tax collections are not going to rise commensurately.

Presumably, this is an issue that the Finance Commission has looked at, in terms of a method to compensate states when central transfers fall short of budget targets.

This is not to argue that the states have done what they can to address the problem. The losses incurred by state governments because of the failure to levy proper user charges on those consuming power and irrigation water, are massive; yet the trend has been for more states to announce free power, only to renege on such promises when they become simply unsustainable.

Indeed, as the RBI Bulletin points out, the enhanced revenue expenditure by the Uttar Pradesh government for the power sector alone accounted for 60 per cent of the increase in consolidated revenue expenditure of all the states.

In fact, if you look at the power and other bonds issued by states (Rs 18,755 crore in 2003-04), this is to be compared with the budget estimates of Rs 5,908 crore for the year!

It also remains true that while increased tax devolution is critical to the states' fiscal situation getting better, very few fiscal corrections have taken place without revenue expenditure cuts ""a study of 74 episodes of fiscal correction between 1970 and 1995 found that around half those which relied on recurrent expenditure cuts were successful, as compared to one in six that relied on hikes in tax rates or cuts in capital expenditure.