This paper discusses the intermediation of financial saving in India and the implications for growth. Recent studies linking financial sector development and growth in India are reviewed. The following statistical data are also provided: employment and labor statistics, agricultural production and yields, index of industrial production, saving and investment, price developments, balance of payments, official reserves, reserve money, monetary survey, central and state government operations, indicators of financial system soundness, financial performance of Indian commercial banks, and selected monetary and exchange rate indicators.

Abstract

This paper discusses the intermediation of financial saving in India and the implications for growth. Recent studies linking financial sector development and growth in India are reviewed. The following statistical data are also provided: employment and labor statistics, agricultural production and yields, index of industrial production, saving and investment, price developments, balance of payments, official reserves, reserve money, monetary survey, central and state government operations, indicators of financial system soundness, financial performance of Indian commercial banks, and selected monetary and exchange rate indicators.

IV. State Government Finances1

A. Introduction and Overview

1. Following a period of relative stability, the fiscal situation of the states deteriorated dramatically in 1998 (Figure IV.1). The combined state deficit rose to an average level of 4.4 percent of national GDP, from less than 2½ percent of GDP in 1993/94. The deterioration reflects expanding state spending especially current and interest costs. Revenue (i.e., current) deficits increased even faster and a rising share of the gross financing requirement is being devoted to current spending rather than investment.

Figure IV.1.
Figure IV.1.

India: Trends in State Finances, 1990/91–2002/03 Budget

Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A004

2. State level finances play an important role in explaining the deterioration in general government (GG) finances. Since 1997/98, the GG deficit has widened from 7¼ percent of GDP to about 10 percent of GDP while the overall official debt burden grew to 84 percent of GDP. As the states undertake more than half of GG spending but account for less than 40 percent of total receipts, about half of the increase in deficit reflects deteriorating state finances.

3. The growing fiscal stress facing the states has manifested in several ways. The official debt of states now comprises 25 percent of GDP, compared to 18½; percent of GDP in 1993/94. The level of outstanding guarantees grew even faster as states made increasing use of guarantees and other assured payments arrangements to finance investment, although in 2002 progress was made in reducing the outstanding stock.2 Nevertheless, these guarantees could well result in direct claims on states’ budgets as the funds are mainly used for infrastructure projects.3 States are prolonged users of short-term credit facilities from the RBI, overdrafts are rising, and they are incurring arrears.4 Fiscal activities are also conducted off budget through various state owned financial corporations (SFCs) and utilities, and in turn, the financial health of these entities has deteriorated.5

Weaknesses in the system of inter-governmental fiscal relations underlie the deterioration. States receive central government (CG) transfers (shares of central taxes and grants) to help implement their budgets (Box IV.1). However, transfers from the center have failed to keep pace with rising expenditure. The average level of transfers fell by ½ percent of GDP during 1998-2001 compared to the 1993–1997. Yet state expenditure has grown by over ¾ percentage points of GSDP per annum since 1998/99. Two main factors underlie this rapid growth (Table IV.1): rising interest payments, reflecting growing debt, but also rising interest rates with the progressive deregulation of rates in the context of financial sector reform; and a 20 percent rise in combined pension and administrative costs (the latter includes wages) reflecting awards of the Fifth Pay Commission.6 In some states, pension liabilities are also expected to rise substantially in 3–5 years. Obligatory outlays now comprise over one-third of total spending and the share of expenditure devoted to investment has fallen to 11 percent.

Table IV.1.

India: Trends in Stale Finances

article image
Source: RBI Study on State Budgets; World Bank States’ database; and staff estimates.

4. The reliance on gap filling transfers creates little incentive for states to bridge the widening gap between expenditure and revenue. Rising spending has been accompanied by deteriorating revenues as the link between expenditure and revenue decisions weakened. States’ own revenue resources cover only half of their current outlays. Relative to the mid-1990s, state’s own revenue resources have fallen by ½ percent of GSDP reflecting the lack of adjustment of user fees for utilities and other government services. In addition, little effort has been made to expand state’s own tax bases causing the average state tax-to-GDP ratio to stagnate at the level of the mid-1990s. Property values have not been reassessed undermining the urban property tax yield, and most states do not tax agriculture income and property.

5. The rest of this paper is structured as follows: Section B examines fiscal performance in the 15 largest states. Section C assess whether the problems experienced in India are common in other decentralized systems. Section D reviews recent reforms undertaken to correct states’ fiscal imbalances, and Section E concludes with policy recommendations.

B. Regional Disparities in Fiscal Performance: The Empirical Record

6. Deficits and debt rose across most states in the 1990s but the deterioration was more pronounced in those with larger initial imbalances (Figure IV.2).7 In Madhya Pradesh and Tamil Nadu, the deterioration reflects growing interest burdens. However for most, it reflects the failure to address already large (Gujarat, Orissa, and Kerala) and in some cases, growing, primary deficits (Andhra Pradesh, Bihar, Karnataka, Rajasthan, and West Bengal). The deterioration in the deficit in Maharashtra, Haryana, and Madhya Pradesh may have been contained by making more intensive use of guarantees to help finance investment. The states experiencing greatest stress remained broadly stable between 1990 and 2000.

Figure IV.2.
Figure IV.2.

India: Fiscal Performance by State, 1990 and 2000

(In percent of GSDP)

Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A004

Sources: World Bank States database; and staff calculations.

7. The more rapid pace of fiscal deterioration in the late 1990s is however attributable to the performance of a few states. West Bengal, Andhra Pradesh, Gujarat, Bihar, Tamil Nadu, and Karnataka account for almost 60 percent of the decline in financial indicators since 1997/98. The share of the states’ combined deficit accounted for by West Bengal and Gujarat rose from 16 percent in 1997/98 to over 20 percent by 2002; that of the other four states rose from 25 percent to 33 percent. Expenditure pressures in these six states were high. While combined state expenditure grew in nominal terms by 11.3 percent, expenditure growth ranged from a high of 123 percent in Bihar to a low of 12 percent in Tamil Nadu. Most of the growth in spending was attributable to recurrent rather than capital outlays. In Karnataka, where expenditure grew by only 6 percent, the decline in own revenue played a more important role.

8. Changes in the arrangements for distributing transfers also exacerbated the divergence across states. The Tenth and Eleventh Finance Commissions (EFC) devolved higher shares of central tax revenue. They also changed the formula for allocating resources between states to assist those states facing greater resource deficiencies and higher costs for service provision, while also trying to provide incentives for states to impose fiscal discipine.8 The new formula cut transfers to Karnataka, Andhra Pradesh, and Tamil Nadu despite above-average financial pressure, and penalized states, such as Kerala, who had reduced their deficit. While extra resources were given to states in greater stress (Bihar, West Bengal, and Gujarat) it was not sufficient to prevent their deficits from widening in the face of the rapid growth in spending.

9. The evidence points to large disparities in the extent of fiscal distress across states. A statistical analysis using cross-section regressions9 suggests that the structure of a state’s fiscal system plays an important role in explaining the cross-state disparities, as does the level of economic development (Figure IV.3):

Figure IV.3.
Figure IV.3.

India: Relationships Between State Deficits and Economic Structure, 1990–2000 1/

Citation: IMF Staff Country Reports 2003, 261; 10.5089/9781451818574.002.A004

Source: World Banks States database; and staff calculations.1/ P-Values are shown in brackets. * implies variable is significant at the 5 percent level.
  • State deficits are significantly larger where the gap between own revenue and expenditure is larger illustrating that central transfers fail the bridge financial gaps between states. The positive intercept shows that transfers are insufficient to close the gap between the combined states resources and expenditure responsibilities.

  • States with greater autonomy demonstrate greater discipline. The higher own resources in total taxes and expenditure, the lower the deficit.

  • Poorer and slower growing states have significantly larger deficits, suggesting the level of development helps explain why some states have larger deficits.

10. Other structural characteristics seem to be less important in explaining the diverging performance. Larger states (area or population), and agricultural or service dependent states are associated with larger deficits but the relationships are not statistically significant. Market borrowing does not have a significant impact on fiscal discipline but the positive correlation suggests potential moral hazard from an implicit CG guarantee. Fiscal deficits are positively, but insignificantly, related to the deficits in the power sector.

11. Between 1997/98–2000/01, states that progressed furthest with economic liberalization experienced greater fiscal stress. The greater the diversification of economic activity away from agriculture, the greater the deterioration in fiscal deficit (except in Bihar). High income, but more slowly growing states also experienced a more pronounced deterioration.

C. Fiscal Federalism in an International Context

12. India’s fiscal system, already one of the most decentralized in the world, became increasing decentralized over the past decade (Table IV.4). States in India are responsible for a higher proportion of GG spending than in most developing economies. Only China has a higher level of subnational expenditure. The higher level of expenditure responsibility is not matched by control over own revenue resources. As a result, states are more dependent on transfers.

13. The extent of the states’ fiscal imbalance in India is high. The combined state deficit accounts for greater share of the general government deficit than in most other countries. In over half the sample, subnational governments run surpluses or near balanced budgets. Many others, especially in Latin America, made progress in the 1990s in correcting sub-national deficits while in India they deteriorated.

14. It is unclear whether the states’ imbalances in India are the result of the greater decentralization. A closer look at Table IV.4 shows that subnational fiscal discipline is not problematic in highly decentralized countries like Canada, Denmark, the United States, Switzerland, and South Africa. However in other highly decentralized system, such as Argentina, Brazil, and Germany decentralization is associated with problems and has eroded macroeconomic instability. Various empirical studies have found that decentralization is associated with fiscal indiscipline at the subnational level and can aggravate fiscal problems at the central level, especially in developing countries.10 For example, de Mello (2000) finds in developing countries that as the share of subnational spending in total government spending increases it tends to worsen the central government balance, yet there is no clear evidence of a deficit bias in the more decentralized OECD countries. Fornasari, Webb, and Zhou (2000) also find that increases in subnational spending and deficits lead to increases in national spending and deficits. Yet for India, Shome (2002) finds that decentralization is associated with lower fiscal deficits both at the individual states and central government levels.11

15. In countries where institutional and financial arrangements for decentralization are weak, decentralization results in macroeconomic problems. Hard budget constraints and the incentives for responsible behavior are undermined when the framework for intergovernmental fiscal relations is characterized by a

  • lack of subnational autonomy over revenue and expenditure; and high dependence on transfers,

  • lack of constraints on subnational indebtedness, and

  • lack of clarity in the respective roles of each tier of government as well as weak institutions arrangements for tax administration and expenditure management.

16. The system of federal relations in India possess many of these characteristics:

  • Tax autonomy is low, especially compared to other countries such as China (Table IV.2). However, shared taxes—which are closer in nature to grants because they are not distributed on a derivation basis—comprise a smaller share of state taxes.12 With less than one-third of taxes comprising shared taxes, most of the tax base is under state control. But in common with China, local income and property tax bases and rates are determined with the CG and states work around the set statutory rates by providing tax incentives.

  • There is a high degree of transfer dependence. Transfers account for a larger share of revenue, and slightly higher share of expenditure, than is typical in most decentralized systems. States have little control over the use of these grants. The split in responsibility for grant allocations across two agencies—the Finance and the Planning Commissions—is also unusual (Box IV.1). It leads to coordination problems, creates incentives for states to overstate revenue needs, and it allows larger and politically stronger states to bargain for larger transfers.13

  • The system necessitates high borrowing. Even after shared taxes and central grants, the states’ deficit remains high (Table IV.3). Elsewhere, tax sharing and grants bring subnational deficits closer to balance.

  • The rules governing subnational borrowing are comparatively liberal and the borrowing regime ranks highly on an index of borrowing autonomy (Table IV.4). Many developing countries prohibit or ban local borrowing (China and Indonesia). Most that permit borrowing impose numerical ceilings on subnational indebtedness. Where ceilings are absent (South Africa and Czech Republic), hard budget constraints is enforced by legally prohibiting CG guarantees of subnational debt and state guarantees of public enterprise debt. India’s borrowing regime is closer to that of advanced economies with the important difference that external borrowing is prohibited.

Table IV.2.

India: Decentralization in an International Context

article image
Sources: GFS, IFS; and staff calculations.

Excluding grants from the central government.

For China, non-GFS data from Ahmad, Keeping, Richardson and Singh (2002) IMF WP/02/168.

Table IV.3.

India: Subnational Autonomy in an International Context

article image
Sources: GFS, IFS: and staff calculations.

Ratio of tax revenue (including shared taxes) to total sub-national revenues, including grants.

Ratio of shared taxes from central government to total situational tax revenue.

Ratio of central grants to total consolidated expenditure of subnational governments.

Deficit as a share of sub-national non-grant revenue; a positive number implies a surplus.

Tax share ratios from Ebel and Yimax (2002).

Tax share ratios from Dabla-Norris and Wade (2002).

Tax autonomy measure is from GFS data from 1995–1999. Other variables measured from data reported in IMF WP/02/168 for 1990–1997 Subnational governments in China receive 25 percent of domestic VAT, the business tax, enterprises income taxes on state enterprises, the person income tax and a number of smaller taxes. Rates on these taxes are generally decided by the centre.

Table IV.4.

India: Subnational Borrowing Constraints in an International Context

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Source: World Bank Decentralization Database; Rodden (2002).

Compiled by Rodden (2002).

Except for the capital city.

17. This combination of (de facto or de jure) soft-budget constraints and transfer dependence generated serious fiscal problems in other countries. Brazil and Argentina are well known examples where the bail out of subnational governments led to moral hazard problems. The ability to tap state-owned banks and enterprises proved problematic in Germany. A weak regulatory framework contributed to subnational bankruptcies and bailouts in the Czech Republic, Columbia, and South Africa. In transition economies, unfunded expenditure mandates resulted in arrears. In India, the states financial problems have not become a source of external instability because of the constraint on external borrowing.

D. Recent Policy Initiatives

18. Various steps have been taken to address state finances but it is not clear that these are sufficient to bring about a lasting improvement in states finances:

  • Efforts to limit borrowing: The growth in guarantees prompted the RBI in 1999 to urge states to set guarantee ceilings. To date statutory ceilings are operative in five states, and administrative ceilings in three others. A few states have set up guarantee redemption funds. One state enacted fiscal responsibility legislation in 2003 that includes debt ceilings, although there are questions about how successful states will be in meeting these various ceilings when they remain heavily reliant on central transfers. The RBI has recently introduced prudential requirements for guaranteed loans and investments. Investments in state government guaranteed bonds outside the market-borrowing program would now attract a credit risk weight of 20 percent. If a guarantee is invoked and is not honored, a credit risk weight of 100 percent is to be assigned.

  • Debt restructuring and write-offs: Arrears and part of the accrued interest owed by SEBs to power generating public sector undertakings were settled in 2003 through the issue of 15-year tax-exempt state-government bonds worth 1 ½ percent of GDP. The rest of the accrued interest was written-off.

  • Voluntary debt relief schemes: Since 1995, states have been engaged in voluntary fiscal adjustment programs with the CG who writes off the debt owed to it in return for fiscal adjustment. These agreements were not legally binding, and did not contain limits on new borrowing or sanctions. The relief provided was small. Thus, the schemes had limited success in arresting the growth in state debt. The new States Fiscal Reform Facility offering additional transfers between 2000 to 2005 for adjustment suffers from similar drawbacks.

  • Debt service relief: From 2003-05, states will use 20 percent of their borrowing from the small savings scheme and additional funds borrowed from the market to prepay (at face value) debt to the CG carrying interest rates in excess of 13 percent. Because interest rates on these new borrowings are lower, states will obtain relief on their interest expenditure.

  • Other steps: There is a growing awareness among states of the need to revise user charges for public services. For example, states have set up State Electricity Regulatory Commissions to determine electricity tariffs so as to reduce subsidies. Further some states have increased fees for higher education.

E. Policy Recommendations

19. The deteriorating finances of state governments need to be tackled with greater urgency. The fact that state finances continue to worsen despite various reforms suggests more needs to be done preserve the credibility of the states’ own reform goals and to close the growing gap in fiscal and development indicators across states. A comprehensive reform that addresses the existing debt stock while redesigning revenue and expenditure assignments to prevent its recurrence is needed. The reforms required are well documented in various studies and should include:14

  • Strengthening the framework regulating subnational borrowing and guarantees: The framework should include an explicit commitment by the CG to reframe from further subnational bailouts; and centrally set ceilings on state debt that are risk based so that ceilings are gradated by the solvency of a state’s finances.

  • For guarantees, establishing escrow accounts in borrowing units; making credit ratings mandatory; and beginning risk-based provisioning.

  • Strengthening supervision of state credit: Prudential regulations should require financial institutions to provide for risky and nonperforming state and state enterprise debt to strengthen the central government’s commitment to a policy of no bailouts.

  • Improving the quality, comprehensiveness, timeliness, and availability state financial data: To facilitate informed credit risk assessment on the part of lenders.

  • Reducing dependence on CG transfers by increasing state taxes: Tax agricultural income; introduce a state level VAT, and extend the VAT to services.

  • Reconsidering the rationale for and relevance of the separation of plan and nonplan expenditure and assistance: Grants could be amalgamated and should address imbalances across states. The distribution formulae should be revised to use criteria that capture deficiencies in basic minimum needs. A portion of the grant may be earmarked for capacity building (South Africa).

  • Strengthening budget planning and implementation: Introduce multi-year fiscal budgeting, monitor and audit fiscal outturns, and evaluate expenditure effectiveness.

  • And finally, as these reforms are implemented and as regulatory, supervisory, and monitoring mechanisms are strengthened, increase reliance on market borrowing, so that states would be subject to the discipline of the market.

Federal Arrangements in India 1/

India is a federal state with strong unitary features. There are three tiers of government. The central government; an intermediate tier of 28 states and seven union territories (five are governed by central government appointees) and local bodies. Local bodies were given constitutional status in the 1993 amendments to the Constitution which made mandatory the creation of rural and urban bodies within states, a provision that was previously optional. There are now 247,033 rural bodies know as Panchayats and 3,682 urban bodies. The Constitution grants strong powers to the central government including the supremacy of central legislative power, control of the central executive over state legislation, the right to take over state administration in a state of emergency. All residuary power rests with the central government.

The Constitution assigns a wide range of functions to the states. The functions of the central government relate to macroeconomic stability, external relations, and areas of cross state interest, and include defense, foreign affairs and trade, transport, post, telecommunications, as well as strategic and heavy industries. States are responsible for health, education, power, irrigation, roads, rural development, public order and other functions.

On revenue, the Constitution prevents overlapping tax powers and assigns taxes by source. The central government exclusively levies personal income tax (except on income earned from agriculture and the self-employed) corporate tax, import duties, and income tax surcharges. States can raise taxes on agricultural and self-employed income, but few states avail of this option. The authority to levy taxes on property wealth and capital transactions is spilt. The centre is responsible for raising taxes on nonagricultural sources. Agricultural sources are assigned to the states but currently no state taxes agricultural wealth and property. Taxes on the sale of goods are the most important income sources for states. Services are excluded from the base, and until the 93rd Constitutional Amendment in 2003 the central government levied taxes on a limited number of services using its residual powers.

The Constitution recognizes that the assignment of tax powers creates vertical imbalances and provides principles for the sharing of resources between the centre and states. States received a specific share of the total central government tax collections. The Constitution does not specify the revenue shares but instead provides for a Finance Commission (FC) to be appointed every five years to recommend how taxes are to be shared, and how these resources are to be divided among the states.

The vertical imbalances that remain after revenue sharing are filled through a combination of central government grants and borrowing. Responsibility for grant allocations is split between two agencies. The main “plan” grant is for implementation of state-level development plans approved by the Planning Commission (PC). These grants are distributed by a formula that effectively allocates resources to states with higher development needs and lower revenue capacity. About 30 percent of PC funds are distributed as grants. Specific earmarked grants for central sponsored schemes are also provided by the PC. The FC recommends grants-in aid to help fill residual gaps on the nonplan budget. The Constitution permits domestic state borrowing which is subject to central approval if a state has outstanding obligations to the centre. Loans from the central government were the most important source of borrowed funds because until 2002/03, it onlent the net proceeds from the small savings funds to states. Now the net proceeds from these funds are channeled directly to the states. The PC also allocates about 70 percent of its resources in the form of loans. Short-term borrowing (ways and means advances) from the RBI, up to specified limits, is also permitted to meet temporary mismatches of receipts and expenditure of the state governments.

1/ See Hemming et al in Ter-Minassian (1997), Rao and Singh (2001), and the EFC for further details.

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1

Prepared by Catriona Purfield.

2

Of total guarantees, 44.6 percent of guarantees are for power, 13.4 percent for irrigation and 0.7 percent for road projects.

3

Banking industry estimates show that defaults on state government guaranteed loans have exceeded Rs. 2,500 crore (0.1 percent of GDP) in September 2002, up from Rs. 1,800 crore at end-March 2002.

4

Twenty states utilized overdrafts at the RBI in 2002. In 2003, the supreme court ordered the payment of overdue salaries in Bihar.

5

The SFCs’ capital adequacy ratio is negative (22 percent), and nonperforming assets range from 30 percent to 90 percent. Electricity cost recovery has fallen to 69 percent and the power sector losses are 1 percent of GDP.

6

In 1998/99, the Fifth Pay Commission recommended a 30 percent increase in civil servant salaries and a corresponding reduction in the work force. The pay increase was granted but employment rose slightly.

7

Except Kerala, Punjab, and Uttar Pradesh.

8

Under the EFC, the weights assigned to cross state income differentials, area, and infrastructure increased while that assigned to tax effort was reduced. A new index of fiscal discipline was introduced but was given only a small weight.

9

Each regression estimated took as the dependent variable the average level of the deficit between 1990/91–2000/01; the independent variables were also averaged over the same period.

11

Except when transfers are excluded and the inability of states to fund from their own expenditure in the absence of central government transfers results in higher state level deficits.

12

In Denmark, Germany (income taxes only), and Hungary shared taxes are distributed on a derivation basis.

13

See Rao and Singh (2000).

14

See RBI (2002); the EFC; The Kelkar Task Forces on Direct and Indirect Taxes; and Shome (2002).

India: Selected Issues and Statistical Appendix
Author: International Monetary Fund
  • View in gallery

    India: Trends in State Finances, 1990/91–2002/03 Budget

  • View in gallery

    India: Fiscal Performance by State, 1990 and 2000

    (In percent of GSDP)

  • View in gallery

    India: Relationships Between State Deficits and Economic Structure, 1990–2000 1/