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October 18, 2013

Fiscal Discipline in the States

Issues in measurement and use as a policy instrument.

Even as the concerns are mounting about the Union government’s competence in managing public finances and more broadly fiscal risks, it may be useful to examine fiscal discipline in the states. Among the key issues are its measurement and its use as a policy instrument in Union-State fiscal arrangements.

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In 2010-11, States generated from their own sources 38 percent of total tax revenue of the Union and State governments combined, but if the States’ share of Union government taxes is included, this proportion rises to 55 percent. In 2010-11, the share of States in combined expenditure was 46 percent. Thus roughly half of the total revenue and expenditure are the responsibility of the States.

Furthermore, as many of the government’s entitlement and other programs (such as provision under the Food Security Act, the Rural Employment Guarantee Scheme and the provision of the The Right to Education Bill) require States to incur expenditure, complexity of their public finances, and interdependence between the Union and the States are expected to increase. The Union government therefore needs the trust and confidence of the States if its programs are to succeed.

During the 2004-05 to 2012-13 period, states contributed about one-third of the officially reported combined fiscal deficit of the Union and the States. The deficit estimation understates fiscal risks, primarily due to cash accounting method used does not take into account accrued liabilities for future pension and healthcare benefits of civil servants, potential liabilities arising from government guarantees, directed loans, off-budget expenditure through public sector organizations and others.

While consolidated time series or cross-section data for even the number of government employees are not published (a gap which needs to be urgently addressed by the Statistical Authorities), the indications are that nearly four-fifths of the total government employees in India are employed by the States. Establishment of the Seventh Central Pay Commission (CPC) on September 25th, 2013, will increase the pressure on the public finances of the States as its recommendations are usually followed with minor modifications by them.

The focus on the measurement of fiscal discipline and its use as an instrument in Union-State fiscal relations is therefore timely and relevant.

The concept of fiscal discipline is complex and multidimensional, making it difficult to capture in a single, relatively static formula. Nevertheless, for allocating weights in devolution of applicable Union taxes, fiscal discipline has been included as one of the factors to provide incentives to States has been used since the 11th Finance Commission (FC11) report applicable for the 2000-05 period. The FC13 assigned a weight of 17.5 percent to fiscal discipline. FC12 has assigned 7.5 percent each for tax effort and fiscal discipline, but FC13 did not include the tax criteria. The other factors used by FC 13 and their respective weights are population, 28 percent; area, 10 percent; and fiscal capacity distance, 47.5 percent.

The 14th Finance Commission (FC14) was constituted in 2012, and is deliberating on its recommendations for the 2015-20 period. Its measurement and use of the fiscal discipline criteria to allocate applicable Union taxes will be keenly watched as there is scope for further refining both these aspects.

FC-13 explained measurement and use of the index of fiscal discipline (IFD) in the following manner. IFD is measured as a ratio of own revenue receipts of s state to its total revenue or current expenditure. Improvements in IFD are measured as the difference in the ratio between the base period (2001-02 to 2003-04 years by FC-13) and the reference period (2005-06 to 2007-08 by FC-13). Improvements in this ratio are then compared to the average for all states. This implies that states with relatively higher improvement than the average for all states receive higher transfers.

Several limitations of this methodology are evident.

First, differing quality of data, and differing comprehensiveness of the budgetary data by various states are not taken into account. Second, the time lag between the fiscal discipline performance and possible reward is fairly long. Thus, the gap between the first year of the base, 2001-02 and 2010, the first year for which recommendations apply is nearly a decade. Even the end of reference period of 2007-08 is distant from the period for which recommendations are applicable.

Improving the quality of public finance data at the State and the local level therefore merits serious consideration. Recommendations based on poor quality data and too large a time lag between Fiscal behavior and rewards or disincentives in allocation of applicable Union taxes mitigates against the objective of improving public finances and fiscal discipline.

Slide1

In table 1, the exercise concerning index of fiscal discipline (IFD) undertaken by the 13th Finance Commission (FC-13), but using 2005-06 to 2007-08 as the base year, and 2008-09 to 2010-11 as the reference year is repeated.

The exercise suggests the following:

One, The twenty eight states’ average representing the country exhibits lower own revenue to revenue expenditure ratio in the reference period (58.34 percent) as compared to the base period (62.43 percent). In only eleven of the twenty-eight states is the fiscal discipline ratio higher than the national average in the reference year.

Two, There are sixteen out of twenty-eight states which exhibit a lower ratio in the reference year as compared to the base year.

Three, The own revenue to revenue expenditure ratio is especially low (below 30 percent) in seven out of eleven special category states, but only in one (Bihar) out of seventeen non-special category states in the reference period.

Four, The extent to which the current tax devolution arrangements and other revenue and expenditure policies concerning union-state fiscal relations are contributing to the lack of improvement in fiscal discipline, and especially low ratio in some states therefore merits serious examination.

Five, When the changes in the fiscal discipline index in individual states is compared with the change in the national average, there are sixteen out of twenty-eight states which exhibit relative improvement, ten which exhibit deterioration, and two which exhibit no change.

Six, Among the non-special category states most likely to receive higher allocation if the methodology of FC 13 is followed are: Bihar, Jammu & Kashmir, Manipur and Sikkim. Among the non-special category states most likely to receive lower allocation are Chhattisgarh, Gujarat, Haryana, Karnataka, Maharashtra and Tamil Nadu. However in each of these cases their own revenue expenditure ratio in the reference year is higher than the national average. Among the special category states whose ratio in the reference year are below the national average but will nevertheless receive less allocation are: Assam, Meghalaya, Mizoram and Uttarakhand.

The above analysis suggests the challenges in taking into account fiscal discipline index to allocate resources in an equitable manner, which nonetheless does not result in incentives to States to behave inefficiently through slackening their fiscal efforts, and being rewarded even when overall fiscal discipline ratio declines.

The FC-14 may therefore consider exploring different ways in which a refined measure of fiscal discipline can be incorporated in the allocation formula; and to devise a package of incentives and disincentives designed to increase their ratio of own revenue to revenue expenditure, especially among the Special Category states long accustomed to depending primarily on the Union government for even their routine expenditure. It is time to take into account both absolute and relative levels of fiscal discipline in Union-State fiscal relations.

Photo: mikealex


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