This Selected Issues paper for India reports that rapid growth is presenting new challenges to macroeconomic policy, although ensuring the sustainability of this growth requires broad-based fiscal and structural reforms. Higher world oil prices present risks in both the near and medium term. In the short-term, higher oil prices combined with robust domestic demand threaten to push inflation higher. Over the longer-term, permanently higher oil prices can depress growth and widen fiscal imbalances, in particular if the economy is not allowed to adjust to new price levels.


This Selected Issues paper for India reports that rapid growth is presenting new challenges to macroeconomic policy, although ensuring the sustainability of this growth requires broad-based fiscal and structural reforms. Higher world oil prices present risks in both the near and medium term. In the short-term, higher oil prices combined with robust domestic demand threaten to push inflation higher. Over the longer-term, permanently higher oil prices can depress growth and widen fiscal imbalances, in particular if the economy is not allowed to adjust to new price levels.

IV. India—State Finances and the Twelfth Finance Commission1

A. Introduction and Overview

1. Long-term fiscal developments in the states have been disappointing (Table IV.1). Between 1993/96 and 2000/03 states’ revenue deficit climbed by 1.9 percent of GDP, their overall deficit by almost 1½ percent of GDP and their debt by over 13 percent of GDP. There are several reasons for this, including the fifth pay commission awards in 1997 (which led to a 60 percent salary increase and a sharp increase in pensions), a relative decline in revenue to be shared with the states (due to poor indirect tax performance), tax competition between the states, a rising interest burden (due to rising nominal interest rates and debt), and low tax buoyancy during the growth slowdown of 2001–2003.

Table IV.1.

India: Trends in State Finances

(In percent of GDP)

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Source: Reserve Bank of India.

2. Staff estimates for 2004/05 suggest that state finances have begun to improve. States reduced their overall balance to just over 3½ percent of GDP, and their revenue deficit dropped by almost 1 percent, to 1¼ percent of GDP. Recent factors for improvement of state finances have included an upturn in the GDP growth rate, a fall in nominal interest rates, the central government’s debt swap facility (which allowed states to restructure their high interest debts), agreement in 2000/01 on floors for sales tax rates and on reduction and elimination of various tax incentives, pension reforms in some states, and incentives from the center to reduce electricity subsidies.

3. However, state’ overall fiscal situation remains problematic. The aggregate state debt ratio remains around 33 percent of GDP (320 percent of state own revenues); while the interest bill continues to consume more than 25 percent of state own revenues. The situation is even more serious for some individual states, with debt ratios approaching 100 percent in some special category states, and debt-to-revenue ratios as high as 400 percent (in the middle-income state of West Bengal). Looking forward, a lack of free resources constrains state governments’ ability to maintain existing infrastructure and invest in new projects, and may limit options to expand social spending.

4. Against this backdrop, in late 2004, the 12th Finance Commission (TFC) submitted its Report and recommendations on fiscal federal relations in India to the government. The Indian constitution requires the appointment of a Finance Commission at least every five years to mediate the sharing of resources between the center and states. The TFC’s framework provides three channels through which states can improve their fiscal circumstance. States will benefit from a higher revenue share and higher grants, and from debt restructuring and relief. The latter is conditional on passage and implementation of fiscal responsibility legislation (FRLs) targeting revenue balance by 2008/09 and a 3 percent of GDP overall deficit by 2009/10. States will also confront a stricter borrowing regime, with the center setting global ceilings on borrowings and henceforth only lending to fiscally weak states. Each of these is a step in the right direction, and in line with previous IMF staff recommendations (see, for example, Purfield, 2004).

5. This chapter looks at the likely impact of TFC recommendations on state’ fiscal position. Section B briefly reviews the key TFC recommendations: more resources for the states, the incentive scheme for fiscal adjustment, and the framework for greater borrowing discipline. Section C then discusses the direct impact of higher resources on both the states and center, and Section D evaluates the incentive scheme and borrowing regime. Section E considers whether the adjustment is on track at an aggregate state level, and Section F examines whether it works for every state. Finally, Section G considers ways in which the fiscal federalism framework could be strengthened, drawing on international practice.

B. Direct Impact on Government Finances

6. The TFC’s framework will have a considerable direct impact on state, central and general government finances. The direct impacts—due to a higher revenue share, higher grants, and interest relief—are before any behavioral impacts due to incentives (the borrowing regime and the debt-relief facility, which are discussed in more detail below). The impact can be considered against a baseline reflecting a continuation of revenue and spending ratios at levels realized during 2004/05 (Table IV.2). Several important points emerge:

  • States can realize a large improvement in their deficit in 2005/06, with little fiscal effort. Revenue and overall deficits could drop by as much as 0.6 percent of GDP due to higher direct and untied transfers.2 States appear to have embedded such improvements in their 2005/06 budgets.

  • However, states will need to undertake fiscal adjustment in future years just to maintain their deficit at 2005/06 levels. The challenge is driven by the fact that grants from the center are (i) fixed in nominal terms, and thus declining in terms of GDP; and (ii) shifting in their composition away from untied gap-filling grants towards tied grants (which must be spent). Thus, to sustain the improvements being realized in 2005/06, fiscal reforms need to continue.

  • The central government must undertake more fiscal adjustment upfront to achieve its fiscal adjustment targets (i.e., as specified in fiscal responsibility legislation). In 2005/06, the center’s revenue deficit would deteriorate by about 0.7 percent of GDP, though the overall central government deficit could remain broadly unchanged if the center stops lending to states as planned.3

  • The general government fiscal deficit could deteriorate. The deficit would increase by an amount equal to the additional tied spending by the states (otherwise, all transfers cancel out in the consolidation). However, the TFC recommended that the center withdraw from spending in areas which are state’ responsibility and, if implemented, this would offset the impact of the higher state spending.

Table IV.2.

India: Projected Impact of Twelfth Finance Commission Recommendations on Fiscal Baseline

(In percent of GDP)

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Sources: Government of India, Report of the Twelfth Finance Commission; and Fund staff estimates.


As in 2005–06 budget.

C. The Impact of the New Incentive and Borrowing Regimes

7. The FRL debt relief incentive scheme introduced by the TFC is a positive step, but there are reasons to be cautious about its impact:

  • International experience to-date suggests that FRLs can assist, but are not sufficient to ensure, fiscal adjustment. In general, countries where FRLs seem to have been effective are those where the law was imposed after the fiscal adjustment began (see IMF, 2005), and have had well-developed public financial management systems and accountability mechanisms; and comprehensive coverage (e.g., of public enterprises). In some Indian states, fiscal adjustment pre-dated the passage of FRLs, but deficiencies in public financial management systems are widespread (especially in the timely and complete reporting of budget data), and no sanctions (apart from reputation) are evident in the model FRL or in the FRLs already passed.

  • The focus of conditionality in India on difficult-to-monitor above-the-line data (i.e., the revenue balance) creates an additional challenge. Experience with the previous Fiscal Reform Facility demonstrated that under stress, fiscal adjustment definitions could be flexibly interpreted (see Chapter 11 of the Report of the TFC). This is also consistent with the international experience of fiscal rules. An effort has been made to close a key channel of past misclassification in India: debt and equity “capital” transfers to enterprises in lieu of subsidies. However, looking forward, accrued off balance sheet liabilities (e.g., pensions, and quasi-fiscal activities in PSUs), and public private partnerships (and the difficult-to-value guarantees which they generate) could provide adjustment loopholes, unless correctly accounted for. Timing considerations also present a challenge: the debt service to be forgiven will come due well before audited information will be available about performance.

8. Similarly, the steps taken to strengthen the borrowing regime are a positive step, but there remain some gaps:

  • Administrative controls remain to be tested and are loose at present. In general, administrative controls can create moral hazard, insofar as approval of state borrowing may make it difficult to deny assistance if a state runs into difficulty later on (Ahmad et al., 2005). In India, the central government has long had the power to administratively control borrowing, and has not always used it effectively.4 In fact, through the required borrowing associated with 5-year plan assistance, and recent requirements that states borrow all resources generated from small savings funds, the center has arguably helped to create the state’ debt problem. This implies that particular efforts will be needed to start a tighter and more credible regime of control. Against this backdrop, state’ borrowing limit for 2005/06, set well above their projected aggregate deficit level, sends a very mixed signal.

  • The full underpinnings for a system of borrowing based on market discipline are not yet in place. International experience suggests that for market discipline to be effective, there needs to be (i) no source of soft lending; (ii) a credible no bail-out commitment from the central government; and (iii) public availability of information on all forms of debt.5 While the central government has withdrawn from lending in 2005/06, soft sources of financing remain: it retains the ability to lend to “weak” states (and under even more favorable terms than in the past); small savings fund (NSSF) deposits remain a captive source of finance;6 state debt is considered part of banks’ statutory liquidity ratio, allowing easy placement of their debt with little mark-up; and the RBI continues to provide ways and means advances. At the same time, the credibility of a no-bail-out commitment may not be high in India, since no state has ever been left to fail, and since bail-outs are not explicitly prohibited. Finally, data on state debt are subject to significant ex-post revisions.

D. Scenarios for Aggregate State Fiscal Adjustment

9. The total impact of the TFC framework on state’ finances depends on the direct impact, the response of states to the adjustment incentives, and on macroeconomic developments. The TFC developed a full macro-fiscal framework taking these factors into account. It assumed that both the center and states reduced their fiscal deficits to levels targeted in FRLs. This created space for higher public and private investment, which in turn underpinned higher GDP growth. At the state level, adjustment efforts involved an increase in the revenue-to-GDP ratio (due to buoyancy and tax base broadening), and a decline in revenue expenditure as a share of GDP (due to a declining interest bill, a reduction in the wage bill, and a reduction in subsidies). The adjustment efforts create room for an increase in public investment by ½ percent of GDP annually (see Table IV.3).

Table IV.3.

India: State Fiscal Adjustment Scenarios

(In percent of GDP)

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Sources: Government of India, Report of the Twelfth Finance Commission; and Fund staff estimates.

10. Recent developments suggest a need to update the medium-term fiscal adjustment scenario for the states. States are in a better initial fiscal position than envisioned: the TFC expected a 4½ percent of GDP overall deficit and a 2 percent of GDP revenue deficit in 2004/05, well above revised estimates. At the same time, it is important to reconsider risks: in the TFC baseline, the projected growth of 7 percent is about 1 percent above its historical average, while the projected real interest rate of 2 percent is about ¾ percent below the 10 year average. Movements towards historical averages—which would narrow the growth-interest rate differential—would have a considerable impact on debt dynamics.

11. Three scenarios are developed, covering a baseline, high growth, and low growth case. The baseline assumes growth will continue at its recent average, while the high and low cases are about one standard deviation above and below the TFC’s baseline growth assumption, respectively. In the baseline scenario, revenue buoyancy is assumed to be in line with recent trends, but rises and falls moderately under the different growth assumptions. In each scenario, states are assumed to try to raise both primary revenue spending (reflecting the need for operations and maintenance and social spending), and capital spending (with a view to achieve the TFC’s target of a total investment increase of ½ percent of GDP). However, if the scenario shows a burgeoning deficit, states are assumed to restrain their spending. Finally, since the aggregate state deficit path differs across the scenarios, the total debt and interest relief received by states is allowed to vary across scenarios: over ¾ of states (on a value-weighted basis) receive the debt relief in the high growth scenario, but less than half do in the low growth scenario.

12. With these assumptions several important results emerge (Figure IV.1 and Table IV.3):

Figure IV.1.
Figure IV.1.

India: Fiscal Outcomes Under Adjustment Scenarios

Citation: IMF Staff Country Reports 2006, 056; 10.5089/9781451818635.002.A004

  • States, in aggregate, are broadly on track to achieve the TFC fiscal targets. Under the baseline, the revenue deficit is cut by about 1¼ percent, to ⅓ percent of GDP, and the overall deficit falls by slightly under 1 percent to just over 3 percent of GDP by 2009/10. Capital spending also rises to 3 percent of GDP.

  • However, broad achievement of TFC targets would not be sufficient to sustainably reduce state debt ratios. Under the baseline, state debt would fall initially by about 1 percent of GDP, but then begin rising. It would reach almost 32 percent of GDP by end-period. Even in the TFC’s scenario, debt reduction were extremely gradual and a small drop in growth is all it takes to reverse debt dynamics.

  • Result are sensitive to growth and interest rate assumptions. In the low growth scenario, targets would be missed by a wide margin and debt would rise throughout the period. States are forced to substantially curtail investment by end-period to cope with a rising interest burden. In the high growth scenario, all targets are exceeded.

13. What policies are needed to shift the outcome towards the high growth scenario? An active upfront adjustment effort in Indian states, focused more on efficiency enhancing measures and creating more room immediately for infrastructure and other investment would be more likely to stimulate growth than a strategy which relies heavily on revenue buoyancy and interest savings to achieve results over time. To achieve a stronger upfront adjustment and improve economic efficiency, expenditure measures would be important, for instance subsidy and pension reform and wage bill restraint. Tax measures would also be crucial, and base broadening and implementation of the state level VAT (and ultimately the GST) would be key areas to focus on.7

E. Fiscal Adjustment in Individual States

14. Even if states in aggregate achieve a sustainable debt level, some states may yet face significant fiscal stress. Since states face widely varying initial fiscal conditions and diverse growth prospects, some are likely to require more fiscal adjustment and/or debt relief than others to achieve a sustainable debt position. The TFC framework, however, only sets a minimum absolute requirement common to all states. One approach to examining this problem would be to simulate fiscal policy for individual states over a 10 year period to highlight the direction of each state’ debt ratio in the five years after TFC targets have been met. An alternative approach followed here, which is much less data intensive, is to consider whether a state would achieve a debt stabilizing balance if it were to implement the full TFC fiscal adjustment upfront (i.e., revenue balance and a 3 percent of GDP overall deficit) and were to be given all of the proposed debt rescheduling and relief upfront.8

15. In calculating debt scenarios for individual states, assumptions are used which bias the analysis against finding problems. For each state, the historic state growth rate is used, adjusted for the difference between projected growth for the economy as a whole under the baseline macro scenario (Table IV.3) and past growth for the economy as a whole. States are assumed to face the same interest rate on new borrowing, approximately the rate on small savings (which are the largest source for state borrowing at the moment). This rate is assumed to remain above market interest rates, but to evolve over time in line with them. Weaker states would, however, almost surely face a harsher borrowing environment. At the same time, if the adjustment were to be phased instead of undertaken upfront, the initial debt ratio would be higher for many states. On both counts, debt dynamics would be worse.

16. Nonetheless, analysis of the general category states suggests that many of them would indeed continue to face significant fiscal stress (Table IV.4):9 10

Table IV.4.

India: Sustainability of State Debts Post-TFC; Baseline Scenario 1/

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Source: World Bank; IMF staff estimates.

Assumes that all debt relief and fiscal adjustment were to be realized up-front.

Amount of adjustment required to realize 1 percent of GDP in debt relief.

Assumes an overall deficit of 3 percent of GDP.

When a positive gap exists, the overall debt level would be declining.

  • The primary adjustment required by the TFC varies greatly across them. Some states are already in sustainable positions (e.g., Haryana), but others face gaps exceeding 4 percent of GDP (e.g., Rajastan). For states facing large adjustments this would not likely be feasible over a 5-year period without deep cuts to key programs.

  • Not all of the general category states would achieve a debt stabilizing primary balance. Four states would face a need for a further small primary adjustment of about ½ percent of GDP to become sustainable.11 If states instead can only implement a maximum adjustment equal to 10 percent of their initial spending level, then a further two states (Rajastan and Gujarat) would also fall short of sustainability.

  • Finally, for those states that do achieve a sufficient primary balance to reduce debt, debt-to-revenue and interest-to-revenue ratios can nonetheless remain very high (e.g., 360 and 37 percent in West Bengal). This signals that significant crowding out of other budget items is likely.

17. At the same time, the debt relief incentive scheme may prove insufficient to motivate a full adjustment effort in some states. While the central government is providing considerable resources to the states in aggregate, for many individual states the debt relief is minor relative to their total outstanding liabilities, and relative to the amount of primary adjustment that they need to undertake (Table IV.4; see also Kurian, 2005). From another perspective, for an amount of debt relief equivalent to only 8½ percent of the transfers they are already set to receive, states would have to undertake very politically difficult policy reforms. For states where there is no present consensus, and which face a very large adjustment requirement, the incentive on offer may prove inadequate.12

18. For those states whose fiscal problems would not be solved even by fully following TFC recommendations, more ambition in adjustment efforts is needed. The TFC did not limit state’ fiscal adjustment to that necessary to achieve a revenue balance and a 3 percent overall deficit. Thus the MoF in the central government should encourage all states to embed a primary balance target in their FRL sufficient to ensure that their debt level will ultimately fall. Borrowing limits should be tailored to this target (see Section D). To provide an incentive towards a more appropriate target, the MoF could offer to cancel a small amount of remaining central government debt (consistent with its own fiscal capacity) at the end of the 5-year period, conditional on fiscal targets having been achieved.

19. More direct measures may ultimately prove necessary for states which do not follow TFC recommendations. For these states, if there is no sign of progress by the time of the 13th FC and they remain in a state of severe fiscal stress, more direct intervention could be considered. While a higher incentive may not be feasible, given the fiscal constraints faced by the central government (nor desirable, in light of concerns about moral hazard), tighter conditionality on grants could be pursued, with an aim to bring about policy reform measures to improve their underlying fiscal balance.

F. Improving the Borrowing Regime and Incentive Structure

20. Given the risks to achieving TFC targets, especially at the individual state level, there is good reason to consider ways in which the borrowing and incentive regime could be strengthened. On the borrowing side much can be done in the short term; however, on the incentive side, due to the constitutional prerogative of Finance Commissions over the design of fiscal federal relations, some of the more attractive options may need to await the Thirteenth Finance Commission (which would likely report in late 2009).

21. India could in the near term take measures to strengthen the borrowing regime:

  • The central government could set borrowing ceilings more in line with FRL adjustment targets. It could also harden the rules for approval of new borrowing: as in some countries with FRLs (Brazil, Ecuador, and Colombia), it could condition approval of borrowing on demonstrating compliance with the FRL. Ultimately credibility will be cemented only when the system is tested (e.g., when growth and revenues unexpectedly fall short) and the government does not raise borrowing limits.

  • In terms of market discipline, the various soft sources of finance need to be progressively restricted and eliminated, and information provision improved. Some countries penalize lenders for assisting subnational governments in borrowing beyond their legal limits—for instance Brazil requires immediate repayment with no interest—and such sanctions could alter lenders’ incentives in India.

  • Finally, it would help to improve both market discipline and the credibility of administrative control if India were to legally rule out future bail-outs. The Czech Republic and South Africa took this approach after past problems with bail-outs.

22. The government could also, at the same time, pursue greater cooperation with states, with peer pressure as a sanction. Under a cooperative approach, negotiations with subnational governments determine a global borrowing ceiling, which is then apportioned to the various government entities (see Ahmad, Albino-War and Singh, 2005). Enforcement can be through an independent intergovernmental entity (e.g., Austria) or through a subnational government association (e.g., Denmark), and should involve some form of financial sanction. In Spain, for instance, subnational governments who violate agreed borrowing ceilings are required to contribute to any fines assessed by the EU (under the Stability and Growth Pact). In India, the central government regularly engages the states on their individual borrowing plans, and has plans to set up a borrowing council (involving the MoF, RBI, Planning Ministry and states). This council could discuss the determination of a global all-state borrowing ceiling, and agree to sanctions for exceeding state-specific targets.

23. In terms of the incentive regime, stronger requirements on information provision, and stronger sanctions would help make it more effective:

  • A key problem to overcome in making the incentive regime more effective is information provision. Key issues would include establishing standardized definitions, accounting systems, and classifications; upgrading and standardizing IT systems; and ensuring that states maintain databases on all financing sources. The central government could also increase the incentive for states to improve information provision by suspending grants when it is inadequate. Brazil and Ecuador have applied information related conditionalities in their FRLs, with Ecuador requiring information provision within 15 days of the date set out in the FRL, upon penalty of suspension of grants (see IMF, 2005; Webb, 2004).

  • The center can encourage states to amend their FRLs to incorporate sanctions for nonperformance. The FRLs (or related legislation) would hold accountable those individuals who were responsible for any breaches of the law. Examples of sanctions include financial reimbursement and loss of employment. The Brazilian framework again provides an example, and while it has not been formally tested, observers see it as having changed civil servant behavior (see Webb, 2004).

24. Looking forward to the next FC, the center may also consider grants which are more tightly linked to fiscal performance, to provide a stronger institutional sanction. In general, there is a good justification for grants conditioned on fiscal performance, given the negative spillovers that excess deficits and debt in any one state can generate (see Ahmad and Craig, 1997). Brazil, Ecuador and Peru have all embedded provisions to suspend grants in their FRLs due to poor fiscal performance. In Peru, the suspension is temporary (for 90 days), and this can avoid worsening the subnational authorities’ fiscal situation. Brazil is seen as having enjoyed good success with its framework, and indeed subnational balances have improved markedly since its introduction (see IMF, 2005; Webb, 2004). Constitutional issues arise in India, however, insofar as the revenue share cannot be subject to conditions. An option might then be to reduce the revenue share, and to use the freed funds to create an equivalent (and ex-ante fixed) grant for each state. This grant could be suspended at least temporarily if a subnational government fails to meet its fiscal adjustment targets.

G. Conclusion

25. The recommendations of the TFC represent a step forward in the process of state level fiscal consolidation in India, but other steps are needed to supplement the framework. The extra resources available to states will give adjustment a significant push, but a stronger adjustment strategy, both in the aggregate and for individual states, would improve overall and individual state prospects. Strengthening borrowing controls will be critical to outcomes, and in this context there is a need to tighten administrative controls and remove impediments to more market discipline. At the same time, the conditionality on fiscal performance could be strengthened, with a focus in particular on sanctions at the state level for not meeting targets, information provision, and sanctions by the center (in the form of withheld grants) for fiscal performance shortfalls.


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  • Ahmad, Ehtisham and Jon Craig, 1997, “Intergovernmental Transfers,” in Fiscal Federalism in Theory and in Practice, ed. by Teresa Ter-Minassian (Washington: International Monetary Fund).

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  • Chelliah, Raja, 2005, “Malady of Continuing Fiscal Imbalance,” Economic and Political Weekly, Vol. XL, No. 31, pp. 3399 –3404 (Mumbai, India).

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Prepared by Mark Flanagan.


The initial reduction in the deficit could even be slightly higher once composition effects—the fact that larger states will be receiving more in resources—are accounted for. See Howes and Prasad (2005) for a more detailed analysis of state-by-state impacts.


Lending to states is recorded above the line for the central government (as net lending) but as borrowing—a financing item—for states. Intergovernmental borrowing and lending has no impact on the consolidated general government accounts.


The central government must approve a state’ borrowing if the state owes anything to it.


See Ahmad, Albino-War and Singh (2005). Market discipline is most prevalent in developed economies (e.g., the United States and Canada) with long histories of no bail-outs.


For some states which are in relatively good fiscal shape, the substantially higher-than-market NSSF interest rates represent a significant burden. For other states, they represent a significant subsidy.


See Rajaraman et al. (2005) for an analysis of the need for revenue and expenditure measures by state.


The debt stabilizing primary balance can be calculated as the nominal interest rate minus the nominal growth rate, multiplied by the initial debt ratio, and deflated by the nominal growth rate.


Data were not available to assess special category states, but it should be noted that their average debt ratio in 2004/05 was 13 percent of GDP higher than the average for general category states, suggesting that the problem might be more acute for many of them.


The high growth scenario does not improve the outcome, since interest and growth rates move up in tandem.


The residual adjustment for two of the states declines to under ¼ percent of GDP if they simply maintain their current deficit, rather than loosening to achieve TFC targets.


Another category of state—those which have already achieved the FRL deficit targets—may choose not to participate altogether. This would allow them to raise their overall deficit (and thus capital spending), which would otherwise be capped at present levels.