Fiscal responsibility and federalism

Hope, then despair, and now confusion

The story of India's fisc over the 15 years since 2000 has been one of concern, then hope, then despair and finally confusion. In 2001-02, the fiscal deficit of the Centre and states combined hit 9.57 per cent of gross domestic product, a record since 1980. The Centre's contribution to this sum had been above five per cent of GDP for each of the previous five years, and six per cent of GDP or above for two of those five. In just four years, the Centre's revenue deficit had more than doubled (without accounting for inflation).

WAY FORWARD

• A crisis in government finances led to the adoption of fiscal responsibility legislation, and the global financial crisis to its abandonment
• State deficits begin to come under control
• Central finances depend crucially on oil prices
• The twin federal devolutions impact — central schemes and the Finance Commission award
• The future path for fiscal responsibility is shadowed and uncertain at both Centre and states

From its peak in 2001-02, the Centre and states then brought down their combined deficits by a startling five per cent of GDP in just six years. They were aided, of course, by handsome nominal GDP growth over those boom years, which ensured the denominator of the deficit-to-GDP ratio grew handsomely. Even so, from Rs 2.26 lakh crore in 2001-02, the combined fiscal deficit of Centre and states went down - in terms of current rupees - to Rs 1.99 lakh crore in 2007-08. The Centre never quite managed to run a revenue surplus - it always spent more on the revenue account than it earned. But it did manage to run a small primary surplus - earning more altogether than it spent, if you excluded interest payments.

Part of this turnaround, at the state level, was due to the introduction of some incentives towards fiscal discipline for them by the 12th Finance Commission, led by C Rangarajan. Debt relief was linked to the enactment of fiscal responsibility legislation, and as a result the states showed a primary surplus for the first time in their history in 2006-07. Several states reformed their support of loss-making public sector enterprises, and others attempted to raise power tariffs that bled their exchequer.

But a big part of this turnaround, at least at the Centre, was due to the Fiscal Responsibility and Budget Management (FRBM) Act, introduced by Yashwant Sinha as finance minister in 2000. FRBM required the government to start living within its means - to eliminate the revenue deficit - by 2008.

Certainly, in the good years, this looked eminently possible, by reducing the revenue deficit by 0.5 per cent of GDP every year. However, many warned at the time that the compromises made to implement the FRBM Act when it was introduced rendered it toothless. Most importantly, a finance minister could essentially hit the "pause" button on fiscal consolidation if he so desired. And this is exactly what happened in the wake of the global financial crisis in 2008. In a single year, many of the gains from fiscal consolidation over the previous six years were wiped out, with the combined fiscal deficit of states and Centre more than doubling to 8.4 per cent of GDP. The Centre's fiscal deficit alone went up to almost six per cent of GDP, driven by a loan write-off, the implementation of Pay Commission recommendations (that included arrears) and indirect tax concessions meant to deal with the effects of the financial crisis.

It also became clear in the years from 2008 onwards that the Centre's fiscal position was far too closely dependent on the global price of oil. India imports about 80 per cent of its oil needs, and in spite of some tentative reform in the early 2000s, the principle that consumer petrochemical products - whether kerosene, gas cylinders, or diesel - should be subsidised by the state had embedded itself deeply into the Indian polity. When oil was between $20 and $40 a barrel, this was affordable; but when oil began climbing to above $110 in the years after 2007, it became clear that such subsidies were simply unsustainable.

In the years after the first major post-crisis fiscal expansion, the high level of oil-related subsidies made returning to spending discipline a struggle. It was not until 2013, and the threat of a crisis on the external account following the "taper tantrum" in international markets that summer, that the government put into place a solid mechanism for reducing diesel subsidies in particular. Petrol subsidies were already being phased out. Since then, gas cylinder subsidies have been capped, but fertiliser and kerosene subsidies remain to be addressed. The current moderation in oil prices, thus, has been a windfall for fiscal consolidation. The ratings agency Icra calculates that the Centre will save all of Rs 88,000 crore, thanks to lower global oil prices, in 2015-16. This made hitting the current year's fiscal deficit target easier - by around 0.6 per cent of GDP. However, as the post-2007 experience shows, depending on moderate global oil prices is dangerous fiscal prudence.

The future path of fiscal consolidation is clouded by several factors. First, there are the "twin devolutions" that have confused Centre-state finances in the past two financial years. Starting with the Interim Budget in 2014, the Centre began the process of passing the responsibility for several Centrally-Sponsored Schemes to states. Earlier, these schemes, which are a significant component of overall government spending, were shared between the relevant central ministry and the state authorities. Many of them have now been passed on to the states to administer completely.

In a parallel development, the 14th Finance Commission in 2015 increased by 10 whole percentage points - from 32 per cent to 42 per cent - the proportion of taxes devolved to states. The Centre, in the 2015-16 Union Budget, then passed full funding responsibility for several previously shared schemes on to the states. The exact path, therefore, that state finances will take following these twin devolutions is unclear. In addition, several states have signed up to the 'UDAY' scheme for the restructuring of power debt. This means that they will have to take power-related liabilities on to their own books, and the implications for their future fiscal rectitude are open to debate.

While the Centre itself has re-committed itself to the fiscal consolidation road map announced three years ago, there is fresh pressure to "pause" fiscal consolidation in order to enhance stimulus spending in the wake of subdued domestic and global demand, and to finance an infrastructure build-out given the unwillingness of the private sector to provide funds on the scale needed in the short term. The exact path of future revenue, also, is uncertain, given the plan to implement the Goods and Services Tax and questions on whether or not it will be completely revenue-neutral. Together with the dependence on moderate oil prices, this means that the essential hope of the early 2000s - that fiscal responsibility could be assured through legislation - remains unfulfilled.