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`Positive impact of VAT appeared sooner than was expected'
January, 24th 2007
It is time to embark on a conscious programme of fiscal conservatism at the level of the States and evaluate the marginal benefits of additional expenditure before sanctioning new projects.


Dr Shanto Ghosh is an economist who specialises in transfer pricing and financial economics. He has over eight years of consulting experience on issues ranging from international transfer pricing, valuation, corporate finance and organisational design. He has also taught at the Boston University, the Harvard Institute of International Development, and the University of California, Berkeley. He is currently the principal economist at Deloitte Haskins & Sells, Mumbai.

Dr Ghosh interacts with Business Line on some of the current issues in State finances.

How are the State governments' finances these days? Are they healthier in comparison to the pre-1990 days?

Public Finance statistics for 2004-05 released by the Ministry of Finance indicate that the combined budgetary finances of the States moved from a position of deficit during 1990-91 (0.02 per cent of GDP) to one of surplus in 2004-05 (0.24 per cent of GDP). However, the surplus in recent years is primarily driven by a surplus in the capital account, which has more than offset the increasing deficit in the revenue account of the States. Focusing merely on the revenue account, the deficit has increased from 0.9 per cent of GDP in 1990-91 to 1.44 per cent of GDP in 2004-05.

What this means is that the States have been funding the shortfall between the developmental and non-developmental expenditure and the direct tax, indirect tax and non-tax revenues by dipping into the surplus funds in the capital account. While the capital account was largely funded by loans from the Centre in the early half of the 1990s, there has been a shift towards market borrowings in recent times, which will add to the future interest burden of the States.

Moreover, the States in aggregate have increased their spending on non-developmental items at an average rate of 16 per cent each year over the period 1990-91 to 2004-05 while developmental spending has lagged behind with an average increase of 11.7 per cent over the same period. Therefore, the deficit in the revenue account of the States is largely due to excessive spending on the administrative machinery of the States and interest payments rather than income generating developmental projects. It is time to embark on a conscious programme of fiscal conservatism at the level of the States and evaluate the marginal benefits of additional expenditure before sanctioning new projects.

Who are the winners and who, the laggards?

A comparison across some of the key States from 1990-91 to 2003-04 reveals the following characteristics vis--vis their finances:

Tamil Nadu's revenue receipts are heavily biased towards tax revenues The State's tax revenues as a share of total revenue exceed that of any other state. This is true for 1990-91 as well as 2003-04.

Gujarat and Punjab exhibit a significant shift towards non-tax revenues as a key source of revenue in 2003-04 compared to their 1990-91 levels. While they relied heavily on tax revenues to finance their revenue expenditure in 1990-91, they are currently more dependent on non-tax revenue sources to fund their revenue expenditure.

In Gujarat, revenues from interest receipts dominate other non-tax revenue sources; in Punjab, the increase in non-tax revenues primarily comes from State lotteries!

West Bengal fares poorly on the expenditure side. Over time, West Bengal's spending on developmental projects has gone down relative to the other States, while it's spending on non-developmental projects has increased. In the sample of States chosen for this comparison, it has the lowest spending (relative to its total expenditure) on development projects in 2003-04, while it has the highest spending on non-development projects both developments speak poorly of the State's ability to divert scarce resources to their most productive use.

Gujarat, Andhra Pradesh and Karnataka fare well in terms of their spending pattern. All three spend a larger share of their revenue expenditure on developmental projects, while reining in spending on non-developmental projects.

Are there new revenue streams that are significantly contributing to the kitty of the State governments?

Overall, the share of direct taxes in total tax revenue for the States has increased from approximately 12 per cent in 1990-91 to 15 per cent in 2004-05; this was accompanied by a corresponding decrease in the share of indirect tax collections (which declined from 88 per cent in 1990-91 to 85 per cent in 2004-05).

Each State's share of income tax has been a major revenue earner. Moreover, the States have borrowed less from the Centre over time, as evidenced in the share of central grants in total revenue receipts it declined from approximately 20 per cent in 1990-91 to 17 per cent in 2004-05.

To summarise, there has been a shift by the States, in terms of their source of revenue receipts, from grants from the centre towards tax revenue (and more on direct tax revenue). This is a healthy move, which will allow the central government to work more effectively towards reaching its self-set goals to rein in fiscal indiscipline.

Do you think the giveaways offered to big industrial units will prove to be unwise? ( For example, sops given to a new car plant in the State.)

Incentives provided to industrial units have the potential to generate benefits that extend beyond a mere consideration of the immediate tax loss (tied to the incentives) and the impact of the industry in generating additional employment and income in the long run.

A proper cost-benefit analysis of evaluating the impact of setting big industrial units must recognise the impact this industry is likely to have on the upstream and downstream industries, as well as the social costs associated with its presence. A successful industry will benefit the growth of the economy which, in turn, will result in development of the masses.

VAT is it proceeding on the right track?

The introduction of the VAT in India in April 2005 has already increased revenue collections in some States. This positive impact appeared sooner than was expected. The introduction of the VAT is an important step, as it attempts to simplify and eventually harmonise a complex mix of State tax rates across all States. However, significant work remains to be done to improve VAT implementation.

Can local bodies issue bonds for raising funds?

State and local bonds are usually long term debt instruments issued by State and local governments to finance developmental expenditure. An essential element that determines the market price of bonds is their credit worthiness.

The success of a State government's ability to raise adequate capital through issuing will ultimately depend on the health of the State government finances (or the finances of the ultimate guarantor against the bonds).

In many countries, bonds issued by local governments have their interest payments exempt from taxes. Such incentives help in increasing the effective post-tax coupon rate associated with a bond and increases the demand for such bonds.

Do we have enough transparency and accountability in the management of State finances?

There is greater scope for fiscal discipline and decentralisation in the management and execution of State Finances.

What commercial principles (of management, accounting and so on) do you think can be apt for the State governments?

Our State and local finances follow a cash-based system of accounting, which creates incentives for excessive spending (without proper regard to the productivity associated with such spending activity).

Moving to an accrual based accounting system, where the local bodies equate the revenue and expenditure associated with each project, can eliminate unproductive or excessive spending. Such accounting can also be effectively used to determine appropriate "return-on-investment" metrics that will improve the quality of project selection and also result in reducing the widening revenue account deficit at the level of states.

Unexploited areas with revenue potential and ignored spends that are proving to be costly.

This question requires in-depth research to accurately identify areas of State finances that can be implemented to improve the States' respective budgetary positions. The reports of the State Finance Commissions (SFCs) can be useful resources in this regard. Ironically, States have shown reluctance in setting up SFCs and failed to adequately cooperate with them to implement their recommendations. Only Andhra Pradesh, Kerala and Punjab have constituted the third SFC; several States are yet to set up their second SFC.

It is clear, however, that all the States' have to embark on a conscious programme of fiscal discipline to curb wasteful spending on the their administrative machinery. There is significant scope for greater fiscal decentralisation with a focus on internal resource mobilisation. The current single digit share of internal resources as a percentage of total revenues of the panchayats should increase rapidly to double-digit levels.

Similarly, on the outflow side. The newer heads of expenditure.

As mentioned earlier, the States have increasingly spent more on non-developmental items. There has been a phenomenal increase in the interest burden of the States from 12.79 per cent of total revenue expenditure in 1990-91 to 22.04 per cent of revenue expenditure in 2004-05. This has resulted in crowding out spending on important sectors such as agriculture (where spending went down from 12.66 per cent of total revenue expenditure in 1990-91 to 7.16 per cent in 2004-05), education (which fell from 22.51 per cent in 1990-91 to 17.49 per cent in 2004-05) and industry (which went down from 1.4 per cent to 0.7 per cent).

One positive trend in the States' revenue expenditure is the spending on power and irrigation projects that almost increased by 72 per cent between 1990-91 to 2004-05.

Leakages that can be plugged, and productivity measures that can ensure more return on outlay.

The States will benefit from controlling their spending on non-developmental items particularly the administrative machinery. Developmental projects should be decentralised and can be selected by evaluating the return on the project. Local governments have access to local information and can identify projects that are likely to have lower transactions costs of implementing a project. Care should be taken to factor in social as well as economic benefits that can result from a well-implemented project.

D. Murali

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