Two decades of FRLs fail to rein in debt in several states: World Bank

A World Bank report to the 16th Finance Commission says state fiscal rules improved headline deficits, but debt levels remain high and uneven across several large states

India’s state-level fiscal rules have improved headline deficits, but the gains are fragile and uneven with major states still grappling with high debt levels, a World Bank report submitted to the 16th Finance Commission (FC) said. 

According to the report, despite nearly two decades of adoption of Fiscal Responsibility Laws (FRLs), debt levels have not converged. And, highly-indebted states such as Kerala, Punjab, Rajasthan, Andhra Pradesh and West Bengal continue to carry elevated debt and persistent revenue gaps. 

 

“Many states that started with relatively high levels of debt and fiscal deficits prior to FRLs adoption in the mid-2000s continue to have higher debt burdens. Some states, like Gujarat, were able to meaningfully reduce debt levels from over 30 per cent of gross state domestic product (GSDP) to below 20 per cent. Debt levels, however, have remained high for other states like Kerala, Punjab and Rajasthan,” highlighted the report titled From Policy to Performance: Analyzing India’s Subnational Fiscal Rules.

 

An analysis of seven major states by the World Bank — Andhra Pradesh, Haryana, Kerala, Punjab, Rajasthan, Tamil Nadu, and West Bengal — shows that rising contingent liabilities, off-budget borrowing and high committed expenditure on salaries, pensions and interest have increased debt levels. 

 

Setting a historical context, the report points out that while the adoption of fiscal rules is associated with reductions in subnational fiscal deficits, the consolidation often comes at the cost of capital expenditure and development-related revenue spending rather than durable revenue and structural reforms.

 

“In relatively rich states, revenue collections did not contribute to the improvement of fiscal deficit during episodes of consolidation. Instead, reductions in capital expenditures and development-related (revenue) expenditures accounted for more than 80 per cent of the consolidation efforts,” notes the report. 

 

The report’s central recommendation is to move away from a one-size-fits-all 3 per cent fiscal deficit ceiling to a differentiated, debt-anchored regime.

 

“India’s subnational fiscal rules framework is clear and enforceable but its one-size-fits-all approach ignores heterogeneity in fiscal conditions across states,” states the report. 

 

It proposes a “traffic light” system in which states are classified as high risk, under observation or sustainable based on debt-to-GSDP (including off-budget), a three-year average operating balance and the ratio of interest payments to own revenue. 

 

Under this scheme, high-risk states would see their borrowing limit cut to 2.5 per cent of GSDP, under-observation states to 2.8 per cent, while sustainable states could borrow up to 3.25 per cent. All would be calibrated to a medium-term debt anchor of 25 per cent of GSDP.

 

To make this work, the paper argues for a parallel strengthening of institutions and accounting.

 

For the most indebted states, it also moots conditional debt restructuring, coupled with medium-term structural reforms.

 

“Implementing an accrual accounting system and establishing an independent fiscal institution (IFI) would enhance the accuracy of the state's fiscal data, improve fiscal health assessments, and facilitate the monitoring of fiscal rules. Increasing flexibility in central transfers, particularly by rationalising Centrally Sponsored Schemes (CSS), which are rigid, is also important,” it suggests.

 

The Arvind Panagariya-led 16th FC’s report tabled in Parliament on Sunday recommended capping states’ fiscal deficits at 3 per cent of GSDP (excluding loans under SASCI). It also called for lowering the Centre’s fiscal deficit to 3.5 per cent of GDP by the end of the award period (2020-31).