by Rakesh Mohan
The Era of Rule-based Fiscal Control
The Fiscal Responsibility and Budget Management Act (FRBM) of the central government was enacted in 2003–04, while most of the states enacted their fiscal responsibility acts in the fiscal year 2005–06. The era of rule-based fiscal control at the Union has been characterized by a series of measures that diluted the rules themselves. The FRBM Act, 2003, and the rules made thereunder laid down a roadmap for the phased reduction of fiscal deficit to 3 per cent of GDP and elimination of the revenue deficit by 31 March 2008. Barely eight months after enactment of the Act, the Union Budget 2005–06 pressed the pause button on the plea that the implementation of the recommendations of the Twelfth Finance Commission would impose additional financial burden. The pause button was again pressed in 2008–09 following the NAFC and increase in the prices of oil. Following the additional obligation on account of the recommendations of the Sixth Pay Commission, the Thirteenth Finance Commission was mandated by an additional terms of reference (ToR) to suggest a revised roadmap. Accordingly, the Commission recommended shifting the timelines for bringing down the fiscal deficit to 3 per cent of GDP and elimination of revenue deficit to 31 March 2014 and 31 March 2015 respectively. By amending the rules, the central government shifted the date for bringing down fiscal deficit to 3 per cent of GDP by March 2017 and introduced the concept of ‘effective revenue deficit’ and its elimination by March 2015, thus diluting the fiscal rules further. The Fourteenth Finance Commission recommended doing away with the concept of ‘effective revenue deficit’ from 1 April 2015 to bring uniformity in the fiscal rules for the Union and the states; it recommended elimination of revenue deficit by March 2020. It is evident that the fiscal rules have not been effective in assuring fiscal adjustment at the Union. At the state level, however, the fiscal rules have been effective in bringing about a significant improvement in fiscal balance. The improvement in fiscal position was on account of reduction of fiscal deficits as well as revenue deficits as a proportion of GDP. In fact, revenue surplus was generated and the ratio of GFD to GDP fell below the permissible 3 per cent. There was increase in capital expenditure. The improvement in the fiscal position at the state level was not only due to the states’ own efforts in increasing the tax revenue and reducing the revenue expenditure, but also due to increased central devolution as a result of buoyant central taxes.
Changes in the Transfer System
The Planning Commission, an advisory body to the Union government, and Finance Commissions mandated by the Constitution, were the main instrumentalities of fiscal transfers from the Union to the states till 2015. Transfers from the Union to the states, outside of those recommended by the Finance Commission, were based on the advice of the Planning Commission. At the time of the initiation of reforms in 1991, about 40 per cent of transfers were in the form of normal central assistance to state plans. The rest were schemes fully or partly funded by the Union but implemented by the state governments. The amounts of transfer to each state were formula-based; the formula was known as Gadgil–Mukherjee formula. The Annual State Plan itself was subject to the approval of the Planning Commission. As the reforms progressed, the normal central assistance to state plans shrank to about 18 per cent and CSS became dominant. During the reform period, recourse was taken to transfer funds directly to implementing agencies, bypassing state governments (this was discontinued from 2014–15). Central ministries were instrumental, particularly during the second half of the reform period, in diluting the non-discretionary flow of resources to the states and in reducing policy space available to the states.
Fiscal consolidation was not high on the agenda of the Planning Commission. The Union used the instrumentality of Finance Commissions to bring about fiscal reforms at the state level. However, conditionality-based approach to transfers started with the Eleventh Finance Commission (FC-XI). As per the Additional Term of Reference, the task of the FC-XI was to lay down a path of monitorable fiscal reform programmes for states to reduce their revenue deficit. To ensure that the states follow these reform programmes, a portion of the non-plan revenue deficit grants was linked to the progress in implementing the reform programmes termed as ‘incentives fund’. Although various states questioned the constitutional validity of such ToR, and there was no unanimity within FC-XI, the majority view in FC-XI was in favor of rationalized monitorable fiscal reform. The final report of the FC-XI had ‘recommended that 15 % of the revenue deficit grants meant for 15 States during 2000-05 and a matching contribution by Central Government be credited into an Incentive Fund from which fiscal performance based grants should be made available to all 25 States’.
The FC-XI did draw up a state-specific reform programme. It suggested that the GoI should set up a monitoring agency comprising, among others, representatives of the Planning Commission, the finance ministry of GoI and representatives of the state governments. This agency was to draw up state-specific reform programmes to reduce their revenue deficits. As far as the yardsticks of monitoring are concerned, the broad indicators as suggested are state-level efforts for greater revenue mobilization and expenditure compression. According to FC-XI, specific expenditure components that required to be compressed were salaries and allowances, interest payments and reduction of subsidies.
The Twelfth Finance Commission (FC-XII) took its task of contributing to fiscal adjustment at state level in all earnestness. It linked state-level fiscal reforms to conditional transfers in several ways. FC-XII recommended that debt consolidation and relief facilities should be conditional upon the enactment of the fiscal responsibility legislation (FRL) at the state level. All the states (except two) enacted the fiscal responsibility legislation post the FC-XII award.
The Thirteenth Finance Commission (FC-XIII) also carried forward a similar approach to inducing reforms by suggesting incentive grants for the states that adhered to the FRL. Consequently, all the states enacted FRL.
The Fourteenth Finance Commission (FC-XIV), recognizing that the Union was preaching but not practising fiscal responsibility, recommended a set of fiscal rules for the Union and the states, in a symmetrical manner within a comprehensive framework. It emphasized the shared responsibility for fiscal consolidation.
It also recommended that the Union government and the RBI bring out a bi-annual report on the public debt of the Union and state governments on a regular and comparable basis and place it in public domain. This was meant to enable wider dissemination of the manner in which this shared responsibility for a conducive fiscal environment was being discharged by the Union and state governments.
FC-XIV recognized the challenge in designing a basic incentive-compatible framework for achieving fiscal correction and adherence to a rule-bound fiscal framework for the Union and state governments to hold each other accountable over agreed fiscal targets. It stressed the need for stronger mechanisms for ensuring compliance with fiscal targets and enhancing the quality of fiscal adjustment, particularly for the Union government. Accordingly, it recommended several actions by the Union government. It suggested making an amendment to the FRBM Act to omit the definition of effective revenue deficit from 1 April 2015. It also recommended that the objective of balancing revenues and expenditure on the revenue account enunciated in the FRBM Acts should be pursued.
It recommended an amendment to the FRBM Act of the Union government, inserting a new section mandating the establishment of an independent fiscal council to undertake ex-ante assessment of the fiscal policy implications of budget proposals and their consistency with fiscal policy and rules. In addition, it urged the Union government to take expeditious action to bring into effect Section 7A of the FRBM Act for the purposes of ex-post assessment. Section 7A requires the CAG to conduct a period review of the compliance of the provisions of the FRBM Act by the Union government.
Select Reforms
Though a beginning was made in 1985–86 with the reduction of the peak income tax rate from 62 to 50 per cent and the rate of wealth tax from 5 to 2 pe
r cent, broad-based reforms in Union taxes were initiated only in 1991, following the recommendations of the Tax Reforms Committee (Chelliah Committee). Under the Constitution, the levy of service tax does not fall either in the Union List or in the State List.4 Because of the growing share of the services sector, the Union government introduced service tax in 1994–95 under the residuary powers vested with it.5 Initially, it was levied on three services, viz. insurance other than life insurance, stock brokerage and telecommunications. Over the years, the service tax has been extended to a number of services. Now, the service tax is being levied on all services except those included in the negative list. Alongside tax reforms undertaken by the Union, there were also tax reforms by the states. A major reform by the states was the introduction of Value Added Tax (VAT) from 1 April 2005. The system of sales taxation prevalent in the states prior to the introduction of VAT was riddled with multiplicity of taxes with both inputs and the output being taxed, resulting in cascading effects. The introduction of VAT brought about an impressive growth in the revenue. The revenue impact was positive since it subsumed a number of taxes, surcharges and additional surcharges, and set-off was given for taxes paid on input and previous purchases.6
The establishment of the Empowered Group of State Finance Ministers is a remarkable institutional innovation in Centre–state relations. In the late 1990s, the need for an ‘Empowered Committee’ was felt to reform the most complex state-level consumption/sales tax system and to replace it with VAT. The Committee did significant innovations in tax policy and implemented a modern tax system—the VAT—at the state level. Though the Empowered Committee is often identified as an institution responsible for implementation of VAT at the state level, it also needs to be noted that as a prelude to VAT, the Committee implemented the concept of a floor rate for sales tax to stop a competitive ‘race to the bottom’ among the states, to attract private investment. The policy of floor rate acted as a major step towards harmonization of the tax system at the state level. This also stopped unhealthy tax competition to a considerable extent and paved the way for implementation of VAT.
The functioning of the Committee so far shows that the states in India have cooperated with each other to arrive at a tax structure that is by and large harmonized under VAT. States have complied with the decision taken by the Empowered Committee with regard to the rate structure of taxes, exemption and thresholds, even when it was not legally binding. It has also emerged as an important institution for negotiations with the central government on the issue of compensation of VAT and the Goods and Services Tax (GST) architecture involving the Union and the states.
A landmark reform introduced by the Union on the recommendation of the FC-XII is the termination of on-lending to the states. The Commission felt that while there might have been some justification for the Union to act as a banker when the market interest rates were higher, there was no such need in the low-interest-rate regime and suggested that the states should approach the market directly and avoid the interest spread charged by the Union. The GoI had accepted this recommendation and dispensed with the practice of on-lending to states.
The Fourteenth Finance Commission recommended an increase in the share of tax devolution to the states from 32 per cent to 42 per cent. But the increase should be seen in the context of including Plan expenditures in the needs of the states. The transfers outside the Finance Commission became predominantly CSS. In the combined revenue receipts, the share of the states after transfers from the Union remained around 64 per cent between 1990 and 2012. Revenue transfers from the Union varied in the narrow range of 24 to 26 per cent in this period. While the states’ share in combined total expenditure varied between 54 and 56 per cent, the variation in combined revenue expenditure was in the range of 53 to 56 per cent. Thus, there was more or less stability in the relative shares of the Union and the states in the combined revenue and expenditure. The FC-XII observed that some of the CSS relating to subjects that can be better handled by states should be in the fiscal space of states. It also expressed the view that there are schemes that normally need to be in the states’ domain, but need support from the Union. The Commission said that the Union should give grants to states for functions that are broadly in the nature of ‘overlapping functions’ and for area-specific interventions.
Power, as a key element of infrastructure, plays a crucial role in fostering economic growth and development. The GoI has initiated a slew of reforms and policy measures over the years to improve the commercial viability of the power sector, which has been plagued by consistent losses. When the opening up of the power sector to private players in 1991 did not yield the expected results, a major revamping of the sector became necessary. First, the Central Electricity Act of 2003 prohibited State Electricity Boards (SEBs) from functioning as integrated power utilities. Second, the GoI enacted the Electricity Regulatory Commission Act, 1998, for the setting up of independent regulatory bodies, viz. the Central Electricity Regulatory Commission and the State Electricity Regulatory Commissions. The former measure of restructuring of the SEBs was aimed at promoting greater efficiency by streamlining operations of distribution, transmission, generation and trading. It was expected to promote transparency and accountability as the budgetary support extended to the power sector had to be explicitly laid out as subsidy in the state finances. The latter measure was expected to strengthen the regulatory structure of the power sector by the establishment of independent agencies responsible for setting tariffs, and promoting competition and efficiency in the activities of the electricity industry.
The reform measures, along with others such as the Electricity Act, 2003, the National Electricity Policy, 2005, and Tariff Policy, 2006, were national initiatives to revive the power sector, which was reeling under losses. The set of measures, though separate for the Centre and the state governments, were in no way independent of each other. For instance, most states buy power from central power generating companies such as the National Thermal Power Corporation and the Power Finance Corporation. Thus, inefficiency of the power sector in the states affects not only state finances but also central finances.
The Centre put in place financial packages that took care of the accumulated losses of state power boards but on condition of reforms. The initiatives relieved the pressure, but did not stop the continuing losses. For most of the schemes, the central government lends a major share of financial support to kick-start the reform process by way of a lump-sum grant. And for the residual cost, the states are made to raise finances by way of loans from banks or other financial institutions.
The Accelerated Power Development Programme of the Ministry of Power in the year 2000–01 focused on strengthening distribution network and restructuring utilities at the distribution-circle level, all across the nation. In 2002–03, the GoI introduced the Accelerated Power Development and Reform Programme (APDRP), a scheme of incentives linked to efficiency improvement. The focus of the programme was narrowed down from the entire country to high-density urban and industrial areas for achieving quick results. Since APDRP too was not fully effective across the nation, the continuance of the programme beyond the Tenth Plan demanded further scrutiny and improvements in certain areas to make it more effective. Restructured Accelerated Power Development and Reform Programme was thus recommended in the Eleventh Plan and implemented as a CSS in 2008 with focus on actual, demonstrable performance to achieve sustained loss reduction and establishment of reliable and automated data.
However, these reforms have not resulted in a financial turnaround of DISCOMs. In November 2015, the Ministry of Power introduced Ujwal DISCOM Assurance Yojana (UDAY). The UDAY scheme is also focused on financial turnaround of state-owned power distribution companies. Under this scheme, participating states would have to take over 75 per cent of the DISCOM debt as on 30 September 2015 in the fiscal year 2015–16 and 2016–17. This will be over and above the fiscal deficit target specified under the FRBM Act. The incentive structure is to provide state
s with additional funding through Deendayal Upadhyaya Gram Jyoti Yojana, Integrated Power Development Scheme, Power Sector Development Fund or other such schemes of the Ministry of Power and the Ministry of New and Renewable Energy on achieving operational milestones as specified. A major downside or fiscal risk in this case is large debt exposure and consequent servicing obligations states have to undertake. Even after UDAY, if the DISCOMs continue to have poor financial health, it would further weaken the states’ fiscal position through higher subsidies to the DISCOMs and a decade of fiscal prudence may disappear, adversely affecting the fiscal space for development spending.
New Setting
A new setting for Union–state relations was ushered in when the Planning Commission, originally established in March 1950, was wound up in August 2014. NITI Aayog came into existence in January 2015; the Fourteenth Finance Commission gave its recommendations in December 2014. The recommendations have, by many accounts, far reaching consequences. The core recommendations have been accepted in full, but no decisions have been taken on some. So, we have an unfinished agenda.
The constitutional amendment facilitating the Goods and Services Tax has been passed recently. It introduces a new dynamic to Union–state relations. The amendment provides for the setting up of the GST Council, a body with representatives of the Union and the states, with joint responsibility for some aspects of design of taxation in an overlapping tax base. This Council was set up on 12 September 2016. This mandated involvement of the Union and the states is likely to have a profound influence on the politics and economics of both. It may affect the inter-se position of the states in dealing with the Union. So, we have potentially a new dynamic and a new balance in Union–state relations.