Economic Survey for IAS by civils360
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  • Most states achieved and maintained the target fiscal deficit level (3 percent of GSDP) and eliminated the revenue deficit soon after the introduction of their Fiscal Responsibility Legislation (FRL).
  • However, the FRL was not the sole impetus behind this impressive fiscal performance. Acceleration of GDP growth, increased transfers from the Centre, decline in interest payments and increased central CSS expenditure contributed significantly to such consolidation.
  • Fiscal challenges are mounting because of the Pay Commission recommendations, slowing growth, and rising payments from the UDAY bonds.
  • Introduction
    • The problem of fiscal management is the lure of eternal procrastination. To advance rather than defer the desirable goal of fiscal prudence, India like several other countries, embarked in the mid-2000s on an ambitious project of fiscal consolidation, adopting fiscal rules aimed at curbing fiscal deficits.
      • The most well-known and best-studied part of this project was the Fiscal Responsibility and Budget Management (FRBM) Act, adopted by the centre in 2003
      • This Act was mirrored by Fiscal Responsibility Legislation (FRL) adopted in the states
    • States’ fiscal position improved after 2005 and that some of this improvement can be attributed to the FRL
    • At first blush, the FRL seem enormously successful. The financial position of the states improved considerably after 2005,
      • The average revenue deficit was entirely eliminated, while the average fiscal deficit  was curbed to less than 3 percent of GSDP, just as the FRL had mandated.
      • The average debt to GSDP ratio accordingly fell by 10 percentage points to a mere 22 percent of GSDP in 2013
    • Yet just because fiscal progress followed the introduction of the FRL doesn’t mean the FRLs were responsible for this progress
    •  Several favorable exogenous factors aided this like
      1. An acceleration of nominal GDP growth which helped boost states’ revenues by about 1 percent of GSDP
      2. Increased transfers from the centre of about 1 percent of GSDP
      3.  Reduced interest payments of about 0.9 percent of GSDP on account of the debt restructuring package
      4. Reduced need for spending by the states as the centre took on a number of major social sector expenditures under the Centrally Sponsored Schemed
  • Summary of the fiscal responsibility legislation
    • The FRL aimed to impose fiscal discipline through a number of mechanisms including:
      1. Fiscal targets were established, which were the same for all states:
      2. The 12th Finance Commission allowed states to borrow directly from the market, in the hope that investors would also exercise some discipline, by pushing up interest rates on states whose fiscal position had not improved
      3. Finally, broad public discipline was enhanced by introducing new reporting requirements. States were required to publish annual Medium-Term Fiscal Policy reports
    • The fiscal deficit target was relaxed temporarily to 3.5 percent of GSDP in 2008/9 and to 4 percent of GSDP in 2009/10 in light of the global financial crisis
    • By FY 2010, the targets were set to the original FRL level of 3 percent.
    • 14th Finance Commission (FFC) recommended that fiscal deficit limits were to be relaxed by 0.5 percentage points for states which meet three conditions:
      1. zero revenue deficit in the previous year
      2. debt to GSDP ratio lower than 25 percent
      3. interest payments to GSDP ratio less than 10 percent of GSDP.
  • Impact on deficits
    • Comparing the 11 years before FRL to the 10 years afterwards (the period for which we have a balanced sample of states), fiscal deficits fell by almost half – from an average of 4.1 percent of GSDP on average to 2.4 percent of GSDP.
    • Revenue deficits also fell sharply from 2.1 percent of GSDP on average to -0.3 percent of GSDP after the FRL
    • The largest reductions in fiscal deficits came from states like Orissa, Punjab, Madhya Pradesh and Maharastra which lowered their deficit by more than 3 percentage points.
    • At the same time, the path of primary deficits hints at an underlying problem
      • A decade into the FRL, the average primary deficit was just as large as it was before the law – and the only reason this slippage hadn’t shown up in the other deficit figures was that interest payments had fallen sharply, in large part due to the centre’s debt relief.
  • External Factors that played a major role in fiscal responisbility
    • Central transfers as a percent of GSDP increase by 0.9 percentage points over this time period. This is more than half of the reduction in the fiscal deficit and about half the change in revenue deficit 
    • Own tax revenues as a percent of GSDP increase by 1 percentage point, largely due to high GDP growth and adoption of VAT.
    • Interest payments as a percent of GSDP fell by 0.9 percentage points, owing to debt restructuring
    • Non-interest revenue expenditure shows a modest increase of 0.4 percentage points
    • Revenue receipts increase from about 12.3 percent of GSDP on average prior to the FRL to 14.2 percent of GSDP post-FRL
  • Off-budget expenditure
    • A crucial concern with any fiscal rule is that it would encourage governments to shift spending off budget
    • By their very nature, these off-budget items are difficult to measure since the instruments may vary by state, are difficult to quantify and are not centrally compiled and accounted
    • In the pre-period budget estimates of own tax revenue are on average 5.9 percent higher than actual own tax revenue. This means that states were on average very optimistic when preparing their budgets.
    • After the FRL, there is sharp drop in the magnitude of the revenue forecast errors
    • Strikingly, the errors actually turn negative, which means the budget projections are pessimistic –
    • The same caution is seen in estimates of expenditure. These are all encouraging signs that FRL actually made a difference to the way states approached their budgets.
    • Another sign of increasing caution is the rise in state cash balances. As states have become increasingly dependent on central transfers, which can be delayed or arrive in lumpy amounts far exceeding the immediate requirements, they have tried to smooth their expenditures by holding large cash balances.
    • Holding of intermediate treasury bills (ITBs) have accordingly increased from 0.9 percent of GSDP to 1.3 percent of GSDP between 6 years before and 10 years after the FRL
    •  This trend is also consistent with a mechanical decrease in expenditure by states resulting from the increases direct expenditure by the Centre through the CSS.
    • Unspent funds are converted to ITBs.
  • Assessment  
    • FRLs clearly made an important difference, both in terms of outcomes and behaviour
      • States kept their average fiscal deficit at 2.4 percent of GSDP in the 10 years after the FRL, well below the prescribed ceiling of 3 percent of GSDP.
      • And there was also a striking change in behaviour: budget forecasting procedures improved, and there was a more cautious approach to guarantees, a build-up of cash balances, and a reduction in debt
    • much of the improvement in financial positions was possible because of exogenous factors, most notably assistance from the centre in the form of increased revenue transfers, the assumption of state debt, and the introduction of centrally sponsored schemes
    • the uniqueness or one-off character of the FRL experience is suggested by the relatively quick “decay.” That is, a few years after the FRL, all indicators of fiscal performance—deficits, expenditures, and especially off-budget activities—started deteriorating.
    • It is possible that the Centre has also prevented this deterioration by exercising Article 293 (3) of the Constitution.
      • Under this clause, States must take consent of the Centre for additional borrowing since they all had borrowing outstanding throughout the post-FRL period
  • Lessons for future fiscal rules
    • how fiscal performance can be kept on track
      • There may need to be greater reliance on incentivizing good fiscal performance not least because states are gradually repaying their obligations to the centre, removing its ability to impose a hard budget constraint on them
    • The Fourteenth Finance Commission (FFC) attempted to shift toward incentives
      • by relaxing some of the FRL limits for better-performing states
      • On the other, the Commission abolished entirely the other more broad-based incentive mechanism deployed by the Thirteenth Finance Commission (TFC) of allocating resources across states (the so-called “horizontal” criteria) based on states’ own fiscal performance
      • This criterion had a weight of 17 percent in the TFC recommendations. There may be considerable merit in going back to such an important incentive mechanism.
    • In addition, greater market-based discipline on state government finances is imperative. At present, this is missing, as reflected in the complete lack of correlation between the spread on state government bonds and their debt or deficit positions.
    • If markets rewarded prudent states, one would expect a positive relationship between the coupon rate and debt. Highly indebted states would have to offer a higher yield to make their bonds attractive.
    • Instead, there is a flat relationship between the spread and the indebtedness of states – states are neither rewarded nor penalized for their debt performance
      • Similarly, there is no relationship between the coupon rate and the fiscal deficit of states
      • Above all, however, incentivizing good performance by the states will require the centre to be an exemplar of sound fiscal management itself.
This chapter suggests that that saga of state prudence has been over-stated but the underlying asymmetry has some intrinsic truth. That is why the path of fiscal prudence embarked upon by this government is critical: in itself but also as a model for the states