82686 v2 Report No. 82686-IN Stabilization and Fiscal Empowerment: The Twin Challenges Facing India' s States Volume II (Detailed Report) May 10,2004 Poverty Reduction and Economic Management Unit South Asia Region 1 Explanatory Note This report is written in three different versions to suit a variety of audiences: o The Executive Summary (in Volume I) is 4 pages long and gives a quick overview. o The Main Report (also in Volume I) is 26 pages long, and conveys the main findings. o The Detailed Report (in Volume II) is 90 pages long, and provides the detailed analysis. The executive summary and main report are brief on attributions and sourcing to save space. We have in fact drawn heavily on work by Indian and international experts. Full referencing and attribution can be found in the technical report. This report was prepared by a team consisting of Stephen Howes, Rinku Murgai, Smita Kuriakose (expenditure issues), Marina Wes, Farah Zahir, Bala Bhaskar Kalimili (fiscal issues), Ronnie Das-Gupta (revenue issues) and V.J. Ravishankar, Bill McCarten and Anwar Shah (fiscal federalism), Vidya Kamath, Shahnaz Rana, Rita Soni, and Jyoti Sriram (report management). The report has benefited greatly from inputs by the whole India PREM Team, and from many sectoral colleagues. Box 1: Definitions and Data >-- If not indicated, the state-level data is aggregated for all states. >-- Much of the report focuses on 14 major states, which make up 91% of the population oflndia. >-- These 14 major states are further divided as poor states (those with a per capita income in 1999/00 ofRs. 10,000 or less at 1993/94 prices) and other states. >-- The poor states are Bihar, Madhya Pradesh, Orissa, Uttar Pradesh and Rajasthan while the other states are Maharashtra, Punjab, Haryana, Gujarat, Kerala, Karnataka, Tamil Nadu, West Bengal and Andhra Pradesh. >-- The data for the three newly created states (created in 2000/01) of Jharkhand, Chattisgarh and Uttaranchal have been aggregated with that of the states of Bihar, Madhya Pradesh and Uttar Pradesh respectively in order to maintain consistency over time. However, data for Jharkhand is not available for 2000/01 and so is not included in the analysis for 2000/01. >-- New- state debt as published by the RBI is included in the old -state debt for 2000/01 (actuals) and 2001/02 (revised estimates). >-- India's Gross Domestic Product (GDP) at market prices is used while referring to All States. >-- Gross State Domestic Product (GSDP) atfactor cost is used for ratios involving the 14 major states, or individual states. >-- Revenues receipts and expenditure are expressed net of lottery expenditures; other indicators are as reported by the Reserve Bank of India. >-- The latest available actuals are used. This is 2001/02 for all states combined and 2000/01 for individual states (only revised estimates for 2001/02 are available for individual states; since we know at the aggregate level there is a large deviation for 2001/02 between revised estimates and actuals, we do not use the revised estimates). The revised estimates for 2002/03, which are available for all states, are used sparingly, and as indicated. >-- For Bihar and Nagaland, 2000/01 figures are revised estimates. >-- 1990 and 1990/91 both refer to the Indian fiscal year 1 April 1990-31 March 1991. Debt-stock is measured at the end of the fiscal year. >-- The source for tables and figures, unless mentioned in the text is the World Bank State Fiscal Database, which is built up from RBI published state-finance data. 11 DETAILED VOLUME TABLE OF CONTENTS CHAPTER 1: THE STATE- LEVEL FISCAL CRISIS OF THE LATE NINETIES; EVOLUTION AND IMPACT I Introduction... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 1 II India's states.............................................................................. 1 III Genesis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 IV Impact..................................................................................... 6 V Response. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 VI Challenges. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ... 13 CHAPTER 2: EXPENDITURE REFORMS I Overview and introduction............................................................ 16 II Salaries and pensions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 III Subsidies................................................................................. 22 IV Public enterprise and debt restructuring............................................. 27 V Reforms to improve the quality of spending.................. . . . . . . . . . . . . . . . . . . . . . .. 29 CHAPTER 3: REVENUE REFORMS I Introduction ........................................................................... .. 34 II State own-revenue structure and reforms .......................................... . 35 III Reforms to tax institutions ........................................................... . 47 IV Conclusion ............................................................................. . 50 CHAPTER 4: FISCAL FEDERALISM AND THE INCENTIVE FRAMEWORK FOR STATE- LEVEL REFORM I Introduction............................................................................ 52 II Borrowing regime..................................................................... 53 III Revenue transfers (grants)............................................................ 60 IV Conclusion.............................................................................. 71 CHAPTER 5: CONCLUSIONS AND PROSPECTS I Introduction............................................................................. 76 II A no-reform scenario: what will happen if reforms stop?........................ 76 III A states' reform package.............................................................. 77 IV Reform scenarios: do the reforms add up?.......................................... 80 V Scenarios for the poor states.......................................................... 81 VI Risks..................................................................................... 82 VII Implications for the central government............................................ 83 ANNEX TO CHAPTER 2: CASE STUDIES IN REFORMS TO IMPROVE EXPENDITURE QUJlLITY .................................................... i............. ................................. 85 ANNEX TO CHAPTER 3: INSTITUTIONS FOR REVENUE COORDINATION......... 92 REF'ERENCES............................................................................................. 94 111 TABLES Table 1.1 Average real per capita growth rates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Table 1.2 Fourteen large states: key social and economic indicators........................ 2 Table 1.3 Fiscal indicators: poor states and others (1999/2000)........................... ... 6 Table 1.4 Average real growth rates of expenditures in some key sectors (14 major states) 9 Table 1.5 Average real growth rates of expenditures in some key sectors (low-income states and others of the 14 major states)........................... 10 Table 1.6 The paradigm transition at the state level....................................... . . . 11 Table 2.1 Ratio of average wages in the public and private sector, 1993/94 and 1999/00 17 Table 2.2 Starting basic salary of primary school teacher...... . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 17 Table 2.3 Enterprise restructuring by state..................................................... 27 Table 2.4 Total redundancy compensation by state.......................................... 29 Table 2.5 Average tenure of managing directors of Rural Women's Empowerment and Development Project (1998-200 1).................. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 31 Table 2.6 Deviation ofactuals from budget estimates, 1998-99 to 2001-02...... ........ 32 Table 2.7 Institutions for effective departmental governance............................... 32 Table 3.1 Structure of state's own tax revenue: 1985-86 to 2001-02...... ...... .......... 36 Table 3.2 Revenue from sales tax and transport taxes per vehicle versus road costs, 2000-01... .. . ... ... ... ... ...... ... ... ... ... ... ...... ... ... .. . ... ... ... ... ... ... ... ... ... 45 Table 4.1 Per-capita transfers among India's states (average for 1995-2000)............ 63 Table 5.1 Fiscal indicators in the no-reform scenario........................................ 77 Table 5.2 Key revenue reform recommendations............................................. 78 Table 5.3 Key expenditure reform recommendations........................................ 79 Table 5.4 Fiscal indicators under three reform scenarios.................................... 81 Table 5.5 Fiscal indicators under three reform scenarios for the 5 low-income states... 82 BOXES Box 1.1 Was there really a fiscal crisis at the state level? .................................... . 4 Box 1.2 State government expenditures and poverty reduction ............................. . 8 Box 1.3 Fiscal responsibility legislation at the state-level in India: the story so far. ..... . 11 Box 1.4 International experience with fiscal adjustment ..................................... . 15 Box 2.1 Experience with para-teacher schemes in India ..................................... . 18 Box 2.2 Tamil Nadu pension reforms ........................................................... . 22 Box 2.3 Attempts to increase the agricultural tariff: a history of repeated failure ........ . 24 Box 2.4 Food subsidy reforms in Tamil Nadu ................................................ . 27 Box 2.5 Public enterprise reforms in Andhra Pradesh ....................................... . 28 Box 2.6 Mid-day meals: an example of productive, additional expenditure .............. . 33 Box 3.1 Tax structures in major federations ................................................... . 35 Box 3.2 Tax administration recommendations for Tamil Nadu's commercial tax department ........................................................................... . 39 Box 3.3 Haryana's VAT- going it alone ........................................................ . 40 lV Box 3.4 International experience with value-added taxes in a federation - lessons for India ................................................................................... . 41 Box 3.5 State taxation of services: expert group versus advisory group .................... . 42 Box 3.6 Five principles for improved cost recovery ........................................... .. 46 Box 3.7 Performance measurement in the commercial tax department, Andhra Pradesh .. 48 Box 4.1 International perspective on India's fiscal federalism ................................ . 53 Box 4.2 Borrowing restrictions on sub-national governments: principles and practice ... .. 58 Box 4.3 HIPC - what is it, and has it worked? .................................................. . 60 Box 4.4 Econometric studies of the determinants and impact oflndia's fiscal federal Transfers .................................................................................... . 66 Box 4.5 R TS approach to fiscal equalization .................................................... .. 68 Box 4.6 Design of conditional grants: international experience .............................. .. 69 Box 4.7 Fiscal reform facility (FRF) .............................................................. . 70 Box 4.8 Problems in the financing of the state plan ............................................. . 74 Box 5.1 Key assumptions and methodology underlying the no reform scenario ............ . 76 FIGURES Figure 1.1 State revenue receipts and expenditures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Figure 1.2 State deficits and debt levels.......................................................... 4 Figure 1.3 State fiscal deficit including power... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Figure 1.4 State fiscal deficit: poor states and others............................................ 5 Figure 1.5 Own and total state revenues: poor states and others.............................. 6 Figure 1.6 Salaries, pensions and interest payments for India's states as a percentage of GDP... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 7 Figure 1.7 Aggregate expenditure trends for India's states as a percentage ofGDP... ..... 7 Figure 1.8 Non-salary operating recurrent spending per rupee of salary spending (14 major states)......................................................................... 10 Figure 2.1 Power sector losses (pre-subsidy) and budget subsidies to the power sector... 23 Figure 3.1 Trends in revenues as a percentage of GDP...................................... .... 34 Figure 3.2 Share of central transfers in state total revenue...................................... 34 Figure 3.3 Trends in states' own revenues as a percentage ofGDP... ... ... . ..... ... ...... ... 36 Figure 3.4 Trends in states' own revenues as a percentage ofGSDP, 2000-01... ... ... ...... 37 Figure 3.5 Tax collection costs..................................................................... 37 Figure 3.6 Real growth in sales taxes for the 14 major states: the impact of floor rate introduction(%).......................................................................... 38 Figure 4.1 Borrowing sources for state governments......................................... 54 Figme 4.2 Debt to revenue ratios for major states & Goi, 2001-02...... ............ ...... 59 Figure 4.3 Central transfers to states, 1985-2000............................................ .. 61 Figure 4.4 Trends in Gol revenues and transfers to states.................................... 62 Figure 4.5 Per capita revenues normalized, 2000/01.......................................... 63 Figure 4.6 Transfers from Goi to the 5 large poorest states as a percentage of total transfers........................................................................... 62 Figure 4.7 State revenues before and after transfers (formal and FCI)...................... 63 v Figure 4.8 Actual vs. equalizing transfers for India's states ................................. . 67 Figure 4.9 Resources other than own-revenue used by states to finance expenditure .... . 72 Figure 5.1 All state debt-to-GDP ratio under three different fiscal targets ................ . 80 Vl CHAPTERl THE STATE-LEVEL FISCAL CRISIS OF THE LATE NINETIES: EVOLUTION AND IMPACT I INTRODUCTION 1.1 India, home to one billion people, is a federation of 28 States and 7 Union Territories. The largest (Uttar Pradesh) is populous enough to be the fifth largest country in the world; the smallest (Sikkim) has a population of less than half a million. Among the 14 major states, the richest has a per-capita income that is five times that of the poorest state. Infant mortality ranges from a low of 14 per 1000 in Kerala, on par with east European countries, to 96 for Orissa, more typical of Sub-Saharan African nations. In an era of liberalization, a state's own policies and quality of government is increasingly critical for a state's development. Since the second half of the nineties, when the slow secular deterioration in fiscal performance of Indian states over the eighties and nineties was catalyzed into a crisis by the fifth pay commission awards, no area of state policy has been more important to development than its fiscal health. 1.2 The fiscal stress of the late nineties gave rise to an intense state-level reform effort. Six years on, this report documents the many initiatives undertaken by the states to restore fiscal sustainability, and become more effective agents of development. It outlines successes, lessons learnt, and highlights further challenges, on both the expenditure side (Chapter 2) and the revenue side (Chapter 3). It also looks at the incentive framework within which the states operate (Chapter 4), and asks whether there is a feasible reform package that will take the states not only out of fiscal crisis, but strengthened to meet the development challenges which confront them. 1.3 This chapter provides the context for what follows by outlining the role and increasingly divergent performance of the state governments (Section II), and then in turn, the genesis of the fiscal crisis (Section III), its developmental impact (Section IV), the reform response of the state and central governments (Section V), and the reform challenges facing the states today (Section VI). II INDIA'S STATES States in India play an increasingly important role in devising and implementing policies to reduce poverty, promote human development, and stimulate growth. 1.4 Under the Indian constitution, state governments are assigned significant responsibilities in sectors such as agriculture, industry, infrastructure, education, health, and social welfare. India's state governments are key financiers of a number of areas critical for enhancing growth and reducing poverty: in 2000/01, 57% oflndia's total government capital expenditure was financed by the states, as was 97 % of irrigation maintenance, 39% of road maintenance, 90% of public health expenditures, and 86% of public education expenditures. In fact, India's states are responsible for a higher proportion of general government spending than in any other developing country, except China. Moreover, the states' increasingly large fiscal deficits mean their fiscal policy is not only an important determinant of their own developmental performance but of India's overall macroeconomic and fiscal sustainability. 1.5 One of the striking features of Indian States prior to the 1990s was the relative uniformity of policies across states. The policy environment changed significantly after 1991 with the central government's liberalization of the trade and investment regime, and the growth of regional political parties. These developments allowed the states a larger role in determining their development paths and attracting investment. The performance of India's states is increasingly divergent 1.6 Balanced regional growth has been an objective of India's development strategy since independence, and is supported by a system of redistributive transfers to the states. Of the 14 major states, the 5 poorest have 1 a per capita income of Rs 10,000 (in 1993/94 constant prices) or less: Bihar, Madhya Pradesh, Orissa, Rajasthan and Uttar Pradesh. These are classified throughout this report as the poor or low-income states. They are home to over 40% of India's population, and nearly 50% oflndia' poor. These states are also slower growing than the other states (Table 1.1 ). In particular, following the liberalization of 1991, most of the middle and high income states were able to take greater advantage of the changes, because of better initial conditions, governance, infrastructure and human resources Table 1.1: Average real per capita growth rates than the poorer states. Moreover a number of the poorer states failed to improve their state-level policies to offset 1980/81-1989/90 1990/91-1999/00 their initial disadvantage in attracting new investment. As a Poor states 2.4 2.5 result, the average per capita income in the poor states Other states 3.1 4.8 relative to the others has decreased from 71% in 1980/81 to 54% in 1999/00. 1. 7 The low-income states rank well below the other states on broader economic indices, such as on infrastructure, and investment dimate (Table 1.2). 1 They also have much worse social indicators than the other states, for example, infant mortality is almost twice as high. Although human development indicators improved in all states, progress on these broader indicators was also generally faster in the fast-growing states, except for literacy, where there was some catch-up. In some cases human development indicators actually worsened in the poor states. For instance, the number of underweight children increased over the nineties for all poor states, whereas it declined for the other states (except Kerala and Maharashtra). Unless the poor states improve their performance, it will become increasingly difficult to accelerate poverty reduction and development in India. Table 1.2: Fourteen large states- Key social and economic indicators Population Per capita Composite Investment Infrastructure Financial Literacy Female Under-weight Infant (in Millions) incomeb performance climate penetration sector strength rate 0 literacy childrene mortality (Rs) index" index" index" index" rated Medium I 495 13471 2.4 2.4 2.5 2.7 75.8 66.7 41.9 47.0 High income states Andhra Pradesh 76 10598 2.1 2.3 2.1 1.6 61.1 70.9 37.7 65.8 Gujarat 51 15768 2.5 2.4 2.3 2.2 70.0 58.6 45.1 62.6 Haryana 21 15304 2.3 2.5 2.0 1.7 68.6 56.3 34.6 56.8 Karnataka 53 12614 2.4 2.7 2.4 2.0 67.0 57.5 43.9 51.5 Kerala 32 11360 2.8 2.8 2.5 2.1 90.9 87.9 26.9 16.3 Maharashtra 96 17107 2.8 2.3 2.8 3.5 77.3 67.5 49.6 43.7 Punjab 24 16659 2.7 2.9 2.5 2.2 70.0 63.6 28.7 57.1 Tamil Nadu 62 13756 2.7 3.1 2.6 2.4 73.5 64.6 36.7 48.2 West Bengal 80 10226 1.7 1.2 2.0 2.0 69.2 60.2 48.7 48.7 Low income states 429 7211 1.1 1.4 1.0 0.9 58.8 44.3 52.7 83.2 Bihar 83 4846 0 0.4 - 0.3 47.5 33.6 54.4 72.9 Madhya Pradesh 81 9037 1.3 1.8 1.2 1.1 64.1 50.3 55.1 86.1 Orissa 37 6602 0.9 1.7 0.8 1.0 63.6 51.0 54.4 81.0 Rajasthan 56 9716 1.5 1.6 1.3 1.2 61.0 44.3 50.6 80.4 Uttar Pradesh 172 7149 1.2 1.4 1.0 0.9 57.4 43.0 51.7 86.7 Notes: a: ConfederatiOn of Indmn Industry (CII), 2002; b: 1999/00, m 1993/94 constant pnces; c: 2001, percent of population 7 years and older; d: 2001, percent of population; e: 1998/99, percent of children under 3 years of age; f: 1998/99, per 1000 live births. Sources: CII, 2002; 2001 Census, 1998/99 National Family and Health Survey. 1 A "composite performance" index (based on state performance in different categories, including investment climate, infrastructure penetration, finance, work force quality, social well-being, agricultural performance, and law and order) calculated by the Confederation of Indian Industries (CII, 2002) gives the poor states an average of 1.1 and the other states a score of 2.4. The index is strongly correlated with GSDP per capita, suggesting that focusing on GSDP per capita to capture regional variations in development and performance is reasonable. 2 Ill GENESIS A slow secular deterioration in fiscal performance over the eighties and nineties was catalyzed into a state-level fiscal crisis by the Fifth Central Pay Commission pay awards in the late 1990s. 1.8 We use the term "fiscal crisis" not to be alarmist, or to suggest faltering macroeconomic performance but to Figure 1.1: State revenue receipts and convey the sharp deterioration in state-level fiscal expenditures performance witnessed in the late nineties - deficits rose, the state-level debt-stock, which had been declining, started rising rapidly, and off-budget liabilities also grew quickly. (See Box 1.1 for a discussion as to whether or not there really was a fiscal crisis.) There was also a liquidity crunch, not on the economy, but on state-governments themselves, who 12.0% started to find it much more difficult to pay bills, and even salaries. State governments themselves certainly perceived 115% that they were facing a crisis. Many wrote White Papers, 110% such as the Government of Tamil Nadu did in August 2001, to apprise legislators and the public "of the extent and causes "0.5% of the serious financial crisis confronting the state". Finally, "0.0% there is a close parallel with the balance of payments crisis of <0 co co co 0 Q) C\1 ~ = ~ ~ N ~ ("') ~ " ~ = 2 ~ 2 N 2 1.() = ~ N ("') " = = ~ == co co co co co 0'> 0'> 0'> 0'> 0'> 0'> 0'> 0'> 0'> 0'> royalties, sales of produce from forests, 0'> 0'> 0'> 0'> 0'> 0'> 0'> 0'> 0'> 0'> 0'> 0'> 0'> 0'> 0'> = N N various user charges, lottery proceeds, interest and dividends. 16 Various suggestions to tax agriculture exist with Rajaraman and Bhende (1998) and recent proposals by the (Kelkar) Direct Tax Task Force (Min. ofFinance,2002), being the most recent. 17 Throughout this report, we deduct expenditure on lotteries from non-tax receipts (and from expenditure) so that we are left with only net lottery receipts. There are many other adjustments which should be made but for which data is not available (e.g. interest receipts are a mix of actual and imputed receipts). 36 3.8 Are state taxes progressive? Aggarwal (1995) concludes that the state sales tax is progressive, though less so than central indirect taxes. Given the bases of motor vehicles tax and stamp duties, these taxes are also likely to be progressive. It is unclear whether excise duties on liquor are progressive, but there are good public policy reasons for high taxes on alcohol. There are significant variations in own-revenue performance among states. 3.9 As Figure 3.4 shows, the Figure 3.4: Trends in states' own revenues as a percentage of GSDP, highest own-revenue/GSDP ratio 2000/01 (Gujarat) is more than twice as high 12% 10% - - as that of the lowest (Bihar). These - = 6% "' ... "' 8% - ratios tend to be on the low side in the poorer states, 8-9% for Rajasthan and MP, 7% for UP and "' 4% ~ Orissa, and 5% for Bihar. The other 2% middle- and high-income states all 0% have ratios in excess of 9% except ~~~ til § ..d 15i .~ Vl ~ for West Bengal, which has a (J) (J)ro .... :9 ~til 'O"O:j:l'O til til~ til 0 a:l surprisingly low ratio, just above ~ ct ct ~ that of Bihar. These differences <---------------------0 the r States--------------------· <------- Poor States-------> between states cannot be explained by rates of taxes, or bases. A key II Own Tax 0 Own Non Tax cause of low taxable capacity is the higher share of the agricultural sector in GSDP in the poorer states. Part of the lower tax/GSDP ratio may also be explicable in terms of low tax effort resulting from poorer tax administration and from the negative incentive effects of being in receipt of a Figure 3.5: Tax Collection Costs large volume of central grants (a subject we return to in Chapter 4; see Box 4.2 Section III). 18000 0 16000 3.10 Revenue net of collection costs is what is 18 ~ 14000 actually available to finance government provision of "' "' ..... ~ 12000 ro goods and services. Yet collection costs data are largely 10000 "" c. ro neglected. Collection costs are on average just over 4 u 8000 Qi percent of tax revenues. This is high by international c. 6000 a. 4000 standards, the norm being 2 to 3 percent. Besides Cl en 2000 inefficiency, this possibly reflects costs associated with C) 0 non-revenue functions. Collection costs 0.00 2.00 4.00 6.00 8.00 10.00 vary systematically and negatively with per capita GSDP (Figure 3.5), due possibly to economies of scale Tax collection costs (as a percentage of own associated with the potential tax base being less dispersed revenues between 1993/94 and 1999/00) across taxable entities in the richer states. 19 18 Date on collection costs are from the sub-head "Collection oftaxes and duties" under the budget head "Expenditure on fiscal services". Clear data errors were identified for Gujarat (1985-86), Karnataka and Rajasthan (1987-88) and Maharashtra (1992-93 onwards). The Gujarat observation, being at the beginning of the sample period, was dropped. For Karnataka and Rajasthan the average compound growth rate between the preceding and following year was used to estimate 1987-88 collection costs. For Maharashtra, where certain transfers to reserve funds have been booked since 1992-93, data net of such transfers were kindly provided by the Finance Department, Government ofMaharashtra. No information on such transfers, if any, is available for other states. 19 Other possible determinants of cost inefficiency, as measured by collection costs as a percentage of tax, include the land area of the state, the share of central transfers in total revenues, and urbanization as measured by the percentage of population in urban areas and total population. 37 The sales tax is the most important state-level tax. Encouraging progress in sales-tax reform -which led to a large boost in revenue - has been stalled by an impasse over VAT introduction. 3.11 The sales tax contributes some 60% of total own-tax revenue; its importance derives from its relatively broad based coverage of industrial goods, even though services are excluded. Sales tax comprises of the General Sales Tax (GST), levied on intra-state sales, and the Central Sales Tax (CST), applicable to inter-state sales, which is legislated by the center but collected by the states. Many states levy additional taxes on selective services (electricity, transportation, entertainment) and additional tax surcharges. 3.12 The Goi-led joint decision of state governments to introduce floor rates and discontinue industrial tax incentives from January 1, 2000 gave an enormous boost to sales tax growth in the next two years (Figure 3.6). It also suggests that the reason for low growth in sales tax revenue over the nineties was a "race to the bottom" as state governments competed with each other to attract industry by offering low rates, and tax incentives. This reform was meant to be a precursor for the coordinated introduction of a state-level VAT to replace the sales tax, something which had first been mooted in the early nineties. However, the coordinated one-time shift of all states to a VAT regime has come undone, with repeated postponements of the target date, the latest one in early 2003 being indefinite. 3.13 The case for a comprehensive sales tax reform remains compelling. India's extant indirect tax regime is one of the most complicated in the world. It is non-transparent and distorting, has large efficiency costs and retards India's growth performance. The existing tax structure consist of multiple indirect and cascading levies; most states continue to impose taxes on inputs and capital goods. With a mixture of specific and ad valorem rates, multiple rates of tax, and cascading, the effective rates of tax on different productive sectors and consumer goods are nearly impossible to assess. Tax rates remain high by international standards and the base is narrow, not only confined to manufacturing goods, but largely at the wholesale level due to the tax mainly being levied at the first point of sale. In spite of recent Figure 3.6: Real growth in sales taxes for the 14 reforms, most states continue to have a great major states: the impact of floor-rate introduction many sales tax rates. Data in 22 states for 2000- (%) 01 in Purohit (2002) shows that the number of rates varied between 6 and 15, with 14 states 16% having 10 or more rates. The maximum rate 14% 12% +-··-~-'--~~,~~,k.~=+-"'":"'"""0----~ O% ~,_,_~'k~'-' varied between 15 percent and 33 percent. 1 1 8% 3.14 The delay in the implementation of the 6% +-~-"-'~ VAT, despite several states having completed 4% 2% their preparations, is a key failure of subnational 0% revenue reform in India. VAT will eliminate ("") <0 r- a:> en 0 '""" ~ e Q:! input taxes, and will allow for the value-added in N en ~ en ~ en ~ en ~ en en 0 0 India's increasingly organized retail sector to be en en en en en en 0 N taxed. It is equally attractive as a vehicle for other reforms of the sales tax regime: such as the introduction of a functional administration system to break the dealer-trader nexus, computerization, and rate simplification. In principle there is no reason why these related reforms cannot be introduced on their own, and without VAT, Box 3.2 gives some recent proposals for administrative reform made in relation to Tamil Nadu, but which are applicable to most states. In practice, however, states have linked them to the introduction of VAT: not without reason, since it makes little sense, for example, to computerize the existing system if the system is about to be overhauled. 38 Box 3.2: Tax Administration Recommendations for Tamil Nadu's Commercial Tax Department A recent analysis of the Commercial Tax Department noted that reforming the way the department did business was TN's "most urgent priority for improving revenue collection and reducing tax-related obstacles for business development in Tamil Nadu". Recommended steps included: o Move to a junctional structure: the single most important reform initiative the Tamil Nadu government can take to reform the tax administration, one that would have to be carried out at the headquarters and territorial levels to separate the key tax administration functions of registration, audit, collection, and taxpayer services. o Create a special structure for large taxpayers: A small number of large traders contribute the bulk of sales tax collection in Tamil Nadu: currently, the largest 400 taxpayers-representing 0.37% of assessments-account for 75% of total sales tax collections To address the compliance risks and the special service needs of this group of taxpayers, the government should set up a special large taxpayer unit responsible for the administration of the largest 200-500 traders in the state, and staffed with senior and experienced tax officials. Such a unit would also considerably facilitate the introduction of a VAT. The unit should be organized along functional lines, and indeed should be a pilot for the re- organization of the department along functional lines. o Strengthen the human resources of the Commercial Tax Department: A professional and specialized tax administration requires an appropriate level of highly qualified staff. This requires increasing the percentage of senior staff at officer level in the administration. o Strengthen the enforcement function: A total of 4,646 inspections of shops were conducted in fiscal year 2001/02. These inspections resulted in the assessment of additional taxes and penalties amounting to Rs.211.86 crore, which accounts for only 3% of total sales tax collections. Enforcement productivity is thus extremely low. To enable the department to counteract tax evasion more effectively requires strengthening risk analysis for case selection; moving from a routine desk inspection to a targeted field inspection system; introducing an enforcement management system with clear plans and regular review of performance of enforcement units; and training of professional staff. o Establish a vigilance unit: The Commercial Tax Department has an audit wing responsible for internal audit of its operations. The audit wing focuses primarily on reviewing the correctness of the assessment work, but does not assume responsibility for ensuring integrity and counteracting corruption in the tax administration. To investigate taxpayer allegations against tax officials and detect corrupt practices and officials in the department, a special vigilance unit should be established. Source: World Bank (2004e) The impasse over VAT introduction might be broken by allowing states to move individually towards VAT, without compensation, but on the basis of floor rather than uniform rates. 3.15 The center has to take the lead ifthe decade-long journey ofthe states' VAT is to resume. Progress to VAT was stalled by political controversy (protests by dealers) as well as complications over the issue of compensation to be provided by Gol to states which would lose from VAT due to the introduction of uniform rates. Tax rates vary greatly across India's states. Whereas a main rate of 12.5% was proposed for all states, southern and western states calculated the revenue neutral rate of VAT to be 15-16%. Hence the call for compensation. But once compensation is introduced, issues of moral hazard and game-playing are raised/ 0 and Go I be<:omes in a sense both responsible for VAT performance, and able to exercise veto power over its introduction. To break the current impasse, over both issues of compensation and trader resistance, a more modest strategy may be warranted. That is, the long-term goal of harmonization should be replaced by a more modest short-term one of ensuring uniform floor rates are adhered to. States should be allowed to graduate individually into VAT, without compensation, with the choice of rates left to the individual states (so that they can choose a revenue-neutral rate, and thus not require compensation). Several states would likely go ahead, and others would then probably follow. Haryana is the one state which has not been deterred by Gol's postponement of VAT (Box 3.3). It in fact introduced a VAT on its own, effective April 1, 2003. It has since experienced reasonalble revenue growth, and has no plans to roll the VAT back. Those states which did not want to go for VAT could pursue other reforms (computerization, functional organization, etc) within the sales tax framework, rather than continuing with a waiting game. De linking the goals of harmonization and VAT introduction would 20 One can note that once Go I announced 100% compensation, states started putting an increasing number of items on the lower 4% rate in the expectation that revenue loss from this would be covered by Gol. 39 allow the former to be pursued over a longer period without holding the latter hostage: it can be noted that the European Union has successfully introduced VAT and floor rates, but is still pursuing the goal of harmonization across member states (Box 3.4). Box 3.3: Haryana's VAT- going it alone. Variants of VAT on manufactured goods using the subtraction method has been tried out in individual states on resellers of taxable commodities e.g. AP and Maharashtra in 1995. While it continues to exist in AP for 19 commodities, Maharashtra gave up the experiment in 1999 after loss of sales tax buoyancy and rise in retail prices and returned to the old system of first point taxation along with turnover tax and surcharge. It is in this context that the decision of Haryana to go in for a VAT from April 1, 2003, against the decision of Goi to postpone VAT introduction, merits attention. Haryana was better placed than most states to introduce VAT because it had introduced input tax deduction from output tax on manufactured goods in 1998. In 2003, Haryana replaced the General Sales Tax Act (HGST) by the Haryana Value Added Tax Act, interestingly without seeking Presidential assent on the grounds that the sales tax is on the State's List of the Constitution (unlike other states, which sought and then failed to receive Presidential assent once Goi decided to postpone VAT). All existing dealers were issued 11 digit taxpayer identification numbers and full input tax credit offered on the opening stock of goods There are three main VAT rates of 4%, 10% and 12% (as under HGST, but not in line with the design agreed by all states of two rates of 4% and 12.5%) besides 1% on bullion and jewellery and 20% on liquor, petrol and aviation turbine fuel. The number of tax-exempted goods is high at 83 items. Input tax credit is allowed immediately on purchase of goods and no correspondence is required between goods purchased and goods sold for input tax credit. Input tax credit on capital goods has been restricted to their use in manufacture of taxable goods for sale. The treatment of inter-state trade is as per the agreed VAT design: input tax on goods exported out of India are zero rated with full input tax credit. Tax on inputs used to produce goods sold through inter-state trade is refundable to the extent the input tax exceeds output tax (CST). No setoff is available on input tax in the case of branch transfer or consignment sale of goods out of the state or on purchase tax. Other administrative reforms introduced by Haryana at the same time as VAT include a self-assessment system, whereby the filing of VAT returns is itself taken as deemed assessment. Detailed criteria have been evolved for selection for assessment, and time limits fixed for completion of assessment. Freedom to design sales invoices provided certain mandatory information is included has been introduced, inspection of business premises by officials without express permission has been debarred, and an audit wing created. The policy of no barriers at the state border has been continued. With the introduction of VAT, the number of tax payers has increased from 6417 to 8504. State sales tax revenue grew 20% in 2003/04 as opposed to 17% in 2002/03. Overall sales tax revenue (including Central Sales tax) grew 14% in 2003/04 as against 13% in 2002/03. With some complaints emerging about non-refunding of input tax credit, the net growth could be a little lower. While it is too early for a definitive verdict on Haryana's VAT, that VAT introduction has not resulted in tax losses and seems to have improved compliance is apparent. 40 Box 3.4: International Experience with Value-added Taxes in a Federation- lessons for India Most federations, if they have a VAT have a centrally controlled VAT, though sometimes administered by the states (Argentina, Australia, Germany, Mexico). America has a state-based retail tax not a VAT. There are three federations which run state-level VATs similar to what India is trying to introduce by replacing the state sales taxes by state VATs: Brazil, Canada and the European Union. All of them have lessons for India. o Brazil's system is that of an uncoordinated dual VAT (centre and state). The central government has a VAT on industrial goods (IPI). The state governments run a VAT on goods and services (ICMS). The ICMS is Brazil's largest tax, and collects 7.9% ofGDP. The IPI collects 1.5% ofGDP. Reviews of the Brazilian tax system commonly refer to problems relating to inefficiencies associated with the existence of a state-level VAT. Major problems diagnosed in Brazil are: (i) complexity of each of the 27 states having its own VAT with 27 different laws, and more than 40 rates, and different rules for assessing tax credits; (ii) evasion- associated with the complexity; and (iii) fiscal wars, with states offering companies reductions in the interstate ICMS rate (even though this is illegal). The system of interstate trade is itself complex: with different rates allowed in different states (though set centrally) for inter-state sales, and both exporting and importing states collecting the interstate tax revenue. o Canada tells a much happier tale: in the province of Quebec a coordinated dual VAT is in operation. The Quebec state government and the central government run a dual VAT system (other states have other tax arrangements: some participate in a unified VAT with the central government, some run their own sales tax). The rates and tax base are set independently by the respective governments but collected by a single administration (the Quebec Department of Revenue). Exports from Quebec, whether to another province or another country, are zero-rated. Imports are taxable but the tax is assessed on the interprovincial imports only when it is a sale by a registered trader to an unregistered trader or consumer in the province. The high degree of collaboration and information exchange between the state and the federal government (e.g. a joint approach to audit) regarded as critical to the success ofQuebec's VAT. o The European Union, if regarded, for the sake of comparability, as a federation, runs a state-level VAT. The EU required as far back as 1967 that each member have a VAT. Broad guidelines have been established, and there is a floor rate of 15%. Despite various efforts at harmonization actual rates vary from 15% to 25%. Sales between states are zero-rated: this arrangement was originally introduced as a transitional arrangement in 1993, but agreement on alternative proposals for tackling inter-state trade has not been forthcoming. What are the lessons for India? o In a positive vein, as Richard Bird writes, Canada has "demonstrated that with good tax administration it is perfectly feasible to operate a VAT at the subnationallevel on a destination basis, at least for large regional governments." Canada also suggests it is feasible to have different indirect tax systems operating in a country, i.e. not all states need introduce VAT at the same time. o At the same time, introduction of state-level VATs will not solve all, or even most indirect tax problems India faces. Its system will closely resemble that of Brazil, and will face the same problems that Brazil does today. To avoid them, India needs to work over time towards the goals of harmonization and information sharing across governments. o The European Union experience shows introducing floor rates is much more feasible than harmonizing rates across member-states, and suggests that VAT introduction should not be held hostage to harmonization. o All the case-studies throw up the issue of how inter-state trade should be taxed. None of the arrangements in place are regarded as fully satisfactory. Brazil's system is open to manipulation, and benefits the better-off states. The Quebec and EU zero-rating systems have the great advantage of preserving a common market, but they break the VAT chain, and give incentives to evade by declaring intra-state sales as inter-state. Various suggestions have been put forward for how to solve this problem, including systems of refunds across states, and through central government taxation and rebating of inter-state trade, but none have yet been implemented The consensus in India is to adopt the Quebec and EU systems of zero-rating inter-state sales, which would be achieved by reducing the Central Sales Tax- which is set centrally- to zero. Since this would give strong incentives to evade along the lines mentioned earlier, the earlier point about improving information sharing across governments becomes even more important. Sources: Guardia and Sonder (2004); Bird (2000); Purohit (2003); Burgess, Howes and Stern (1995). 41 Phasing out of the distorting and inequitable CST is critical, and will likely require compensation. 3.16 The Central Sales Tax (CST) is particularly distortionary and there is widespread agreement that it should be eliminated. The CST applies to interstate sales; it is collected and retained by the exporting state. Because the CST is levied on the basis of the origin of goods, it has enabled the relatively advanced states to export the burden of their own taxes to the less developed states, which tend to be net consumers. The result is a considerable concentration of CST revenues among a few states. Origin-based taxation of interstate sales also leads to tax evasion via branch transfers and consignment sales, and is a serious impediment to the achievement of economic efficiency and a common market. Recent reform of the Central Sales Tax to permit states to tax local sales of declared goods at multiple points has reduced constraints from separate regimes for declared and other goods. Nevertheless, further steps need to be taken to phase out the CST. There is no reason for the phase out of CST to be linked to VAT, but it will require compensation to the losers. It will also demand increased surveillance over interstate trade since shifting to zero-rating of inter-state exports will increase the incentive to evade the state sales taxes by claiming goods are being exported (Box 3.3). India's long-term, indirect tax goal should be a national VAT 3.17 International experience has a number of lessons to teach India in its pursuit of a dual centre-state VAT (the Gol indirect tax is also a VAT, CENVAT). These are summarized in Box 3.4, and some have already been highlighted. Brazil's experience is particularly salutary. It suggests that, even with state VATs, India' indirect tax system will still be very complex, and that a dual VAT system should only be viewed as a staging post towards a more integrated, national VAT, with revenue starting between the centre and states. Transfer to states of the right to tax services is a very positive initiative. 3 .18 This constitutional amendment will give states access to the fastest growing sector of the economy, and reduce India's high level of vertical imbalance. It is not yet clear how this will be implemented: there are two competing proposals (Box 3.5) Over time, it does not seem desirable that states should be allowed to integrate the taxation of services into their sales tax/VATs. Box 3.5: State taxation of services: expert group versus advisory group The recommendations of the Planning Commission's Advisory Group for Tax Policy and Administration for the Tenth Plan under Parthasarathi Shome in 2001 and the Finance Ministry's Expert Group on Taxation of Services (Govinda Rao Committee), 2000-2001 differ in a significant way. The former has recommended that the power to tax specified services be given to states with the Centre retaining the power to tax other services. The Govinda Rao Committee recommended comprehensive VATs covering both goods and services at both Central and state levels implying concurrent taxation of services, as is currently the case with goods. Since input rebates for Central levies are unlikely to be granted by states and vice versa, the scheme proposed by the Shome Committee will result in continued taxation of inputs and cascading of tax. Concurrent taxation by Centre and states, as proposed by the Govinda Rao Committee, will avoid this as each level of government will provide rebates for its own input taxes. There is a rich agenda for reforms in other taxes, requiring wide-ranging actions by the center and the states. 3.19 Currently, the professions tax- the base of which is essentially income or presumed income in the case of the self-employed - is not levied in five major states at all. Where it is levied, enforcement is weak. A key problem with the professions tax is that the constitutionally-imposed ceiling is very low (Rs 1500 per person), and needs to be raised. This requires action at the centre to amend the constitution and quadruple the floor rate. 42 Increasing this rate will give states more incentive to utilize this tax, especially in the unorganized sector.Z 1 We estimate that potential collection from the professions tax is possibly 10 times the current level of Rs 2, 200 crore (that is 0.9% of GDP rather than 0.1% as currently) with ceiling revision and improved collection. Especially given the undertaxation of services, this tax, which will cover services as well as industry, seems well justified. One possibility that may simplify administration is outsourcing tax collection from professionals to professional associations, with risk based sample follow up checks by the concerned tax department. 3.20 State excise duties are levied on the production of alcohol and other narcotic substances and via license fees for liquor wholesale and retailing permits. They are the second most important source of revenue for most state governments, and contribute on average 14% of state own-tax revenue. Duties are mostly specific. Despite alleged rampant evasion and smuggling, excise revenue from alcohol sales is a relatively buoyant source of own revenue (with an all-state buoyancy in excess of 1), though the buoyancy has shown a small secular decline over time. Confiscation of liquor on which duty has not been paid and fines also provides a steady revenue stream. 3.21 The liquor market in India is fragmented into "Indian made foreign liquor" (IMFL) and "country liquor" segments; the former can be traded across state borders whereas the latter cannot. Country liquor vending licenses are auctioned in many states, where country liquor is not banned, leading to revenue buoyancy in this segment. IMFL has proved to be somewhat less buoyant. To safeguard IMFL revenue and enforcement, some states have monopolies in wholesale IMFL trade (e.g. Andhra Pradesh, Kamataka) and retail trade (Delhi, Tamil Nadu). Retail monopolies are costly in terms of efficiency, but wholesale monopolies can be effective. There is also some evidence that ad valorem duties may have greater revenue potential, as they are inflation proof, but only if complemented by effective excise enforcement. Maharashtra implemented an ad valorem excise duty with a specific floor in 1997. Though this led to an immediate jump in excise revenue, this did not improve revenue buoyancy, almost surely due to weak enforcement. 3.22 Even though most excise departments have inspectors posted at distilleries and breweries, procedures are not very effective and leakages are a major problem, with corruption alleged to be a major reason. Most excise departments have yet to adopt modem distillery monitoring technology and have outdated information systems. Large excise duty cum sales tax rate differences (and prohibition, in some states, of either country liquor or all liquor) lead to cross-state smuggling, an activity which can only be curbed if rates are harmonized. Since some states benefit from cross-border smuggling induced by rate differentials, this may be hard to achieve. 3.23 There is much scope to improve the performance of state excise duties. Kamataka's creation of a new wholesale IMFL monopoly, and a crack-down against illegal "seconds" has boosted excise revenue in 2003/04 by an estimated Rs 300 crore (more than 10%). Even before inter-state information sharing becomes a reality, gains can be made by curbing leakage via control of inputs (molasses, raw alcohol), induction of modem distillel"J monitoring technology, random checks by staff, and targeted generation and management use of information such as fluctuations in input-output ratios in distilleries and, above all, staff incentives. Other measures include expanding the number and kind of retail outlets, though such measures should be taken only if they are felt to be in consonance with health concerns of individual states. 3.24 Stamp duties and registration fees are the equal third most important tax for state governments, contributing about 9% of revenue. These taxes are governed by central acts, with variations incorporated in state-level acts; as for rate setting, there are central, state and concurrent powers for different classes of documents. Stamp duties and registration fees, for which property transfers are the major base, have had the best 21 It has been suggested that central reluctance to raise the ceiling is because the professions tax is as a deduction from income subject to the income tax. However, from the point of view of states, the implied loss in shared central revenue is outweighed by direct collection from the professions tax. For example, for Uttar Pradesh given its 19.8 percent share of central taxes recommended by the Eleventh Finance Commission, and the 29 percent share of states in total central tax collection, Rs 100 from the professions tax results, even at the maximum marginal income tax rate of30 percent, in a loss of shared revenue ofRs. 5.94, resulting in a net gain ofRs 94.06. The net increase in the taxpayer's extra tax burden is Rs. 70. 43 recent revenue performance among major state taxes, largely due to the secular rise in property construction and sales and also property values in the wake of rapid urbanization. 3.25 Fees on the transfer of immovable property are very high by international standards, sometimes by an order of magnitude. High rates of duty have induced avoidance as well as undervaluation of property. Some states have carried out a number of important reforms along with a reduction in the rate of stamp duties. The rate of stamp duty on property sales has been brought down in a number of states including Rajasthan, Karnataka and Uttar Pradesh, leading to additional increase in the declared quantity and value of property sales. 22 To reduce the undervaluation of land, some states (Andhra Pradesh, Karnataka, Maharashtra, Uttar Pradesh) have completed or are in the process of strengthening their official valuation machinery and, by publishing guidance (minimum) value lists, and have made valuation transparent reducing the scope for corruption. Streamlining of document registration procedures through automation (in Maharashtra and Karnataka via outsourcing) and strict monitoring of duration norms have also led to improved citizen's services. A fourth, progressive, reform in Karnataka in 2003 was to abolish the archaic use of stamp paper which itself is likely to have reduced the scope for forgery and loss of revenue. These important reforms can also help other states to increase their stamp duty revenues. Halving by the Centre of all stamp duty rates that are centrally set has been proposed in 2004, though this will impact at best 5 percent of the tax base. 3.26 Further scope for reforms to boost revenue exists. The most important is the closing of loopholes whereby properties are transferred through substitute transactions which attract a lower duty rate (such as "power of attorney sales") by raising duties close to rates on property sales. Second, improved land valuation can be accompanied by improved enforcement to curb unregistered property transfers and undervaluation of buildings as discussed previously. Third, most stamp departments require reforms of incentives, given the considerable scope for corruption that still exists based on the high average property price and the prevalence of middlemen like real estate agents and even local revenue officials (Caseley, 2004). Reform of stamp duties and registration fees and its administration should ideally be designed as part of an overall policy to improve the security of land titles and contract enforcement. 23 3.27 Transport tax Like the stamp duties and registration fees, the transport tax constitutes about 9% of state-level own-tax revenue. There exists both a central and a state Motor Vehicles Act governing motor vehicle regulation and taxation. The revenue implications ofthe central act are minor, with the Act setting uniform fees for transport department services like issuance of licenses and permits. The major revenue raising power lie with the state acts. Given the explosion in the motor vehicles population on Indian roads during at least the past decade, the low buoyancy of taxes on transporr4 comes as a surprise. It is possible that part of the low growth is due to the gradual relative decline in the importance of buses as a means of transport in recent years as more private cars or two-wheelers are seen on Indian roads. The latter are less heavily taxed. Moreover, tax rates on buses and trucks are specific - even though they are subject to frequent revision. 3.28 Another source of low buoyancy is state monopolies of public passenger transport (STUs) with most transport departments fighting a losing battle to control violations of route monopolies by private transport operators, especially mini-buses and "maxi-cabs"? 5 Consequently, to increase revenue from motor vehicle taxes as well as improve economic efficiency, state governments will need to "de-nationalize" most routes currently reserved for STUs. This should also result in lower administration costs and reduced corruption. 22 Stamp duty in Rajasthan was lowered from 12 percent to 7 percent in 1996-97. World Bank (2000) documents a 36 percent increase in stamp revenues between 1996-97 and 1998-99. The rate was subsequently raised to 10 percent. 23 A discussion of the major flaws in current institutions in this respect is beyond the scope of this chapter. See, for example, Wadhwa (2002), and Das-Gupta (2003a) and references cited there. 24 Though the all-state buoyancy for 1993-94 and 2000-01 was 0.83, buoyancies were above 1 in 8 of the 14 major states (AP, Bihar, Gujarat, Kerala, MP, Orissa, Punjab and UP), being above 1.5 in Orissa. Thus states other than the 14 major states have had low buoyancy along with the other six major states. 25 World Bank (1998) estimates the tax gap in Uttar Pradesh in 1996-97 at around 24 percent of potential. 44 3.29 Rate reform can lead to major revenue gains and is also desirable on efficiency and equity grounds: the motor vehicles tax as well as the tax on goods under the goods and passengers tax (the passenger tax is discussed below) can be viewed as an "excise duty" on motor vehicles and should ideally be levied on the benefits principle as a user charge. Benefits include road usage, and tolerance of environmental damage and vehicular congestion by citizens. Viewed from this perspective, motor vehicles tax rates are skewed and disproportionately favor two wheelers, jeeps, taxis and multi-axle and heavy commercial vehicles at the expense of mass transport vehicles, and to a much smaller extent, cars and light commercial vehicles (see Table 3.2). Therefore, economic efficiency and equity suggest raising of taxes on other vehicle classes relative to buses. Such a rate rationalization could also be revenue enhancing, if it is done by raising tax rates, given the faster growth rate of all other classes of vehicles, compared to buses, and the likely absence of extreme sensitivity to small price changes for vehicles other than trucks. a es T ax an dT ransportT axes Per V e h' T a bl e 3 2 : R evenue f rom Sl I versus ICe R oa d C OS t s, 2000-01 (Indices with 2-wheeler = 1) Cat~ory 2-wheelers Cars Jee{>/Taxi Bus LCV HCV MAV Revenue 1.0 9.4 10.1 322.3 12.2 32.6 59.0 Road capital and maintenance cost 1.0 3.4 8.8 6.4 6.3 26.6 41.0 Road maintenance cost 1.0 3.5 9.0 7.1 6.7 38.4 57.2 Notes: (i) For two wheelers, the road maintenance to revenue ratio is estimated at 0.55 and the capital and maintenance cost ratio at 2.34. (ii) MAV: Multi-axle vehicles. HCV: heavy commercial vehicles. LCV: light commercial vehicles. Source: Calculations based on data in World Bank (2003). 3. 30 The passenger tax is a tax on transport services and so should ideally be merged with the state VAT when it is extended to services. Given the ease of evasion of this tax, a per-seat-per-quarter specific rate, coupled with rebates for presumptive bus operating costs may be easier to administer. 3.31 Other taxes Among the many other state taxes in existence, most are of minor revenue importance. They should be merged with the VAT on goods (a part of luxury tax, entry taxes, special levies on motor spirits, cesses and surcharges). Others should be merged with the state VAT if services are included in the VAT base (electricity duty, entertainment tax, betting tax). The electricity tax is important in a context of law tariffs, and can be Utsed to reduce subsidies to particular categories of consumers, but should not further increase the tariff burden on industry. Property tax on houses accrues to local government, and is increasingly the focus for reform, especially in urban areas (reference). Non-tax revenues have stagnated, and need more policy attention from state governments. 3.32 As shown in Figure 3.3, there has been a significant deterioration in the performance of own non-tax revenues, from just below 2% of GDP in the mid-eighties to just above I% of GDP today. It is imperative that state governments focus on improving the revenue performance of major non-tax revenue sources. 26 Unlike tax revenues, where many problems are common across taxes and their administrations, different non-tax revenues sources have very distinct problems although institutional strengthening is of importance across the board. 3.33 Revenue from mineral royalties already constitutes a major source of non-tax revenue for many states, and there is potential for further increases. Recent hikes in the international price of steel as well as greater demand for building materials due to increased road and building construction activity have caused mineral royalties in some states (e.g. Karnataka, Uttar Pradesh) to become the fifth most important source of own revenue. Measures that may further increase the importance of this source of revenue include rule-based setting of royalty rates by the Centre, and also states, including revision at least once in three years with reference to market prices; streamlining of the clearance process for grant of mineral prospecting licenses with the help of automation; strengthening of administration, particularly where minor minerals are of importance; and introduction of self-assessment and risk-based scrutiny of royalty returns to reduce litigation. 26 Information on the cause of Punjab's non-tax revenue increase is not available. 45 3.34 Revenue from the sale of forest produce is often next in importance to mineral royalties. A problem with many forest departments is their limited attention to sale of forest produce since they perceive their role 27 primarily in terms of conservation and protection of forests and wild-life. One way out is the formation of forest corporations to enable focused exploitation of forest resources on commercial lines, while leaving conservation and ref:ulatory functions, including regulation of corporations to the govemment as is already the 8 case in some states. This will be facilitated with time-bound completion of mandatory "work plans" for forest exploitation in some states (e.g. Assam) in the absence of which forest revenues have been badly hit. A second major reform with great revenue potential is strengthening the infrastructure for eco-tourism, with the participation of the private sector. 3.35 The performance of user charges has been poor. A key reason for this is inadequate, and in many cases, deteriorating recovery of costs, associated with a more general problem in the provision of government services, discussed in Chapter 2, namely a lack of commercial discipline, manifested in an unwillingness to withdraw 29 services from non-paying customers. Restoring commercial discipline and improving cost recovery can be very difficult in the public sector, especially when beneficiaries are politically powerful. Where external benefits or merit good characteristics are unimportant, rather than attempting recovery of user charges, the government should ideally withdraw. Where the government stays involved, some basic principles for improved cost recovery and commercial discipline need to be applied. These are summarized in Box 3.6 below. Not all user charge increases are controversial, and governments need to carefully scrutinize all services offered and charges levied to see where it is feasible to implement increases. Box 3.6: Five principles for improved cost recovery Principle 1: Price discrimination and usually product differentiation with a self-selection mechanism can lead to improved cost recovery while continuing to provide cross-subsidized and free services for target groups, in applicable sectors (e.g. health, higher education, hostels for weaker sections, inspection bungalows). Principle 2: Introduction of collection and enforcement incentives for field staff, both rewards and sanctions, can lead to greater collection effort and cost recovery in applicable sectors (e.g. forests, mines, irrigation, hostels for weaker sections). Principle 3: Identification of under or unutilized government assets, including land and buildings, and improved utilization, with private sector participation in suitable cases, can reduce the direct cost of government services and also give rise to new sources of non-tax revenue. Principle 4: Computation of notional cost-based prices and explicit compensation via book transfers for the difference between notional prices and user charges can bring about greater transparency and realism in costing of government services by removing hidden cross-subsidies, in applicable sectors (e.g. inspection bungalows, housing, health, education, forests, irrigation). Principle 5: Physical and financial performance indicators should reflect quality and quantity of outputs within the control of responsible departments and social outcomes relative to targets as accurately as possible and be subject to external auditing. Source: Das-Gupta (2004) 3.36 Interest performance The importance and performance of interest receipts in state non-tax revenues is difficult to determine as the heading includes notional contra entries, a major item being irrigation contra entries, and pass through receipts. For "genuine" loans, published documents do no give details of loans, interest rates, arrears, write-offs and other information necessary for performance evaluation. Similarly, aggregate dividend data are not readily available and must be compiled from surveys of public sector undertakings. Nevertheless, no 27 For example, though forest revenues were important in Assam up to the 1990s, their importance decreased sharply after a Supreme Court judgement requiring tree felling according to scientific work plans, since the forest department had not completed 90 percent of the work plans even by 2000. See D. K. Srivastava et. a!. (1999b ). 28 According to the Indian Forest Conservation Act, these corporations must be wholly owned by the government to ensure that no overexploitation occurs. Several states are handing over collection of minor forest produce to community groups. 29 For recent studies of government subsidies, which are the complement of cost recovery, see Rao (2003) and D.K. Srivastava and Tapas K. Sen (1997). These studies document the low rates of cost recovery even for goods which have no externality benefits or merit good features. 46 state shows impressive growth in these sources of revenue. Alleged reasons are that loans to public undertakings and cooperatives are often really grants, not intended to be recovered. The poor performance of PSUs is of course well-documented. III. Reforms to Tax Institutions Tax administration reforms are probably more important than tax policy reforms but have received relatively less attention to date. 3.37 Tax reforms in India require not just policy changes, but also institutional reforms to improve policy- making, weed-out corruption, and increase incentives for compliance and collections. We have already presented some tax-specific administration reforms. We now turn to more cross-cutting reforms, without which a sustained increase in the tax/GDP ratio will be difficult to attain. The institutional structure of major revenue raising departments is currently weak. They suffer from many of the problems most other government departments suffer from, briefly outlined in Chapter 2. Many do not have mission or vision statements; transparent performance monitoring is often absent as is systematic citizen's feedback on services provided and individual accountability; departments often have limited budgetary flexibility; management information systems are rudimentary; and anti-corruption institutions are often ineffective. Overall performance reporting of administrations via annual reports that stress effectiveness in achieving goals and (cost) efficiency are as yet absent. This leads to lack of transparency in the performance of tax administrations, hampers legislative oversight and limits departmental accountability. Within tax administrations, absence of performance indicators and poor record structures for functional units and individual staff makes accountability for performance difficult. 3.38 Chapter 2, Section V listed some general principles for improving government effectiveness. These apply equally to the functioning of tax departments. Some specific recommendations are summarized below. 3.39 Strengthening accountability. Departmental accountability can be promoted through better articulation of departmental goals and more budgetary flexibility, and individual accountability through the provision of incentives to staff. In some states, encouraging progress has been made in achieving clarity of goals via mission and vision statements, and especially citizen's charters. However, not all mission statements reflect concern for effectiveness and efficiency of activities. Revenue collection performance and performance in delivering non- revenue services are also not well-addressed. Less progress has been made in translating these statements into measurable indicators, except in rare cases (see Box 3.7). Without such indicators, targets for tax departments will continue to be ad hoc and primarily in terms of revenue. Sustainable improvement in the revenue effort of tax departments requires performance assessment not only in relation to revenue targets, but also in the manner in which these are achieved. Important dimensions include: improving identification and registration of taxpayers and sanctioning of non-compliance with requirements; effective targeting of tax inquiries at evasion prone cases to limit underassessment of taxes due to corruption; non-arbitrary assessments which will withstand legal challenge thus limiting appeals; improved tax collection efficiency rather than growing arrears; and citizen friendly procedures to limit non-compliance caused by excessive bureaucratic complexity. 3.40 Non-tax revenue retention. Some states, notably AP, have tried to provide non-tax-revenue-raising departments with the capacity to retain at least some of the revenues they raise, thus providing a direct incentive for departments to investment more in revenue collection. This is a common practice in other countries, as it helps departments internalize the state-wide goal of revenue mobilization. In many states, field units, such as hospitals and water-user groups are also allowed to retain their user charges. This has the added advantage that such units are thus able to show improved service charges in return for improved collections. 47 Box 3. 7 Performance measurement in the Commercial Tax Department, Andhra Pradesh In 2001, the Commercial Tax Department in Andhra Pradesh introduced a system of departmental performance indicators which included (a) departmental indicators of corresponding to each component of its mission, including revenue raising and citizen's services and (b) numerical performance indicators for individual staff posts. Noteworthy features of these indicators were the inclusion of achievements relative to targets and potential and only a five percentage weight given to the discretionary "general impression of superior". However, individual indicators were still to incorporate quantitative indicators of service delivery to citizens, since client feedback had yet to be institutionalized. These staff evaluations were linked to salary increments and promotions. The impact of these indicators has been reported to be positive, particularly on work disposal and arrears collection in "unpopular" activities such as the professions tax or appeals. Source: A 2001 presentation on "Performance Indicators" by the Commercial Taxes Department, Andhra Pradesh. A general discussion of fiscal performance indicators in Andhra Pradesh is in Finance Department, Government of Andhra Pradesh (2002). 3.41 A frontal attack on corruption is required. As discussed in Chapter 2, anti-corruption institutions need to be strengthened. Functional organization of departments instead of current systems where a single officer is responsible for groups of taxpayers, are a key reform to reduce corruption, besides increasing administration efficiency and effectiveness. This has only begun to be introduced in some state tax departments. Clearly laid down arms-length procedures which minimize unsupervised contact with taxpayers and computerized personnel record which permit individual accountability for actions to be determined are also important reforms. Removal of discretion in recruitment and transfers is also critical. 3.42 Promoting user-friendliness and citizen feedback. The importance of e-governance and improved citizen's services is increasingly being recognized by governments at all levels in India, and significant steps have been taken in tax administrations in some states to improve citizen's servic:es. These steps include: (a) commitments made by the government to service quality and timeliness via Citizen's Charters; (b) improved public information through pamphlets, information kiosks, public information desks, and websites; (c) easier access and compliance such as via e-governance kiosks, on-line forms, electronic payment, application and return filing; (d) improvements in the location, layout and facilities of offices dealing with citizens. In a few instances (the Transport Department in Karnataka and the Stamps and Registration Department in AP), institutionalized taxpayer feedback on service quality, timeliness and corruption: as noted in Chapter 2, encouraging consumer voice can be a powerful way to improve government service standards. In some cases, this has been achieved by involving the private sector and even outsourcing. 30 Additional measures required are the inclusion of data on compliance with the Citizen's Charter and citizen's feedback in management information systems, performance indicators and reports, and providing incentives (positive and negative) for improved service delivery to citizens. 3.43 Reforms to the structure of revenue departments. In many states, the administration of revenues is fragmented among 10 or more administrative departments, which mostly also perform non-revenue functions. This leads to problems of coordination, lack of uniformity in administration and fragmented taxpayer records. A more promising structure is one with four departments: a main tax department which would cover most taxes, and separate departments which would combine revenue and regulatory functions ~or transport, land, and mines. A permanent, secretary level, revenue committee would ensure coordination. This structure is close to that in states which have commercial tax departments. Since, in the case of stamp duties and registration fees, bifurcation of registration and duty collection would possibly have efficiency benefits, registration of deeds could be made the responsibility of the land revenue department and stamp duty collection could be brought under the tax department. Box 3.6 provides a summary of tax administration recommendations for improving Tamil Nadu's commercial tax department. 3.44 Modernizing field enforcement and check posts. While mobile squads and particularly border check posts constitute an impediment to internal trade and a common market, their removal at the current stage of 30 In a number of Stamps and Registration Departments such as Andhra Pradesh, Maharashtra and Karnataka. 48 31 development, given large scale evasion will lead to reduced state capacity to collect revenue. However, current check posts at state borders are generally poorly equipped and corruption-prone: a recent estimate puts the cost of "facilitation payments" at about 10% of transport costs" (Harral, Jenkins, Terry, Sharp, 2003). Besides, separate check posts are typically maintained by different departments, including sales tax, state excise, motor vehicles, mines and minerals and forests adding greatly to waiting times at state borders. By integrating border check posts and mobile squads across different departments, and eliminating most internal check posts, these costs can be reduced. 32 Furthermore, by adoption of modern technology and institutional reforms, their 33 effectiveness and cost efficiency can simultaneously be increased, while reducing avenues for corruption. 3.45 Use of common facilities Certain institutions can be on a common footing to facilitate coordination across all departments. Importantly, this includes common taxpayer identification numbers. Coordinated field services, via mobile squads and check posts, can also be made the responsibility of a single department to reduce duplication and citizen's compliance costs. Other common activities for taxes and mineral royalties include delinquent collection, except for unpaid land revenue, and maintenance of overall taxpayer master files and current accounts. 3.46 Inter-jurisdiction revenue coordination While several institutional mechanisms are in existence for coordination of revenue policy and administration between centre and states and also between states, most are ineffective, often because their role is merely advisory. In some important cases, the need for coordination is yet to be recognized. For example, it is impossible to get information on rates and bases across states for most taxes, preventing lessons from being learned from cross-state analysis and hampering the work of Finance Commissions. 34 The encouraging recent experience of the Empowered Committee of State Finance Ministers, through which states have achieved significant coordination in streamlining their tax regimes for taxing goods and in designing the proposed state VAT, shows that effective inter-state coordination is possible and can yield major benefits. Conversely, lack of coordination results in (a) inter-state tax competition reducing revenue potential of states; (b) inter-state trade diversion and resource misallocation due to differing tax rates and tax provisions; (c) tax avoidance by exploiting the timing of taxes in different jurisdictions; and (d) impaired ability to identify tax reforms to promote revenue buoyancy and economic growth. Much more serious is lack of coordination in revenue administration. This lack of coordination has its greatest impact on revenue by limiting information available to different tax administrations to combat evasion. A major negative impact on economic efficiency and revenue collection efficiency also arises from duplication in revenue administration such as via identical taxpayer reporting requirements imposed by different tax departments and by multiple check posts at state borders. While comprehensive estimates of the economic and revenue cost of this lack of coordination are not available, piecemeal estimates suggest that these costs may equal several percent of India's GDP. Some proposalis to strengthen revenue coordination, as well as some examples of how other countries handle this issue, are contained in the Annex to this chapter, which appears at the end of this volume. 3.4 7 Development of tax policy and forecasting capacity. There is no single channel for proposing revenue reforms and, in most states, no laid down technical analysis procedure for evaluating the impact of such proposals. Consequently, it is often the case that no view on a proposal is expressed and no analysis offered by revenue departments. Capacity for this needs to be developed both in tax departments and in Finance 31 Das-Gupta (2003) presents evidence that the removal of border check posts in the European Union in 1997 possibly led to negative revenue effects despite its developed economic status. This is supported by conclusions in Ebrill, et. a!. (2001). See also Cudmore and Whalley (2002). For India, Das-Gupta (2003) argues that Maharashtra, which along with Haryana has no sales tax border check posts, has a poorly performing sales tax. 32 Integrated check posts are being established in Andhra Pradesh and Karnataka and possibly Maharashtra. Das-Gupta (2003) reviews desirable ingredients of integration and modernisation packages. 33 The importance of institutional reform to accompany induction of modern technology is illustrated by the experience of Gujarat. Computerisation of Gujarat's border check posts in 1999 Jed to a threefold growth of check post revenues in 2 years. However, staff resistance and Jack of maintenance Jed to check post equipment becoming unusable thereafter. See Pandey (2002) 34 For example, fiscal equalization by Finance Commissions requires estimates of tax exportation which, in tum, requires data on sales tax rates and bases. A second example, a long standing recommendation by fiscal experts to lower stamp duty rates has been resisted by states since evidence that lower rates would result in greater revenue buoyancy is lacking wthout improved cross-state data. 49 Departments so that an informed view can be taken. No state has a tax forecasting model: tax forecasting capacity needs to be urgently developed not least to help withstand the temptation to artificially inflate revenue budget estimates (Chapter 2.V) 3.48 Rationalization of tax laws. Tax rates, including ad valorem rates, can be revised by annual state budgets. However, tax rules, procedures and forms do not require either cabinet approval or legislative sanction. Furthermore, mid-year changes to the tax base, rates and especially exemptions can be made by executive ordinance, subject to ratification by the legislature within 6 months. A consequence of mid-year changes and executive discretion is the existence of a large number of government orders and notifications, not forming part of relevant acts or rules. This proliferation of orders and notifications can also give rise to gaps in administrative control. A legal clean-up is overdue for tax law in many states. 3.49 Involving the private sector. Tax farming is being tried for collection of the entertainment tax from cable television operators in Maharashtra. It has also been used for octroi (a local tax on the passage of goods), though with mixed results. State tax departments are also increasingly turning to public-private partnerships, especially for computerization, e.g. in Karnataka and Maharashtra for property registration. While clearly not a general solution to tax collection, involving the private sector can help, provided regulatory issues are satisfactorily dealt with. 3.50 Tax amnesties Several states have in recent times announced one or more tax amnesties particularly for sales taxes and stamp duties (including AP, Karnataka, Maharashtra and TN). Amnesties tend to reduce taxpayer compliance in the long term and even short term revenue gains may be illusory since only those taxpayers who are likely to lose tax disputes or who have a high probability of being caught will rationally participate: Amnesties are generally best avoided. There is also no justification for a permanent tax amnesty via a settlement commission. These institutions greatly weaken the ability of administrations to enforce taxes and have negative effects on willingness of taxpayers to comply with taxes. Since they are typically limited to large taxpayers, they are also inequitable. 3.51 Dispute resolution institutions are slow and services not logically priced. In most states, there is a vast backlog of tax appeals, mainly for sales taxes, and additional disputes pending in courts. Many appeals are filed purely to delay tax payment and take advantage of the slow disposal of appeals cases. This is facilitated by low filing costs of tax appeals and the absence of any direct cost to appellants of seeking adjournment of hearings. Furthermore, appeals are typically viewed narrowly and do not result in comprehensive reassessment. Other appeals, particularly higher appeals filed by tax Departments, have a high chance of being decided in the taxpayers favor or, at best, low revenue return for the time and expense incurred by tax departments. To increase revenue effectiveness and reduce taxpayer compliance costs, dispute resolution institutions need urgent reform. IV Conclusion 3.52 Further tax reforms are necessary to help restore fiscal sustainability and to raise revenues for public investment and other developmental spending. As a guiding principle, the revenue productivity of Indian states can be increased by broadening the tax base coupled with reforms to ensure few low rates and limited exemptions. This will also help to improve compliance. Major specific recommendations are summarized in Table 5.1 in the concluding chapter. The key reform is to replace the sales tax and other minor commercial levies by a destination-based consumption-type VAT on goods. The move to an integrated VAT on goods (and, if possible, services) is likely to have appreciable growth benefits, provided tax administration is also streamlined and tax payer compliance is held in check. The distorting and inequitable central sales tax should also be phased out. Significant further revenues can also be raised through reforms to the professions tax. 3.53 State tax reforms require wide-ranging actions by both the states and the center. The center has to take a lead if the decade-long journey of the states VAT is to resume; we have suggested a way out of the current 50 impasse by allowing states to graduate ahead individually into VAT, without compensation, with a choice of rates restricted only by a cross-state agreement on floor rates. Professions tax, where there is potential for states to raise an additional 0.8% of GDP, can also only move forward if the center takes the lead in amending the constitution to increase the floor rate. 3.54 Sustained improvement in the revenue performance of states cannot be achieved without thoroughgoing institutional reforms in tax administration and inter-state coordination facilitated by the induction of modern technology. The Centre could take the lead in institutionalizing inter-state coordination, not only in tax matters but, perhaps more important, tax administration and information sharing. Institutions for coordination and information sharing between central and state tax departments also needs urgent attention (see the Annex to this chapter for details). Most importantly, strengthening weak tax administration institutions and related e- governance reforms will enable effective use of enforcement information, increased managerial control, better incentives for tax department staff, and improve taxpayer services. Of all pending reforms, improved enforcement technology and procedures coupled with staff incentives, management flexibility and effective anticorruption institutions have the greatest potential to lead to a significant and sustained increase in state revenue. 51 CHAPTER4 FISCAL FEDERALISM AND THE INCENTIVE FRAMEWORK FOR STATE-LEVEL REFORM I. INTRODUCTION By international standards, India's states have a lot of autonomy. 4.1 To understand why states are in fiscal difficulty, and how to strengthen their development-effectiveness and motivation to reform, one needs to look at the incentives they face. These incentives are in turn determined by India's federal fiscal architecture, the subject of this chapter. Box 4.1 provides a summary oflndia' s fiscal federal arrangements from an international perspective. We have already noted that their heavy expenditure responsibilities are matched only by China among other developing countries. On the borrowing side too, relatively few limits are placed on the states compared to several other developing country federations. Nevertheless, Goi still plays a dominant role in the Indian federation. Relative to their expenditure responsibilities, India's states are unusually dependent on central-government transfers. In 2000/01, central transfers contributed 3 7% of total state revenue. Central transfers are particularly important for the poorer states, who get 51% of their revenue from the central government. Second, Go I plays a leadership role with respect to many national policies: for example, the Central Pay Commission in theory sets salaries only for Goi civil servants, but in practice influences salaries paid in the public sector throughout the country. Third, Goi not only lends to the states but, under the Constitution, sets the borrowing framework within which states operate. India's complex system of fiscal federalism is important to understand in any analysis of state reforms. 4.2 India has developed elaborate and complex institutional structures in the area of fiscal federalism. The two most important federal institutions are the constitutionally mandated Finance Commission, which convenes every five years to determine the sharing of revenues between the center and the states, and the Planning Commission, which, though not a constitutional body, is responsible for developing the national 5-year plan and approving state-level plans, and which provides funding for the same. Whereas the Finance Commission recommends allocation of tax shares and grants, the Planning Commission oversees allocation of both grants and loans. 4.3 In many ways, India's fiscal federal system has served the country well, and has brought stability over an extended period of time. Yet, with growing fiscal stress, and divergence in performance, the system has become the subject of increasing controversy. Following the award of the Eleventh Finance Commission for 2000-05, some have argued that center-state transfers are not adequately progressive to address the widening imbalances between states, while others have complained that the high-income states are being punished rather than being rewarded for performance. For all the disagreement, there is also a clear and shared recognition of need for change. Traditionally stated policy objectives of center-state fiscal arrangements, namely inter-regional equity and efficiency in the use of public resources, have been joined by a new set of objectives -- fiscal responsibility, sustainability and public financial accountability - which have gained prominence in recent years. 35 4.4 In part because we advocate the need for a sharp distinction to be made between grants and loans, we approach this chapter by considering separately the state-level borrowing regime (Section II) and system for the distribution of central transfers to the states (in Section III). Section IV concludes. We begin by noting that the study of fiscal federalism both internationally and in India is vast; our main aim in this chapter is to summarize and synthesize the work done by Indian and other scholars in this area. 35 In the words of Dr. C. Rangarajan, Chairman of the recently constituted Twelfth Finance Commission, mandated to recommend the regime of resource-sharing between the center and state governments during 2005-2010, "Equity considerations must be incorporated within a framework of fiscal prudence". 52 Box 4.1: International perspective on India's fiscal federalism Expenditure responsibilities India is very decentralized in terms of expenditure responsibilities. The share of state to total expenditure is about 57%; this is the same as Canada, and below China, but above most other countries. The average for OECD countries is 35% and for Latin America 15%. Sub-national as a percentage of total ... (1 )/(2) Revenue transfers and vertical gap. The share of state in total Expenditure Revenue revenues in India is about 39%. This is about average, but low given ( 1) (2) the extensive expenditure responsibilities of India's states. The ratio of expenditure to revenue for India's states is 1.45, which is below China 81.5 59.7 1.37 Australia and Denmark in the table, but above everyone else. This Canada 58.8 53 1.11 reflects a high degree of dependence on central transfers as well as India 56.7 39.1 1.45 borrowing. Denmark 53.9 31.7 1.70 Australia 49 31.7 1.55 Equalization. Most federations have some sort of commitment to Argentina 45.6 39.1 1.17 equalization built into their federation. Some, such as Canada and U.S.A. 44.4 42.1 1.05 8~· Germany, have the goal of horizontal equalization explicitly built ..;G::..:e:.:.rm=an;;;.Y'-------=3-= 8 ;..:3;.;...8:..__ ___;1:.:..1;;.:...5 '---__;3 into its constitution. India's constitution, in many respects detailed, is quite vague on the principles which should guide central transfers, leaving the onus of interpretation on the Finance Commission. Similarly, in terms of outcomes, central transfers are progressive in practically all federations, but very equalizing only in some (Canada, Germany, Mexico, Australia), and partially equalizing in others (Brazil). As we discuss in detail in the text, India fits in the latter category, no doubt in part because the constitutional and institutional commitment to equalization is India is much less explicit. Borrowing rules India's rules for sub-national borrowing, especially as they are put into practice, are relatively liberal. An IMF study of 53 countries found that all but 6 had some restrictions on sub-national borrowing; in 16 sub-national governments were barred altogether from borrowing; in 19 overseas borrowing was banned. (see Ter-Minassian and Craig, 1997; Anand, Bagchi and Sen, 2003) Overseas borrowing by states is banned in India, but, unlike in many other countries, there are no aggregate limits on domestic borrowing: by contrast, in Italy, for example, regions can borrow only for capital projects and subject to a limit that debt service not exceed 25% of a particular definition ofrevenue; Brazil's states, under the country's Fiscal Responsibility Act, face a debt limit equivalent to two times the states' net current revenue to be achieved within a 15-year period, with annual reductions equal to 1115 1h of the original excess over the limit. Two restrictive features oflndia's borrowing arrangements, which have not always been present in some others, and have caused trouble when they have not (e.g. in Argentina, Brazil), are that states are not able to borrow from central or provincial banks ("print money") and that there is a limited, though not absent, history of debt write-offs. India is unusual in acting as a creditor to state governments. Pakistan, whose federal government used to extend loans to finance investments of state governments, has discontinued this practice Debt levels: Reflecting the relatively liberal borrowing regime, India's states seem to be the most highly leveraged in the world. In 2000, for all of India's states combined, the ratio of debt to revenues stood at 203%. Canada was next with 189%, Brazil with 170%. In Argentina the ratio was 69%, and the US 44%. II BORROWING REGIME States face six sources of borrowing, all of which have been increasing since the late nineties 4.5 The 1950 Constitution of the Union and States of India sets the basic rules of India's sub-national borrowing regime. Section 293 forbids state governments from borrowing abroad and requires them, as long as they owe even one rupee to the Union Government, to obtain central approval for domestic borrowing. The following sources of domestic borrowing are open to the states: (i) Go! (central plan) loans. These accompany the central grants to help finance state plans. See para 4.9 for a more detailed discussion. (ii) Market borrowing. State bonds are issued to banks and financial institutions through a process managed by the Reserve Bank oflndia. Nearly all bonds from states are sold at the same time and the same price. RBI also manages debt-servicing, and allocates for this purpose funds transferred from the central government, all of which pass through the RBI. Thus such funds are supported by an implicit escrow 53 arrangement though not by a central guarantee. The amount of borrowing per state is determined by Go I (Finance Ministry) at the start of the year, largely based on precedent, though ad hoc adjustments are frequently made in the course of the year to allow for "additional market borrowing". (iii) Negotiated loans. These are from public insurance companies and other Gol-owned financial institutions. Their quantum is determined at the time of Plan finalization, and also subject to being supplemented during the course of the year, with room for central discretion and hence for political lobbying. (iv) Small savings: net public deposits in central post office savings schemes with administered interest rates that have been maintained above market rates. All such deposits are available to the states in which they accrue- partially for general deficit financing purpose (80%-60% during 2002-05) and partially to swap with old and more expensive small savings debt (v) Provident and insurance funds. These are involuntary savings of the state government employees at administered interest rates - the net inflow being the difference between deposits of monthly premium by each account holder, on the one hand, and the sum of net loans extended and final payment on maturity (at the time of retirement), on the other hand. (vi) Other Public Accounts. By definition, Public Accounts include all transactions in respect of which the state government acts like a banker. Besides the involuntary savings (provident fund accounts) of state employees and those in state-aided institutions, Public Account borrowing is a practice best understood as one in which expenditures are booked under a public account, but not incurred. The increase in the balance of the public account is then defined as deficit-financing for the booked expenditure. Expenditure booked in this way are by definition not incurred in the year in which they are booked, and experience shows that in fact they are often not incurred in subsequent years. Other Public Account stocks are excluded from debt stock calculations, Figure 4.1: Borrowing sources for state governments and Other Public Account "borrowing" lS often 5%.----------------------------------------------- fictitious. 36 4% li. i· r-- ~ - 4.6 As Figure 4.1 shows (and 3% - as was also discussed in Chapter 1), borrowing from all sources was ll.. c I I. ~~r--" (!) 2% r - ~- 1- - constant at around 3% ofGDP, but ~ Iii ~ ~ 0 has been above 4% since 1998/99. 1% l£_ d if~ ~ I I ~ ~ The most important source of borrowing is now small savings, 0% ; 1!11! ~-~ ~ about 40% of the total. Market ~ !:? 1? ~ ~ ~ ~ q ~ ~ ~ bi ~ s:l 9 9 9 . bOrrOW111gS are t h e second mos t -1 o ~-~--gs-~~8l1--m-8l--8l 8l 8l m----m-m g-g- Of< L()(Of'o-COO'lO..-NM<:t,},r.bf'o-dJO'lo..- important at about 15%. ..- ..- ..- ..- ..- ..- ..- ..- ..- ..- ..- ..- N N Negotiated loans have grown very GJ Go I Loans til Market loans D Negotiated loans rapidly and now make up almost lliil Small savings II PF etc g Public accounts 15% of total borrowing, up from just 1 or 2% at the start of the nineties. Go I loans are a declining share: they were above 20% of the total, but are now down to 10%. The provident fund has also declined to about 10% of total borrowing. Borrowing from other public accounts fluctuate wildly, reflecting accounting adjustments rather than real debt accumulation. 4. 7 There are also two other borrowing mechanisms, which exist outside the formal framework. First, to circumvent central controls on market borrowing, some states raise funds through special purpose vehicles: the debt is off the budget, but debt-servicing is through the budget. Such practices became very popular in the course of the nineties; various orders have been issued by Gol and RBI, which would, if implemented, bring off- 36 See Ravishankar and Mathur (2003) for further discussion. Note that this item is defined residually, and thus also includes changes in the cash balance. 54 budget borrowing to an end, or under stricter control. Second, states run up arrears. The most striking case of this was in the power sector, where budget constraints were truly soft as states could "buy" power from central utilities (para 1.29), sell it at a loss, and not have to pay for it. One of the most significant developments of the post-crisis period is the reform to the paying mechanism for central utilities, which has, at least to a large extent, closed offthis loophole. The strengths of the sub-national borrowing regime are its ban on offshore borrowing, and the limited history of bailouts. But there are many weaknesses: too much borrowing, and neither effective central regulation nor market based discipline 4.8 Strengths and weaknesses. The strengths of the sub-national borrowing framework in India include: its bar on borrowing abroad, which is strictly implemented and which augurs well for macroeconomic stability; the inability of states to print money; and the strong controlling role given to the central government under the constitution, although the implementation of these controls is far from complete. Another important strength has been the limited history of bailouts. Although there have been some debt write-offs offered periodically by various Finance Commissions, these amount to 7% of GDP over a 30-year period, and less than 2% of GDP in the last 20 years (i.e. not annually, but spread over the number of years mentioned) Thus, so far, states have normally had to repay debt that they have incurred. At the same time, the borrowing framework suffers from a number of weaknesses: o Too much state-level borrowing, especially for the poorer states. This is the most fundamental problem. India's states were already heavily leveraged before the crisis: they have the highest debt/revenue ratios of any sub-national entities world-wide (Box 4.1 ). Since then, the state-level debt burden has skyrocketed. The poorer states are particularly indebted with significantly higher deficit and debt ratios than the other states (see Chapter 1). This problem is unlikely to go away soon. Small savings is a key source of debt that is growing explosively. In the last two years, Goi has wisely controlled the growth of small savings by earmarking a significant and increasing portion of new small savings to retire old, high-cost small savings loans. However, this can clearly only be a temporary solution. o Limited central control of state borrowing. Federations around the world show a great deal of variety in their sub-national borrowing regimes; as discussed in Box 4.1, India is stricter than some, and more relaxed than others. What one can say is that the actual controls over sub-national borrowing are far below what the constitution allows for. Of the six borrowing sources outlined above, only three - loans from Goi itself, market borrowing and, to some extent negotiated loans - are under the direct control of Goi. The other sources are not capped by Goi though they make up over one-half of total borrowing. o The interest rates states face are independent of their creditworthiness. By and large, states all pay the same interest rates for their debt, and have the same access to capital markets. States typically approach the market together, and it is well known that the RBI pushes creditors to buy a mix of state bonds, in particular leaning on them to purchase bonds from states perceived as being less credit-worthy: thus the better-managed states cross-subsidize the worse-managed. Such practices enormously weaken the incentives for prudent fiscal behavior. In 1999, the RBI did allow states to sell bonds on their own, up to 3 5% of their total allocation. But this remains only an option, not a requirement, only a few states take advantage of it, and there has been no subsequent liberalization of the market-borrowing facility. o Soft budget constraint Budget constraints are said to be soft if there is a perception of a bail-out in the future. While bail-outs have been limited in India, they have not been entirely absent. Some small states, such as Himachal Pradesh, are repeatedly bailed out, and states in stress are sometimes given additional loans by the central government. This sort of behaviour clearly weakens the incentives for fiscal prudence (McCarten, 2003; Anand, Bagchi and Sen, 2003). 55 o Complex system, with elements of discretion and arbitrariness. The borrowing regime is complex with multiple borrowing channels, each with its own rules. There are clear elements of discretion and arbitrariness, especially relating to open-market borrowings. The allocation of market borrowings between states follows no pattern except history. The additional market borrowings window gives rise to significant lobbying, and reinforces the perception that borrowing is a source of revenue to be maximized rather than managed. India is also one of the few federations in which the central government acts as a creditor to the states. This again gives rise to lobbying opportunities. Several econometric studies have shown undesirable outcomes from this arrangement (see Box 4.4), including that politically powerful states get more access to central loans, and end up with higher deficits. o Planning process out of step with pro-reform fiscal framework. The emphasis on enlarging the aggregate size of 'State Plans' and the system of financing through a package of central transfers, central loans and additional borrowing has fed into a spiral of debt accumulation by the states, unrelated to the debt bearing capacity of each state. (The planning process and the problems it causes for the states, and possible solutions are discussed in Box 4.8 at the end of this chapter, since it cuts across both loans and grants.) 4.9 In summary, the states are disciplined neither by the credit markets nor by the central government: consequently, neither the hierarchical nor the market-based controls advocated by the literature on sub-national borrowing are well developed. Reforms need to be considered both to govern future borrowing and to handle the large, existing stock of debt. We consider these in turn. The most important reform to the borrowing regime would be to introduce flexibility within a global cap. 4.10 In general it is clear that the sub-national borrowing regime needs to be rationalized and simplified. At one extreme, one could advocate forcing all states to go to the market for borrowing, and relying on the markets to discipline the states, and punish imprudent policies with worse credit ratings and higher interest rates (Lane, 1993). Such a system of market-based fiscal discipline works well in developed countries such as the US, Canada and Australia, which face few, if any, central controls, even over foreign borrowing. However given the experience in some other developing countries, especially Latin America, and the lack of a role for credit- markets in the current federal fiscal system in India, it would be risky to rely solely on this approach. Thus the consensus in the literature is for "market-based discipline supplemented by rules-based controls."37 There is a good argument for, at least for the time being, developing a "global cap", which would place an upper bound on state borrowing. Within that cap, however, states should be provided with the maximum flexibility for arranging their own borrowing, and be exposed as much as possible to market discipline. Adoption of such an approach would have a disciplining impact on both the states and the center. It would close avenues for political bargaining by the states for additional loans, and closes the avenue for the center to use the approving of additional loans to states as political favors. We outline below some of the steps, which could be taken to move the borrowing regime in this direction. o The first step would be to define the global cap, which would be the maximum amount of borrowing a state government could undertake in any given year. Many countries have such caps: see Box 4.2 for examples. The cap should be based on observables, and not subject to negotiation: it could be based on a percentage of GSDP or revenue from a couple of years earlier. Given that states are now adopting fiscal responsibility acts, the central government can simply adopt, and enforce, the borrowing targets already legislated by the states. It could be based on debt-servicing or debt-stock or debt-flow ratios. While in theory different states could sustain different degrees of debt, dependent on their growth rate, in practice, it would probably be more feasible to have the same ratio across all states. This ratio would need to be below current levels of borrowing for most states, which would force one to define a time- period within which borrowing would need to be brought under the cap, and a transitional path. It would also need to be decided what borrowing sources would be brought under the cap. On the one hand, the 37 Anand, Bagchi and Sen (2003, p. 95) 56 definition should be comprehensive; on the other it should be practical, and able to be enforced. Whether the cap should include borrowing from the public accounts, off-budget borrowing, and other guarantees should be given particular attention. o Once the cap has been decided on, enforcement mechanisms are needed, ex ante and ex post. Ex ante, all resource allocation discussions between the centre and state (e.g. Plan discussions) would have to be consistent with borrowing being at or below the cap. Consideration would have to be given as to whether the cap would be enforced by law (e.g. Brazil's 2001 Fiscal Responsibility Law) or simply by administrative order. It could be based on debt servicing or debt stock or debt stock flows. Ex post, one would need mechanisms to ensure that actual borrowing is consistent with the cap. Special consideration will need to be given to captive, open-ended borrowing sources, such as small-savings and provident funds. If such sources are retained in their current form, the degree of access to them should be contingent on total borrowing not exceeding the cap; any borrowing over the cap in one year would have to be offset in the next year. It will also be important to establish a credible system of timely reporting of states' debt and guarantees to enable the center to set and administer hard, state-specific borrowing ceilings. o Borrowing arrangements within the cap should be simplified to the extent possible. Just as Goi is, so the states should be largely, if not completely, dependent on market borrowing, and face interest rates determined by their own credit rating. The main fear in this regard is the likelihood that some states would be unable to access the markets at all due to poor fiscal performance. However, with RBI providing liquidity (escrow) support, this situation might not arise, and poorer and poorer-managed states might be able to access markets, but at a higher interest rates. If necessary, Go I could also offer a guarantee facility, at a price, to backstop poorer states. o Captive sources of loans should be done away with. Financial institutions and small-savings should have to buy government bonds, not offer loans directly to state governments. This would reduce lending pressure on state governments, and also lower their interest costs. If Goi wants to offer subsidized interest rates to small savers, it should cover the costs of this, and not burden the states. Off-budget borrowing should either be banned, or included within the cap. o Lending from Goi to the states should also be done away with. This would not only be consistent with international practice, but also with the principle of reducing complexity and discretion and increasing the role of the markets. A special problem is posed in this regard by the role the central government plays as an intermediary between official external financiers and the states. This is discussed in para 4.36. o Relying only on constraints on borrowers means that lenders such as public sector financial institutions may still push loans and find politicians with a short-term perspective willing to borrow, despite the rules. Hence tighter regulation of the financial sector is also needed in the form of a disincentive for financial institutions to make high-risk loans to non-creditworthy sub-national public clients. In the event that market based fiscal discipline, with interest rates on sub-national debt that reflect risk premia, is not feasible for India over the next five to ten years, then it may be worth considering a suggestion (Eaton, 2003) that the risk-weighting required for lending to states (currently uniform) be linked to an experience rating that reflects the probability of loans and guarantees becoming non-performing. 57 Box 4.2 Borrowing restrictions on sub-national governments: principles and practice Ter-Minassian and Craig (1997) undertake a survey of the control of sub-national borrowing around the world. They draw four main conclusions: o Sole reliance on market discipline for government borrowing is unlikely to be appropriate in many circumstances. However, market discipline can be a useful complement to other forms of borrowing control. o The case for centralized administrative controls on borrowing (involving, for example, a centralization of borrowing or approval of individual loan operations) is not strong; in particular, it undermines transparency. o Rules-based approaches to debt control would appear preferable, in terms of transparency and certainty, to administrative controls. o These considerations would argue for setting global limits on the debt of individual sub national jurisdictions on the basis of criteria that mimic market discipline, such as the current and projected levels of the debt service in relation to revenues. It is important that projections used for these ceilings be realistic, preferably conservative. It is equally important that a comprehensive debt definition be used (including extra budgetary operations, guarantees, and recent financial innovations, such as long-term leases). Petersen and Valadez (2004) in a more recent review states that "Regulatory schemes for sub national borrowing need to have prudential limits that are clearly stated, well-monitored and enforceable. Good information systems are key components of success." (p. xxxv). They note the need for clear definitions to avoid conflict and give the following examples of common debt limits and rules: o The amount of indebtedness issued, usually expressed as a ratio of revenue o Annual debt service as a ratio of uncommitted annual revenues o No rolling-over of short-term indebtedness o Long-term borrowing restricted to capital investments o No external borrowing Not all borrowing controls work. Burki, Perry and Dilinger (200x) note the mixed experience in Latin America. They argue for "neither a purely regulatory nor a purely laissesz-faire approach", but also note that "the name of the game is effective hard-budget constraints on subnationals, and these can be done or undone in several ways." Some country examples: o Poland: annual debt service no more than 15% of current revenue; debt no more than 60% of revenues. o Romania: in addition to limits, a requirement that each subnational debt instrument contain a statement that there is no express or implied central government guarantee. o Brazil: As part of the Fiscal Responsibility Act, a debt limit equivalent to two times the states Net Current 4.11 The reform agenda sketched out above is ambitious. It could of course be picked up piecemeal. In principle, a global cap could be introduced without any simplification in the borrowing rules. However, the advantage of tightening up overall access to loans while introducing flexibility within the cap is that it offers benefits to both the center and the states. 4.12 It is also important to realize that a global cap may not be the final solution. International experience suggests that, whatever the cap, states will always try to get around them. For example, in Australia state governments started to make extensive use of capital leasing to get around borrowing restrictions. Over time, it should be possible to rely more and more on discipline by markets (and voters) and do away with a centrally imposed global cap. However, we are a long way from that happy scenario now. Allowing states to borrow commercially to restructure debt is consistent with a shift to a "global cap with flexibility" model. But debt relief raises a number of questions 4.13 Treatment of existing debt-stock: options for debt-restructuring and relief. The debt restructuring initiated by Go I over the last few years (para 1.30) is a welcome development for the states. The practice of ear- marking a significant ratio of small-savings to retire high-cost debt has helped keep overall borrowing levels down in the last two years, and provided a temporary solution to the explosive growth of small savings loans. Such earmarking should continue until a permanent solution is found to the problem of small savings utilization. Allowing states to access market funds to finance debt-restructuring is also consistent with giving states more flexibility to manage their debt within a fixed ceiling, and could be used to get states used to more commercial 58 borrowing operations. For example, states could be allowed to go in for additional market borrowing to finance debt restructuring provided that they obtain a credit-rating, and that they agree to their bonds being auctioned separately, rather than mixed up with other states. Debt-restructuring could also be a good use of adjustment lending resources available from external funding agencies. 4.14 For some Indian states, the combination of voluntary debt-restructuring and fiscal reform will be insufficient to restore fiscal solvency. The more highly indebted states shown in Figure 4.2, most of whom are the poorer states, are unlikely to eliminate their deficit on the current account, even with the strongest possible efforts to improve their own revenues and control their non-interest expenditures, because of the heavy burden of debt and annual interest burden that they have inherited (see Chapter 5.V. for further elaboration of this point). Just as the international community has floated the "HIPC" (Highly Indebted Poor Countries") initiative (summarized in Box 4.3), the suggestion has been made that Gol should float a "HIPS" (Highly Indebted Poor States") initiative, under which good fiscal performance would be rewarded by debt write-downs. 38 There is certainly merit in this suggestion: a well-designed HIPS scheme would incorporate the same suggestions made for the current Fiscal Reforms Facility (discussed later in Box 4.7) with perhaps a greater emphasis on a track- record of several year's good performance. At the same time, one has to note three caveats. 0 First, the theoretical basis and practical backdrop to the HIPC initiative is the Krugman (1988) idea of "debt overhang". This noted that, in a scenario in which sovereign states were defaulting on their debt, agreeing on a workout could be in the interests of both the creditor and the debtor. But this observation does not apply to the Indian context, at least not in any immediate way, since default on state-level debt by the Indian states is rare. In such a context, the provision of debt-relief and additional assistance are equivalent. As noted, India already has the Fiscal Reforms Facility (Box 4.7), which provides additional assistance to reforming states. If necessary, more resources can be made available under the FRF to highly-indebted states, subject of course to meeting the Figure 4.2: Debt to revenue ratios for ma.ior states & Gol, 2001/02 performance benchmarks. Maharashtra 153% o Second, since the set of Karnataka 170% highly-indebted and poor states largely overlap, any Tamilnadu 134% shift towards horizontal Haryana "132% equalization (discussed in the Andhra Pradesh ~I " "137% next section) will at once ease the relative debt-burden of the Uttar Pradesh Iiiii' 215% poorer states. Gujarat I 2"13% ' o Third, the states' largest Kerala 235% creditor, and the only one Madhya Pradesh .m 249% which could offer relief, is the ' central government. Its Rajasthan ib;illl .. 286% indebtedness, as measured, Punjab m ,·, 301'/o say, by debt/tax ratio, is above Orissa !1, 325% 400%, which is higher than even the most indebted state West Bengal 328% "' I (Figure 4.2). The rationale for Bihar 382% a more-indebted creditor to Go! ,,m,ll IH .... 467% extend debt relief to less- indebted debtors is unclear. 0% 100% 200% 300% 400% 500% 4.15 Thus while the problem of 38 The 121h Finance Commission has been asked, for the first time, to assess the debt position of the states, and suggest corrective measures consistent with debt sustainability, and giving "weightage to performance in the fields of human development and investment climate." 59 excessive debt-levels certainly needs to be taken care of, it is unclear if this should be done by provision of debt relief or by addressing other problems - adequate rewards for good fiscal performance, and adequate horizontal equalization. Even a well-designed scheme runs the risk of inadvertently undermining the current expectation among Indian states that debt incurred will need to be repaid. The Latin American experience with frequent debt bailouts suggests that this is a path to be trod only with great caution. Box 4.3: HIPC- what is it, and has it worked? HIPC began in 1996 with the goal of removing the debt overhang as a constraint to economic growth and poverty reduction. It was enhanced in 1999 to bring about deeper, broader and faster debt relief, and also to support a more ambitious set of objectives: to provide a "permanent" exit from debt rescheduling, promote growth, and release resources for higher social spending. The key HIPC target was to reduce the ratio ofNPV debt/exports: initially to 200-250%, then to 150% under E-HIPC. Any country with a ratio above this level, and which met the performance criteria, was eligible for HIPC assistance. Initially, a country was required to put in 6 years of "good performance" to qualify for HIPC: a 3-year track record of macro stability and policy reform was required to reach the "decision point", i.e. become a HIPC candidate, and then another 3-year period to reach the "completion point" at which time debt relief became available. However, the enhanced HIPC halved the track- record time requirement by making debt-relief available at the time of the decision point From 1996 to 1999, only seven countries became eligible for debt relief. But 20 countries became eligible (reached decision point) by the end of 2000; another 6 qualified by August 2002. By August 2002, the number of countries eligible for HIPC relief reached 42, while 26 were actually receiving relief. The cost of the initiative is expected to be $27 billion in 2001 net present value terms. It is difficult to evaluate HIPC at this stage, given the shortness of time that has passed. Evaluations of debt relief more broadly are divided. Some (Sachs 2002, Hanlon 2000) argue that debtors have been given just sufficient relief to enable them to pay their primary creditors, but not enough to allow their economies to grow, let alone to reduce poverty. Other studies concluded that the greatest relief has gone to countries with bad policies (Easterly 2002) or without good governance (Neumayer 2002), and that it has not yet been used for poverty reduction (Allen & Weinhold 2000), or that debt reliefhad little effect on the actual flow of debt payments because those debt service obligations which were forgiven were largely ones which debtors would not have met anyway (Policy and Operations Evaluation Department, 2003). The independent Operations Evaluation Department of the World Bank published a review ofHIPC in 2003. It found that it the anticipated debt relief is delivered, the initiative will succeed in substantially reducing most HIPCs' external debt stocks and their debt service to below the levels of other poor countries. But to achieve the broader objectives, the initiative would have to transfer additional real resources, which in turn would require an increase in the global aid budget, whereas in fact there was a sharp decline in global net resources about the time HIPC started. The OED review also found that the "track record" requirement for HIPC relief was progressively reduced in the enhanced HIPC, and that there were questions over whether some HIPC countries had the policies in place to generate sustained poverty reduction. III REVENUE TRANSFERS (GRANTS) India is characterized by a large degree of vertical imbalance. 4.16 Vertical imbalance. The tax and functional responsibility assignments between the center and the states of the Indian Union, as stipulated in the 1950 Constitution, imply a significant vertical gap -- that is, an imbalance between the revenue-raising ability of a level of government and its expenditure responsibility. The center is resource rich relative to its expenditure responsibilities, while the states are revenue poor relative to their rich mandate of expenditure responsibilities. This vertical imbalance, as measured by the share of central transfers in total state revenues, is about 40%, high by international standards (Box 4.1 ). 60 A long-term decline in central transfers to the states is one of the contributory factors behind the deterioration in state finances. 4.17 Transfer volumes and channels. There are three Figure 4.3: Central transfers to states, 1985-2000 principal ways in which the 6,---------------------------- vertical gap is filled by transfers from centre to states: Finance Commission (FC) transfers, block grant transfers which are part of the plan allocation to states, and specific-purpose grants for schemes run by Gol. Figure 4.3 shows the trends in total transfers and by categories. Block grants As was grants overall discussed fromin Chapter 1, the centre t--r:~:::~:!~~~~~§_..~:;=:;~::~=====~- ~' w ..~~:~~ ,, -.....-- - -. have been declining from about Special-purpose grants 5% in the early nineties to about 0 +-"'~-rD~-,_--.--"'~-m.__,-o~--.--N~-C'l~--g,---.-"'~-rD~-,_--.-"'--.-m--.--o~ 39 4% ofGDP today. A decline in ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ all three sources of transfers is responsible for this, though the sharpest decline in the falls in special-purpose grants. Some brief details on the three types of transfer channels follow: (i) FC transfers are largely untied, formula-based transfers, consisting of tax sharing and unconditional grants, 40 which are distributed among the states by the Finance Commission, a constitutional body, for a 5-year period. 41 As Figure 4.3 shows, FC transfers account for major and growing share of the total revenue transfers during the 1990s (two-thirds by 2000/01). They suffered a sharp cyclical decline in 1998/99 and 1999/00, but have subsequently recovered. The awards of the Finance Commissions have generally been based on a formula- driven tax revenue sharing component,42 and a small (10%) grant component that is determined on the basis of projected gaps between revenues and expenditures of states. (ii) 'Block' grant transfers called 'Central Assistance to State Plans', are the grant component of a mixed grant-loan transfer overseen by the Planning Commission: the loan/grant mix is 70/30 for the major or 'general category' states and 10/90 for the special category (small and border) states. The transfers consist of a "normal" portion, whose aggregate size is at the discretion of the central Ministry of Finance and 70% of which is distributed among the 15 major States according to a Planning Commission formula43 with 30% earmarked for the special category states; and an "additional" portion, which is the onward transmission of generally earmarked external resources through the center to the states. Block grant transfers make up about 20% of total transfers, and just less than 1% of GDP. 39 The most recent actual data for central transfers received by state governments is for 2001/02 which shows a further decline to 4.0% of GDP (from 4.2% in 2000/01) due to a decline in tax devolutions, associated with stagnant tax collections by Gol that year. This data is not broken down into block grants and special-purpose grants, and so is not included in Figure 4.1. 2002/03 actuals are only available for tax devolutions: they are at 2.3% ofGDP 40 Small parts of the FC awards do have conditions. For example, the Eleventh Finance Commission award (2000-05) included one portion of grants conditional on fiscal correction by the states, under a centrally administered Fiscal Reform Facility: see Box 4.7. 41 It is not mandatory upon the Government oflndia to accept the recommendations of the FC, but it invariably does with respect to the tax sharing formula. 42 The formula varies from commission to commission: the Eleventh FC formula used weights of population (10%), income differential with the richest state (62.5), area (7.5%), index of infrastructure (7.5%), tax effort (5%), fiscal discipline (7.5%) 43 The revised Gad gil formula ( 1991) gives 60% weight to population, 25% to an inverse measure of per-capita income, 2.5% to tax effort, 2.5% to fiscal management, 2.5% to national objectives and 7.5% to special problems. 61 (iii) Specific-purpose or conditional grants finance centrally designed programs through cost-sharing arrangements with the states. Some of these also involve loans, but most are given as grants. They finance about 130 schemes, about half of them for rural development; other significant schemes are in the areas of health, nutrition, and education. Special-purpose grants have fallen sharply as a share of total grant transfers during the 1990s: from close to 20% in the early nineties to less than 10% now. It is important to note, however, that what is reported here as specific-purpose grants are only those received on-budget by the states. Many centrally- financed cost-sharing programs do not appear in the books of the state governments; rather, both the central and state governments provide funds in agreed ratios to third-party implementers, typically district-level societies. In 2000/01, 62% of central grants were disbursed under such an arrangement. It may well be that the fall in specific-purpose grants reflects a greater shift to this type of disbursement arrangement. As noted in Chapter 1. V, in the last few years, a new type of conditional grant has come into existence, namely one which links fund disbursement not to particular Figure 4.4: Trends in Gol revenues and transfers to states sectoral expenditures but to the 45.0% 15% achievement of various reform milestones. These remam quantitatively small, but are a 0 significant development in the (!) 0 37.5% Indian fiscal federal landscape. c., 35.0% 7°/o ., I:? a.. 6°/o 4.18 Both those central 32.5% +-+-+-,_~-r-r-r-+-+-+~~~~~r-r-+5% transfers linked to the tax take of the central government (tax devolutions) and those specified in absolute values have fallen. More recent data is available for tax devolutions up to 2002/03 (Figure 4.4), and this confirms the fall seen in Figure 4.3. In the 13 years before 1997/98, the ratio of tax devolutions to GDP fell below 2.5% only once; from 1997/98 to 2002/03, it has never exceeded it. Central transfers have fallen both because Go I revenue has fallen as a percentage of GDP (this explains two-thirds of the fall); and because there has been a decline in transfers to the states as a percentage of central revenue, reflecting the central government's own fiscal stress. The formal transfer system is modestly progressive 4.19 Of the different transfer types, the FC transfers are the more progressive (negatively correlated with the income level of states), other Goi transfers less so (see Table 4.1). The combined effect is a distribution of central transfers that is negatively correlated with, but much less varied than, state income: while the per-capita income ofthe richest state is more than 4.5 times the poorest (among the 14 major states), the per-capita transfer to the poorest state is a little less than double that to the richest. Also, while the richest states clearly get less than the poorest, the middle-income states often get more. For example, Table 4.1 shows that for the period 1995-2000, Tamil Nadu, Kerala, and AP all received more central transfers per-capita than UP, the second poorest state. Figure 4.6: Transfers from Gol to the 5 large poorest states as a percentage of total transfers 55% 50% 45% <£> 00 ;;;; ....... 00 00 ;;; 0 0> ;:::; :;:; 0 N 52 <'> <1") ... <'> I<> <1") ;;;: <.t> <1") ;;;; ....... <'> co <1") ;:::: 0> <'> ;;; 0 0 ;:::; :s 0 :;:; ~ ?.> <1") <1") <1") <1") <1") <1") <1") <1") 0 ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ 0 N 62 Table 4.1 Per capita transfers among India's states (average for 1995-2000) Per capita transfers FC GSDP transfer Other p.c. s transfers Total Poor States )3ihar 4846 614 120 734 Uttar Pradesh 7149 436 125 561 1 tgure 4 5 p er cap1 a revenues norma rIse d, 2ooo1o1 F" .. Orissa 6602 557 197 754 0.9 t-- 1--- r-- - Madhya Pradesh 9037 549 210 759 0.8 c-- - - Rajasthan 9716 432 190 622 0.7 - 1--- A veraf!e Poor States 7211 500 153 653 0.6 f----- Other States 0.5 1--- 1--- - Andhra Pradesh 10598 479 163 642 0.4 1--- 1--- 1-- - - Karnataka 12614 391 158 549 0.3 - - I Kerala 11360 460 131 591 0.2 1--- West Bengal 10226 379 125 503 0.1 Tamil Nadu 13756 417 148 564 0 I -:;; ..<: iij "'<:: ..<: ..<: "' "' " "' "' Gujarat 15768 356 122 478 ..0 <:: :?! ..>! Ill )6 ·;: "' = 1: ""' 2"' )6 ·:;- iij G; "' -:;; Ill "" <:: "' Q) "' "' "' .!::! t\ ""' ..<: Ill Ill ..<: ifi IHaryana 15304 263 167 430 " )6 Ill "' ·e ::.::: ""' "' "' t\ ·;;; ""' "' a: "' 0 Punjab 16659 289 124 413 (L I )6 ..<: ~ <:: )6 ::.::: a: "' a: 0: ~aharashtra 17107 273 115 388 "' ~ "' 1- ~ "' "' ): = ~ "' ..<: ""' <:: ""' ::5 f4verage Other States 13471 374 137 511 <( ~ "' !Average 14 States 430 144 574 • Own revenues 0 Transfers Correlation with GSDP p.c. -0.91 -0.32 -0.87 4.20 Although progressive, central transfers, separately or combined, do not come close to achieving anything like horizontal equalization. Table 4.1 shows total per capita revenue for the 14 major states, normalized to the state with the highest revenue per capita, Punjab. It shows that among most of the middle- and high-income major states there is not much difference in per capita revenue. However, the per capita revenue of the poorer states is much smaller. With low own revenues and transfers, Bihar and UP end up with less than half of the per capita revenue capacity of Punjab. MP and Orissa do slightly better, but nevertheless end up with no more than 60% of Punjab's revenue; Rajasthan has 70%. Similar results are obtained if one looks at per capita Figure 4.7: State revenues before and after transfers revenue capacity rather than actual revenue, i.e., (formal and FCI) abstracting from differences in tax effort (Bagchi 100~--------------------------------- and Chakraborty, 2003). The modest progressivity of the transfer system can be seen from Figure 4.6 90 + - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - which shows that the 5 poorest large states with 40% of India's population and about 50% of its poor get 50% of central transfers. The figures also illustrate the stability of the distribution of transfers among states, with some year-to-year volatility, but no significant underlying trend. I 50 There are also large and regressive informal !l 40 transfers. Once these are considered, India's ·e. transfers are roughly distributed on a per capita 5 30 basis. ~ 20 • 4.21 Informal transfers. Beyond these formal 10 transfers, there are hidden or implicit revenue transfers among states, with substantial fiscal 0 consequences. Chapter 3 has already discussed 0 5000 10000 15000 20000 25000 30000 inter-state tax exportation through the Central Sales GSDP per capita Tax: this is a regressive tax since it is imposed by 63 the manufacturing (rich) states on the consuming (poor) states. Another hidden transfer arises from the procurement of farm produce. This concerns the practice of the Food Corporation of India to procure at above market prices from particular states. Seventy-three percent of the rice and 84 percent of the wheat purchased by the Food Corporation of India (FCI) is from the relatively well-off states of Haryana, Punjab, and AP, even though these states produce only 26 percent oflndia's rice and 35 percent of its wheat. Farmers in these states enjoy assured sales at prices, which are much higher than where the FCI is not active. 44 An attempt has been made to quantify the benefits of this enjoyed by the various states (World Bank, 2004e). The results are startling: Punjab and Haryana together account for 67% of the subsidy, and receive more in FCI subsidies than they do through the formal subsidy system: for example, Punjab gets Rs 814 per capita through the FCI subsidy, but only Rs 63 6 per capita through the formal system. 4.22 The informal transfers vitiate the modest progressivity of the formal transfer system. On average, India's transfer system for all its complexity, approximates a system in which transfers are made to states on a per capita basis. That is to say, there is no correlation between transfers and income per capita. This can be seen from Figure 4.7 wherein the trend line plotting total per capita total revenues (i.e. after transfers, including FCI transfers) is parallel to the trend line plotting per capita own revenues (i.e. before all transfers). Thus, on average, all states gain the same amount per capita from the transfer system. 45 India's system of central transfers has several core strengths but also weaknesses. 4.23 India's transfer system has the virtue of stability. It is quite remarkable that the core Finance Commission recommendations which concern the sharing of some 3% of GDP are accepted automatically by the political system: this fact provides basic stability to federal finances as well as a degree of fiscal security to states. The constitutional change, effected in 2000, in the basis of FC transfers from individual central taxes to all taxes is also a welcome development. Another positive development over the nineties is the elimination of the practice of subsidized lending to states, which used to provide large transfers to generally better-off states (Rao, 1997). However, the Indian system of transfers also suffers from a number of related weaknesses, which have been pointed out by a large number of analysts (for recent reviews, see Rao and Singh, 2003; Bagchi and Chakabrobarty, 2003; Srivastava, 2003). Box 4.4 summarizes the extensive empirical research done into India's federal fiscal architecture. o High degree of vertical imbalance. Some amount of vertical imbalance is inevitable since it often makes sense to collect taxes nationally, but spend them in a decentralized way. However, large transfers from higher to lower levels of government weaken accountability to the taxpayers, as they weaken the connection between marginal expenditure and taxation decisions by each level of government. Econometric evidence (summarized in Box 4.4) suggests that this is not just a theoretical problem, but a practical one in India, which reduces tax effort and possibly leads to higher deficits. o Declining volume of grants. At the same time, the solution to India's vertical imbalance is not to reduce central transfers without increasing the taxing powers of the states, which is what has been observed in India over the nineties. While some of the decline in special-purpose grants may be only due to a change in fund-flow mechanisms (see para 4.9), in fact all sources of transfers show a decline. This trend has exposed the states to increased fiscal stress and constrained the growth of expenditure in productive areas. o Only partial elimination of horizontal imbalance. While central government transfers are progressive, they fall far short of achieving horizontal equalization. We have seen that once FCI transfers are taken, all states receive roughly equal per capita transfers, regardless of income. It should be noted here that, 44 Saxena (2003) reports that "In January 2002 the author found that farmers in east UP were getting only Rs 330 to 350 per quintal for paddy whereas Punjab farmers were getting 540 for the same crop." 45 Revenue from tax exports are included in own-revenue numbers. However, these figures do not show the sources of such taxes. Rao and Singh (2003) estimate that Uttar Pradesh losses 0.8% of its revenue in taxes paid to other states. 64 unlike some federal constitutions, the Indian constitution does not mandate equalization, and that there are other federations which also show only partial equalization (Box 4.1). 46 Given the vast disparities within India, it is unlikely that a per capita distribution of transfers is optimal. Indeed, however there are strong efficiency and equity reasons for a more progressive distribution of resources, though any shift to provide more resources to the poorer states would admittedly have to grapple with issues of incentives and varying performance, given that the poorer states are also in general the poorer performing. o Weak incentives for reform and good performance. The practice of Finance Commission to award additional grants to states with large projected revenue deficits (para 4.9) sends out a wrong signal in this regard, even though the amounts involved are small, and a large part of the projections are normative, rather than based on state-provided actual data. There are few explicit rewards for reform or good performance, though, as mentioned, the last few years has seen a growth in reform-based funds. There is also econometric evidence that block transfers are determined in part by factors other than need and merit, in particular political affiliation (Box 4.1 ). o Linking of loans and grants. The practice of transferring resources as a mixed loan-grant package has the problem that it mixes together funding sources, which should be treated in very different ways. While grants can be provided on the basis of need and priority, borrowing has to be provided on the basis of affordability. Mixing them together blurs this fundamental distinction, which in turn contributes to the mentality that leads states to borrow on the basis, not of affordability, but availability. o Proliferation of centrally sponsored schemes. Specific purpose grants to finance specific programs are justified to the extent there are externalities and high priority national goals. However, in India there are now almost 200 such schemes. 47 Transfers impose restrictions on the use of funds, thereby possibly undermining efficient allocation choices. o Complexity and discretion: There is no one agency in charge of transfers from Gal to the states. The Finance Commission, Planning Commission, and Finance Department are all key players, but each has responsibility for particular areas, and neither can control the behaviour of the others, and thus plan for reform of the transfer system in an integrated way. 48 o Hidden transfers India's hidden federal fiscal transfers are not only, by definition, non-transparent, but large and regressive. 46 The Brazil comparison is particularly interesting. World Bank (2002a) shows that the standard deviation of income per capita of the states 50% of the mean and the same figure for state revenues is 36%, i.e. a reduction of28%. The same figures :fiJr the 14 major states oflndia are 35% and 28%, a reduction of20%. 47 According to the Expenditure Budget of the Government oflndia, 2004-05, there are 178 specific purpose grant programs administered by over 30 line ministries/departments. 48 As it was recently put in an Economic and Political Weekly editorial (Feb. 21, 2004): "Recourse to the multiplicity of channels has precluded the evolution of a rational system of intergovernmental transfers that could redress the twin imbalances - vertical and horizontal- that all federations face." 65 Box 4. 4: Econometric Studies of the Determinants and Impact oflndia's Fiscal Federal Transfers. Determinants of grants and loans. There is an extensive literature which tries to link the grants received by a state to its political affiliation with the central government. Results vary from author to author but generally find some degree of political influence on at least some categories of grants, especially the more discretionary ones (see Rao and Singh, 2003 for a survey of the various studies). Khemani (2002)looks at the political determinants of loans (deficits) to states. She finds that a state which is politically affiliated with the central government gets a deficit which is 10% higher, with the additional deficit of politically affiliated states is financed almost entirely by additional loans from the central government. Results from other countries also often find political determinants underlying transfers, especially discretionary ones. Impact of transfers on deficits It is generally believed that "transfer-dependent governments face weak incentives to be fiscally reliable." (Rodden, Eskeland, and Litvak, 2003, p. 14). However, the evidence is mixed for India. Purfield (2004) indeed finds that the higher a state's dependence on central transfers, and the higher its reliance on central government for loans (relative to other funding sources), the higher its deficit. However, Khemani (2003) finds no evidence for the view that the design of intergovernment transfers lead state governments to run higher deficits. In fact, she finds a small, negative effect of transfer-dependence on state deficits. Impact of transfers on tax effort. There is a large literature on the impact of transfers on tax effort in India, surveyed in Naganathan and Sivagnanam (1999) (see also Jha eta! (1999)and Coondoo (1999). The general finding is that higher grants by central government reduces tax effort. Research carried out for this report (by Arindham Dasgupta ) also finds that dependence on central transfers reduces tax collection efficiency. Findings from other countries are similar. For example, a recent study (Baretti, Huber and Lichtblau, 2002) found that the very strong commitment to equalize state revenues in Germany produced high "marginal tax rates" on states' tax efforts, and therefore tended to discourage state tax effort. Use of a normative system (e.g. basing transfers on estimated tax capacity rather than actual tax collections) will minimize such distortions, but not necessarily remove them (even without any tax on tax effort, higher transfers may produce an income effect which reduces tax effort). At the same time, 90% of variation in p.c. own revenue among India's states can be explained by GSDP per capita, suggesting that the main determinant of tax performance is level of economic development (Figure 4.7). India's system of revenue transfers is complex, and there are various reform options. But it seems clear that grants and loans should be delinked, and informal transfers ended. 4.24 Reform options. As already noted, India's system of revenue transfers is complex, with multiple issues and stakeholders, and is more amenable to a discussion in terms of options rather than clear-cut prescriptions. But from the summary diagnosis above, three recommendations are straightforward. First, loans and grants should be delinked so that they can be allocated using different criteria. Under such a scenario, either block grants would be done away with (and merged into one of the other two categories of transfers) or they would continue as a funding source for state plans, but allocated separately from loans, in line with our discussion of the borrowing regime in the previous section. Second, hidden or informal transfers should be done away with. As discussed in Chapter 3, the Central Sales Tax needs to be phased out, while procurement of farm produce, though beyond the scope of this report, clearly needs a major overhaul (World Bank, 2004). Third, grants related, albeit only partially, to actual deficit levels (the "gap-filling grants" of the FC) give incentives to poor fiscal performance and should be discontinued. These three recommendations would find widespread support, but beyond that it becomes controversial. The three much more difficult questions being asked about fiscal federalism in India are: (i) should vertical imbalance be reduced?; (ii) should horizontal imbalance be reduced?; and (iii) should grants be made conditional to provide positive incentives for good performance? 4.25 The international fiscal federalism literature has fairly clear answers to these questions. It is argued that vertical imbalance should be reduced to promote state-level accountability, that horizontal imbalance should be reduced both for equity and national efficiency reasons, and that conditional grants should be used to increase spending in particular areas where there are cross-state externalities or where national and state priorities diverge. These questions are more difficult to answer in India for three reasons. First, because own-revenue is an increasing function of per capita income, reducing vertical imbalance (by increasing the state's tax base) disproportionately benefits the better-off states, thus increasing horizontal imbalance. Second, because state government performance is viewed as low, there is a view that conditions should be tied to grants to induce 66 better performance; and because the performance of poor governments is seen as particularly poor, there is a reluctance to make the distribution of transfers more equitable by giving more to poorly-performing poor governments, especially if the grants are not conditional. Third, the Constitution gives no clear guidance on how to distribute central transfers, and judgments vary on how much Finance Commissions are meant to give back to each state the central taxes collected in them, and how much they are meant to redistribute such taxes on normative lines. 4.26 To illustrate the controversy, compare the position of Bagchi and Chakraborty (2003) that "in the last analysis, the task of fiscal transfers is to provide a level playing field", and that transfers should be primarily equalizing, with conditionalities kept to a minimum, with that of God bole (200 1), who contends that FC transfers already give more weight to equity than is justified by good policy or Indian's Constitution, and that "the golden rule must be not to release any funds unconditionally". Others take an intermediate position that equalizing grants are entitlements of the states, and should not be subject to conditions, but that other forms of "central assistance to states should be linked to specific action to be taken by the states to overcome the particular constraints that hold back their performance" (Ahluwalia, 2000). 4.27 Given this controversy, and underlying it the difficult issues outlined above, it would be over-optimistic to expect an easy resolution. In the paragraphs which follow, we simply present some analysis, options and suggestions for reform of the grant system which we hope is useful. Authority to tax services and an increase in the professions tax rate would help increase the tax/GDP ratio and reduce vertical imbalance. 4.28 Reduction of vertical imbalance would require increasing the taxing capacity of the states. Given the need to increase India's tax/GDP ratio, it makes more sense to think of new taxes for the states rather than ones that are already being taxed by the centre. Included in this category are the suggestions made earlier that states be allowed to tax services (moves to this end are already underway), and collect a much higher amount through the professions tax (see Chapter 3.11). Better off states would benefit more from these reforms, so any such reforms would add to the weight of arguments for improving the equity of the distribution of central transfers. 4.29 Even with these reforms, the central government and Finance Commission will need to decide what further measures are required to reverse the long-term decline in central transfers to the states (a shift which would most benefit the poorer states). The most likely way this will happen is through an increase in the central tax/GDP ratio, which is the aim of current central government tax reform efforts. Improvements in horizontal equity will be incremental. Adoption of the Representative Tax System would be a positive step forward. 4.30 How much equalization across states India should Figure 4.8: Actual vs. equalizing transfers for India's states pursue is a matter on which, as we have noted, opinions differ. 3000 One extreme equalizing objective, which is useful as a 2500 Equalizing transfers benchmark, is revenue equalization at the level of the 2000 state with the highest per capita -~ g. own-revenue. In this very equal u 1500 ~ world, the "richest" state would 0. • Ul not actUlally transfer revenue to ~ 1000 other states (there are no mechanisms for this in India), 500 but would not receive any central transfers either. How far 0 central formal transfers are from 0 5000 10000 15000 20000 25000 30000 achieving this goal is shown by GSDP per capita (Rs) 67 Figure 4.8, which plots actual transfers against equalizing transfers. It shows that the current system of transfers is far from equalizing both because the progressivity of existing transfers is too modest, and because they are simply too small relative to the size of own-revenues. Equalizing transfers decline much more sharply as income rises than actual transfers, and on average they are much larger than actual transfers: 30% larger in fact. 49 Moving to such a system would both disadvantage the better-off states by reducing their grants, and the central government by increasing the overall share of central taxes devolved to the states. It is also possible that more resources to the poorer states would weaken the incentives of these states to "reform and perform". 4.31 While full equalization can be ruled out as a feasible objective, there are certainly ways through which the current system can be made more progressive, and the equalization objectives of the system made more explicit. For example, the Finance Commission could dedicate some part of its transfers to a revenue capacity equalization objective, which is more modest than the benchmark considered above. The Representative Tax System, first introduced by Canada and now used by a number of other countries, including Russia (see Box 4.5), guarantees states a minimum of the average revenue capacity enjoyed by other states. This is an affordable goal (rough calculations suggest it might cost up to 50% of FC transfers), and one which would improve progressivity (the poorer states would get a larger FC allocation), without fully equalizing (the revenue of the richest states is almost twice that of the average). Nor would it directly weaken incentives for tax mobilization: since transfers would be made relative to the calculated revenue capacity of the state, not its actual performance, there would be no direct incentive to weaken tax effort. Box 4.5: RTS Approach to Fiscal Equalization A Representative Tax System measures the fiscal capacity of a state by the revenue that could be raised if the government employed all of the standard sources of tax and non-tax revenues, at the national average intensity. To estimate equalization entitlements using the representative tax system, information on the tax bases and tax revenues for each state is required. Fiscal capacity of the poorer states is brought up to the median, arithmetic mean, or other norm. Using the arithmetic mean of all states as a standard, the equalization entitlement of a state for a revenue source is determined by the formula: E~ = (PQP)x[(PCTB)~a X f~a]- [(PCTB)~ X f~a] where E 1 is equalization entitlement of state x from revenue source i, POP is population, PCTB 1 is per capita tax base of revenue source i, l is national average tax rate of revenue source i, subscript na is national average, and subscript x is state x. The equalization entitlement for a state from a particular revenue source can be negative, positive, or zero. The total of these values indicates whether a state receives a positive or a negative entitlement from the inter-state revenue sharing pool. For a federal program, as in India, negative entitlements are ignored and the federal government compensates the states with fiscal deficiencies. (In Canada 8 out of 13 provinces receive transfers under the RTS). The RTS approach has long been used by mature federations such as Canada, and has recently been adopted by the Russian Federation. The application of the RTS to fiscal equalization in India is a doable task as data on tax bases and tax collections of states for most major taxes are available in published or unpublished form. The RTS does not impose new data requirements and can be readily implemented for a federal program. Of course, for some unusual revenue source such as lottery revenues, a determination has to be made whether or not such revenues form part of the standard basket for Indian states - if they do, then a decision on a proxy base to be used will have to be made. For the sales tax, the largest single source of the states' own revenues, there is a problem posed by the difficulty to separate tax base from the degree of compliance. Regression techniques could be used to overcome such problems. Alternatively, given that 90% of own-revenue for the major states is explained by income per capita, simple proxies for taxable capacity can be used. A more ambitious and complex alternative to the RTS is to equalize expenditure (rather than revenue) capacity, again at some average level. This is attempted in Australia, and takes into account both differences in tax capacity and in service- delivery expenses. However, data requirements are considerably more demanding, and, some argue, the rationale less obvious. Source: Shah (1004); Spahn and Shah (1995). 49 This exercise assumes that all central transfers are used to equalize. Alternatively, and more realistically, if only FC transfers were used to pursue horizontal equalization, it would only allow equalization up to the own revenue per capita level Rs 2000 (rather than Rs 2600 - the highest p.c. own revenue among the states, that of Maharashtra), and the seven richest states (which currently get 30% of the FC transfers) would not receive any transfers from the FC; in the unconstrained case only Maharashtra wouldn't receive transfers. Bagchi and Chakraborti (2003) have a similar finding that transfers "meant to bring up the level of revenue expenditures in all states to at least that of middle-income states" would require an increase in central tax devolutions from 27% to 44% of the central tax revenue. 68 There are various ways to improve incentives for performance, the most important being rationalization of the existing range of special-purpose and untied plan grants. 4.32 One far-reaching step would be to reform the Goi system of untied plan grants and special purpose grants, which largely supply additional funding for developmental particular purposes. International best practice (summarized in Box 4.6) suggests replacing the large number of specific-purpose grants currently in existence with a small number of non-discretionary grants that are designed to help the state achieve certain national minimum standards in service delivery (such as universal enrollment). Such grants, as deployed in other countries, are conditional in the sense that, once they have received the grants, the states are required to achieve the standards set, but the expenses are not necessarily tied to particular expenditures, or even to the sector. Such an approach would contribute to changing the incentive structure from one that only encourages more spending to one that encourages paying attention to broad output targets, and thus, it is hoped, improve performance. In India, attention would have to be given to data limitations, weak financial management systems, and the vast disparities in service levels across states, but the idea should be to have a minimum number of grants and conditions, and to link the two to outputs as much as possible. These grants could also be made more progressive, conditional on performance, than they are now. That is, the amounts available to the poor states could be increased, with access still dependent on performance. Box 4.6 : Design of Conditional Grants: international experience Evidence from the history of transfer programs in the US and Canada over the last three decades indicates a shift from narrowly-defined matching grants toward greater use of lump-sum conditional grants, also called block grants. In Canada, federal transfers for health were converted from a shared cost program into a block grant program in 1977, in order to contain costs, allow the provinces almost complete flexibility in allocating resources within health, and to respect provincial constitutional jurisdiction within these areas. Conditional transfers to set national minimum standards can be used to encourage the attainment of economic union or a common internal market . Such transfers that impose conditions on attainment of service standards, and broader access to these services especially by the poor and disadvantaged, can foster national efficiency and equity objectives without undermining state and local autonomy. Canada, USA and Indonesia used these transfers to create a national network of highways and link roads. Canada, Brazil, Chile and Colombia have used these transfers to widen the access of health (Canada and Brazil) and education (Canada, Chile and Colombia). The Canadian health transfer program represents an example of a simple (per capita) program with conditions on standards and access of health care but no condition on the use of funds. Sources: Boadway and Wildason (1984) 4.33 As discussed earlier, there are now also special-purpose grants which impose no limits on the use of funds, but which provide funds conditional on reforms. Some analysts consider them too intrusive, but if it is accepted that Go I already has a decisive influence on the states, and that the large degree of vertical imbalance creates incentives for poor fiscal performance, and in particular makes it difficult for the central government to credibly commit not to bail out states in distress, then the need to provide positive incentives in key reform areas also seems acceptable, especially when they have a direct fiscal impact. This would call for a reforming rather than jettisoning of these schemes: some suggestions are provided in Box 4. 7 using the Fiscal Reforms Facility as an example. 69 Box 4, 7: Fiscal Reform Facility (FRF) The Eleventh Finance Commission was provided additional terms of reference to "draw a monitorable fiscal reforms programme" and link part of the Commision's grants to progress under this programme. The result was the Fiscal Reforms Facility, a fund of Rs 10,600 crore, available to all the states over a five period conditional on achieving an average 5-percentage-point per year reduction in the ratio of revenue (current account) deficit to revenue receipts. The Twelfth Finance Commission has been asked to review the FRF and "suggest measures for effective achievement of its objectives." The FRF has been controversial from its inception, with one member of the Eleventh Finance Commission submitting a dissenting note on the creation of the Fund. It has been argued that the imposition of conditionality violates "the basic rationale of transfers meant to bridge vertical and horizontal imbalances in a federal system", and that the central government should rather focus its energies on hardening the budget constraints, which states face (Anand, Bagchi and Sen, 2003). It has also been noted that the proliferation of a number of small reform incentive schemes will have little impact on state performance (Rao, 2004). There is not much international experience with FRF-type instruments. Russia has a Regional Fiscal Reform Fund, created in 2001, an incentive-based transfer mechanism which funds states conditional on their success in implementation of two-phase reforms of regional public finance. Targets include a mix of process and outcome indicators. The Russian Fund is rather small (about 10% the size of the FRF). Nevertheless, a June 2003 World Bank update concludes that it "has proven to provide sufficient incentives for regions to prepare and implement high quality reform programs." Australia also had a similar incentive scheme, but for structural rather than fiscal reforms. That program was considered a success, at least in its early years (Allen, 2003). There is of course a lot of international experience with adjustment lending (SALs) which also attempts to improve policies through the provision of additional funding. The experience with SALs is mixed, and its interpretation controversial. A World Bank (1992) review found that adjustment lending was associated with fiscal deficit reduction, and increases in revenue, but that general spending cuts were often at the expense of "critically important O&M" and too much spending on salary relative to non-salary inputs. A more recent analysis (Gupta, Pivovarsky and Tiongson, 2003) found a mixed impact ofSALs on domestic revenue mobilization. Judged by its own objectives, the FRF cannot be considered a success: if all states were to qualify for the FRF incentive funds, the revenue deficit of the states would be eliminated by the end of 2004-05. Clearly that is not going to happen. In fact, with interest burden rising, the revenue deficit is relatively unchanged as a percentage of GDP. However, one has to bear in mind that the FRF is a very small fund (about 0.5% of GDP spread over all states and 5 years), and one needs to judge its success by more modest yardsticks. It has clearly been useful in catalyzing states to prepare medium-term fiscal frameworks. These in turn have, for the first time, provided the central and state governments with a basis on which to discuss state-level fiscal performance in an integrated manner, rather than through the limited lens of state-plan discussions. The single-monitorable indicator approach of the FRF, while no doubt arbitrary, has the advantage of simplicity, and keeping discretion to a minimum, although it has not always been clear if the indicator is defined the same way over time and states, in particular, whether off-budget liabilities are being consistently treated. Assuming it is decided to continue with an FRF-type facility, there are some issues which clearly need to be addressed. The first is whether a "single monitorable indicator" approach should be retained, or whether a multiple- indicator approach, as originally recommended by the Eleventh Finance Commission, should be reverted to. Consideration also needs to be given as to what that indicator(s) should be, and whether it should include interest payments and central grants, which are, to a large extent, beyond the state's control at any given point oftime. The adjustment path also needs to be fitted to the initial conditions of each state. Requiring the same degree of fiscal correction from each state, as the first FRF does, results in targets that are unrealistic for some and inadequate for others. One option would be to make the FRF award contingent on adherence to the state passing and adhering to a Fiscal Responsibility Act. This would provide flexibility across states, while still promoting objectivity, and would give state-level FRAs more prominence and importance. It would be desirable if the various FRF documents were publicly available. Especially given the concerns that different definitions have been used in different states, opening up the various MOUs to the state would encourage public scrutiny and consistency across states and over time. More generally, reporting requirements need to be strengthened, and more attention given to deficit-reduction through accumulation of arrears. Since the late nineties, various multilaterals and bilaterals have provided adjustment-lending to the states (through the central government) to support state reforms, including, but not limited to, fiscal reforms. Although the SALs began before the FRF, adherence to FRF targets has now become a sine qua non for access to them. While the track-record of SALs in India is also mixed, recent analysis by the World Bank (2004) does suggest successful fiscal adjustment in Bank SAL-receiving states. One option moving forward would be to have the external funding agencies fund the FRF (Mark II) itself, as well as, or in place of, the funding of individual states. 70 4.34 So far we have focused on strengthening incentives in Gol grants, which are outside of the FC's jurisdiction, but there is still the issue of what to do with FC transfers: even ifFC switches to the RTS system, as we have suggested, this may not exhaust all FC funds, as there would be too many big losers. The FC would face the following options for the remainder of it funds: o First, given that the RTS would address equalization of revenue capacity, the remainder of the FC award could be distributed on an equal per-capita basis and/or to address cost disadvantages and special expenditure needs; o Second, it would also be possible for the FC to establish its own special-purpose grants. It does already allocate small special-purpose grants, and the first of the Gol reform-based funds, the Fiscal Reforms Facility, was in fact created at the recommendation of the Eleventh Finance Commission (see Box 4.7). As recommended by some, the FC could, create large funds available to all (or only poor) states to enable them to meet minimum service-delivery standards (Bagchi and Chakraborty, 2003). The main risk to avoid here is complexity overload since one would face the prospect of a double set of (FC and Gol) special-purpose grants. The FRF -- designed by the FC and implemented by Go I -- provides a good example of coordination between the two central entities. Similarly, in the urban sector, where FC also has a mandate of supporting local governments, rather than developing its own incentive fund, it would make more sense for the FC to support - with any necessary recommendations for improvement - the recently created Gol reform- incentive urban funds, namely the City Challenge Fund and Urban Reform Incentive Fund (WSP, 2004); and o Third, FC could continue with the approach of incorporating both performance and need in allocating resources beyond the RTS 50 . Since need and performance are the two factors which people trade-off when they make judgments about the inter-state distribution of resources, a weighting system which combines both, and makes the trade-offs explicit, has some merit. However, the disadvantage of such an approach is that it may be difficult to understand and accept by the states, compared with an approach that uses different instruments to address different policy objectives. IV Conclusion The central government has a vital role to play, particularly in setting "the rules of the game" so that they provide appropriate assistance to poorer states, and incentives to better performance. 4.35 The state-level fiscal crisis cannot be solved by the states alone. While India's federal fiscal system shows many strengths, prime among them stability, the fiscal crisis has also brought to light a number of weaknesses. The regime of revenue transfers is not progressive enough, and contains few incentives for good performance. India's borrowing regime is on the one hand too strict where more flexibility could be allowed (the detailed rules governing access to different borrowing sources could be relaxed) and on the other not strict enough where control is needed (over the total borrowing a state undertakes). Credit markets play a very small role in the allocation and pricing of loans, and all states face the same interest rate for borrowing. Thus, with no penalties for profligate behaviour, states can borrow now, and worry later. Both the grant and the loan regimes are complex, and have significant amounts of discretion built in to them. Finally, grants and loans are linked together, preventing these two types of transfers from being given the very different treatment they require. 50 Similar to concessional aid that is distributed by the International Development Association using a formula which weights both need (poverty) and performance (as measured by a country policy and institutional rating. 71 The nineties have seen a "scissors movement" whereby state governm1ents have received fewer grants but more loans. 4.36 The nature of India's fiscal federal transfers has changed greatly in Figure 4.9: Resources other than own - revenue used by states to finaillce expenditure the nineties. Since 1998/99, borrowed 6% resources now supplement a state's own revenues to a greater extent than 0. c 4% central government revenue transfers t!l do (Figure 4.9) . In general, central 3% grants to the states need to recover their lost ground, while borrowing 1% needs to be reduced to sustainable levels. This is particularly true for the poorer states, which are highly dependent on both loans and revenue -Borrowed Funds -Transferred Funds (from Go!) transfers to supplement their own meager resources. Revenue transfers need to be made more progressive, while loans less so. From the perspective of fiscal sustainability, no reform is more important than the centre introducing global caps on aggregate borrowing. 4.3 7 Such a reform, which the centre is entitled to introduce under the constitution, will not only force fiscal deficits down, but will put an end to lobbying for loans, and significantly harden the budget constraint. It will do more to promote prudent performance than any number of special schemes directed to this end. Consistent with the autonomous approach to fiscal responsibility adopted to date, such caps could be based on the states' own fiscal responsibility laws. For efficiency reasons, and to force governments to face the costs of fiscally imprudent behavior, not in the future but today, states need to be given more flexibility in who they borrow from. Rather than having six different borrowing sources, with their own rules, as at present, states should predominantly receive debt financing through the market, at a market-determined interest-rate which reflects their creditworthiness. 4.38 Debt-restructuring along commercial principles is in line with allowing states more flexibility under a global cap. Performance-based debt-relief will also help poor, highly-indebted states, but has the risk of, however well-designed, undermining hard-budget constraints: more progressive grants, and ones which reward fiscal reformers may be a better alternative. The grant regime is institutionally more complex than the borrowing regime, and reforms, while needed, are likely to be incremental. 4.39 Any recommendations concerning the system of grants must face difficult issues concerning trade-offs between the needs of poorer states for more funds, and doubts concerning their ability to effectively use them. However, some suggestions can be made. If for no other reason than to help increase the national tax/GDP ratio, the tax base of the states should be expanded, and, since this will take time, and especially if borrowing is to be reduced, the declining trend of central grants as a percentage of GDP needs to be reversed. The FC could consider introducing an explicit equalization objective to provide a floor for states; distribution of the remainder of FC funds, as now, on the basis of a formula, which reflects both need, and past performance seems appropriate. To further strengthen incentives for performance, and help poor states achieve national minimum standards, conditions on special-purpose grants should be used, but the number of such grants needs to be reduced and their distribution, while still subject to good performance, made more progressive; any special- purpose FC grants should be merged with Go I grants to avoid duplication - the FRF is a good example of this. Block grants themselves should either be discontinued (and merged with FC and special-purpose grants), or, if 72 continued, should be de-linked from loans so that each can be provided the different treatment it deserves. Informal transfers (such as associated with food procurement and tax exportation) should be phased out. There are some key institutional reforms, which would help with strengthening India's fiscal federalism. 4.40 The difficulty with implementing such sweeping changes is that different central actors determine different components of the central fiscal framework. Rationalization of the system requires a road map covering all three formal channels of grants from the center to the states, as well as the six channels of loans. Co-ordination among the various actors involved will be critical so that win-win elements of the possible reforms can be brought about: for example, for the poorer states, fewer loans but more grants; for all states, tighter control over total borrowing, but more flexibility to manage borrowing within that global cap. Reforms to the borrowing regime may be simpler since the main central player involved is the Go I Ministry of Finance, but reforms to the transfer system are likely to be at best incremental. There are three institutional reforms which would help coordination among the main players with respect to both grants and loans: o The first would be if the Finance Commission was made a permanent body, as it is in Australia, for example. o The second would be if the responsibility for compiling timely state-level fiscal data were entrusted to a single agency, such as the RBI, the Planning Commission or a permanent Finance Commission. The challenge is not just to improve the timeliness and accuracy of existing data reporting (though the current situation is far from satisfactory in this regard) but also to provide credible reporting of state fiscal performance against targets, such as in the Fiscal Reform Facility or in the state's own Fiscal Responsibility Act (Hausmann and Purfield, 2004, Bagchi, Sen et al.,2003). o The third suggested institutional reform is an overhaul of the role of the Planning Commission as Box 4.8 discusses. The one fiscal indicator state chief ministers are most familiar with is the size of the plan, and the target they have most internalized is to maximize the size of the plan, regardless of whether it is funded by over-optimistic revenue targets or unaffordable borrowing levels. The elimination of the distinction between 'non-plan' and 'plan' expenditures is long overdue, not only because the distinction lacks economic rationale, and complicates budgeting and accounting but because it would remove this incentive to fiscal imprudence. Multi-year plans, if needed, should encompass the entirety of resources available for development in the state, not just a segment artificially referred to as the "State Plan". The Planning Commission could then function much more as an overall strategy, monitoring, evaluation and reporting agency with respect to both fiscal and development outcomes. 73 Box 4.8: Problems in the financing of the State Plan The approach to, and mechanism of, financing the public sector 'plan' of each state, continues to encourage, or fails to discourage, fiscal profligacy on the part of the states. Since (a) the size ofthe 'State Plan' is finalized after the annual budget is presented, (b) the Planning Commission guarantees a floor and does not impose a ceiling on every state's annual borrowing, and (c) the size of the Plan is the politically most salient and visible fiscal indicator at the state level, the system generates incentives for states to: o engage in over-estimation of resources in the annual budget, in support of their lobbying with the Planning Commission for larger and larger size oftheir annual plan; and o seek additional borrowing to make up for actual revenue shortfall during the year, with support from the Planning Commission in the name of meeting annual targets implicit in the Five-Year Plan. The problem with this approach and mechanism has been understood for some time. A recent, very clear exposition of the problem, from a state government perspective, is provided by the Interim Memorandum submitted to the Twelfth Finance Commission by the Government of Jammu & Kashmir. This argues that, "There is an urgent need to change the modality and mechanics ofplanning since the main culprit of the fiscal crisis in the states is the Plan. The problem is that in the post fiscal reform period, the approach to financing the state plans hasn't undergone a change. All of it continues to be what it was earlier, even though the entire fiscal regime has undergone fundamental changes. The result is that it is impossible for the states to finance their plans in a manner that doesn't add to their fiscal woes . .. " ... the resource position of the states is so poor that they cannot even finance the same plan size as last year. Yet they are committed to a plan size that can't be lower than last year given that they have to meet the Tenth Five-Year Plan targets in terms of investments. Add to this the fact that no state government/political party wants a smaller plan; a bigger plan even ifpartially un-funded is preferred to a fully funded smaller plan. " ... while finalizing any state plan, the Planning Commission matches the overall plan outlay, i.e., revenue and capital outlay combined with the overall resources available for the plan ... resources on the revenue account are not separately matched with the revenue component of the plan. Therefore, a diversion of borrowed funds is built into the plan ... In the current context, it may be better for the Planning Commission not to determine the size ofplan but focus only on the central assistance to state plans ... states will then have no way out but to go for smaller plans which are fully funded and the diversion from capital to revenue will also get reduced." There is clearly an urgent need to better align the role of planning with the current macroeconomic and fiscal framework, focused on development outcomes, which are a function not merely of the size of one component of state expenditure called the 'State Plan', but of all components of public expenditure, their quantity as well as quality, and impact on the private sector. Some attempts have been made at reform, such as through the introduction of a "core plan". And now State Plans are meant to be consistent with deficit targets agreed under the Fiscal Reform Facility. But the Plan continues to put upward pressure on the deficit, and to present states with conflicting signals concerning desirable borrowing. More radical reforms are needed. De- linking of loans and grants, and cessation ofthe practice of providing Planning Commission approval for a "plan size" for each state, are options to be considered. The bolder option is to redefine the role of the Planning Commission altogether, and eliminate the distinction between 'plan' and 'non-plan' expenditure in government budgets and accounts, retaining only the distinction between recurring and capital accounts. External funding agencies are also participants in India's fiscal federalism, and we conclude with some implications of the above analysis for donors, and how government might treat them. 4.41 Donors contribute a mix of grants, concessional and commercial loans, and they pass their funds through the central government. They have been well accommodated into the current system, but it is unclear how they would operate in a reformed borrowing regime. Donors have also been accused of concentrating their efforts in the better off states and indeed the correlation between per capita income and external assistance is 74 positive (Srivastav, 2001). Donors of course are passive players in India's fiscal federal system: they do not set the rules of the game. But how might they fit in a reformed system? o For donor funds flowing to the states, it would indeed be useful if grants, concessional loans and commercial loans were distinguished between one another, rather than transferred on the same terms, as they are today (on the same terms as plan loans, i.e. for most states a 70% loan, and 30% grant, with an effective interest rate of just under 5% ). Alternatively, if the government wants to pass on all aid on the same terms, setting a concessional interest rate for all of it would be consistent with de-linking grants and loans. What the interest rate should be has been a matter of much debate; the latest analysis suggests that current arrangements profit the central government at the expense of the states, though this has varied over time (Srivastav, 2001). Whatever approach is used, it would be advisable to make it automatic and transparent. One approach would be to simply operate on an expected non-profit no-loss basis, passing on to states at the same terms as faced by the center. Another would be to set an interest rate somewhat below that of the market to give states incentives to go for external financing over market borrowing despite the reform conditions imposed by donors. o As to where donors should concentrate their financing, this depends whether the role of external financing is seen to be promoting horizontal equalization, or rewarding good performance and piloting new initiatives. These two forces will pull in opposite directions, making an easy answer to this question impossible to give, though of course donors should make every effort to promote good performance in poorer states. o We have commented on the complexity of India's federal fiscal landscape, including on the issue of providing incentives for fiscally responsible behavior. This would suggest closer coordination between donor and government initiatives. Already, access to SALs has been made conditional on satisfactory performance under the FRF. It would be possible to go further by, for example, a merging of the donors' adjustment lending efforts with the Fiscal Reforms Facility of the central government. (Similar efforts are now underway by donors in relation to the Goi urban reform incentive fund, URIF.) Donors' grants could top up the FRF; while donor loans could be provided to finance debt restructuring for FRF- qualifying states. o Finally, we have recommended that the central government stop playing the role of creditor to state governments. In such a scenario, what to do with official financing, since state governments are constitutionally forbidden from borrowing off-shore? As we suggested earlier, either an exception to this rule would have to be given for external financing, or a special purpose vehicle could be set up to intermediate between external financiers and state governments. 75 CHAPTERS CONCLUSIONS AND PROSPECTS I Introduction 5.1 Five years on from the onset of the fiscal crisis, many states have embarked on the reform path, but none have yet recovered. It is an open question as to whether states will continue to embrace reforms, or will tire of difficult, perhaps politically-unpopular prescriptions and look for easier solutions. All the states are home to large numbers of educated unemployed, and face enormous pressure to re-open the hiring flood-gates. Existing employees are looking for a wage increase. Farmers are increasingly vocal in demanding government support and want more subsidized power. Industry complains of a heavy tax burden. Yet, as the simulations in the next Section II shows, abandoning reforms at this half-way stage is not an option, and the states face no choice but to continue with reforms. Section III summarizes a proposed expenditure-and-revenue reform package applicable for most states, culled from the analysis and suggestions of Chapters 2 and 3. Section IV shows that with such a reform package states can emerge from the crisis, and emerge strengthened. The simulations undertaken also show, however, that care needs to be taken in the choice of fiscal targets, and that the poorer states will require special treatment from Goi, however. Section VI considers various risks to stabilization. Having summarized the reform implications for the state governments in Section III, Section VII then concludes with a discussion of implications for the central government. II A no-reform scenario: what will happen if reforms stop? 5.2 The case for fiscal adjustment is made by showing the consequence of not continuing with adjustment, under a base case no reform scenario. We simulate a halt in reforms by assuming that the combined states' fiscal deficit stabilizes roughly at its current level of 4. 8%. Other assumptions are listed in Box 5 .1. Box 5.1: Key assumptions and methodology underlying the no reform scenario Revenues: No major reforms on the revenue side are implemented. Revenue/GSDP ratio remains constant. Expenditures: The civil service hiring and pay restraint is relaxed over the coming years and a new pay commission is established leading to a one-off increase in the wage and pension bill at the state level in 2006/07; the wage bill increases by 0.5 percentage point and the pension bill increases by 0.2 percentage point. No major reform to reduce the subsidy, or pension bill, both of which gradually increase over time. Macroeconomic assumptions It is assumed that real annual GDP growth is 6.5%, real interest rates are assumed to be 6% and the rate of inflation is forecast at 4.5%. 51 The base year for the projections is 2003/04. In the base year the debt stock is 28.5% of GDP and primary deficit is 1.8% ofGDP. The revenue deficit is 2.6 percent ofGDP and the real growth rate is 8 percent ofGDP. Methodology Debt projections are based on the difference equation for debt. Assuming a constant nominal GDP growth rate g and a nominal interest rate ofr on government debt, the debt to GDP ratio evolves according to the formula l+r dt = dCt-IJ*--+PDt, l+g where dis the government debt to GDP ratio, PD is the ratio of the primary deficit to GDP, r is the real interest rate, g is the real growth rate and the subscript refers to fiscal years. 51 Nominal interest rates for state debt in 2001-02 was calculated as interest spending in that year as a proportion of the average value of debt at the beginning and the end of the period. The figure was 11.5 percent, up from 9 percent a decade ago. Going forward, nominal interest rates of 10.5 percent are estimated taking into account the impact of the debt-swap program. 76 The consequences of a halt in reforms are bad for all states 5.3 The quality and quantity of productive expenditures would fall, and the risk of crisis would steadily build with higher and less sustainable debt levels over the medium term. The states' fiscal finances could easily spiral out of control as a self-propelling spiral of revenue deficits led to larger borrowings entailing higher outgoings on interest payments which would in turn lead to larger deficits. The only cap on the deficit would come from the limited access of the states to borrowing sources. Assuming that the combined states fiscal deficit does not, for this reason, exceed its base-year level of 4.8%, debt levels would nevertheless increase from 28.5% currently to 34.1% by the end of the forecasting period. The composition and quality of spending would deteriorate significantly over the next five years. Committed spending (debt service, wages, pensions and subsidies) would increase from 89% oftotal revenues in 2003/04 (10.5% ofGDP) to 106% oftotal revenues in 2007/08 (12.5% of GDP). Other recurrent spending (excluding subsidies, as well as pensions, interest and salaries) would collapse fall from Rs 0. 73 for every rupee of salary spending toRs 0.32. 5.4 Under a "no reform" scenario, the choice will be thus between more borrowing and less non-salary productive spending: less borrowing will simply result in a crowding out of capital expenditure and O&M expenditure. Most likely, as assumed in this scenario, the forced adjustment will be by a mixture of both more borrowing and less non-salary spending. 5.5 These negative fiscal and developmental outcomes are quite likely if hiring or pay restraint is relaxed, if subsidies are not reduced and if revenue performance does not improve significantly. A particular risk built into the model is the establishment of another pay commission leading to significant real wage increases: this alone would undo much ofthe good work undertaken to date. Table 5.1: Fiscal indicators in the no reform scenario 2003104 2004105 2005106 2006107 2007108 RevenuesiGDP 11.8 11.8 11.8 11.8 11.8 Total Spending 16.6 16.6 16.6 16.6 16.6 Interest IGDP 2.8 3.0 3.2 3.3 3.5 Wage bill I GDP 5.2 5.3 5.4 5.9 5.9 PensionsiGDP 1.5 1.5 1.6 1.8 1.8 Subsidies I GDP 1.2 1.2 1.3 1.3 1.4 Other Recurrent Spending 3.8 3.5 3.0 2.2 1.9 Capital Spending 2.1 2.1 2.1 2.1 2.1 Interest/Revenue 23.7 25.5 27.0 28.3 29.5 Primary deficit 2.0 1.8 1.6 1.5 1.3 Fiscal deficit 4.8 4.8 4.8 4.8 4.8 Revenue deficit 2.7 2.7 2.7 2.7 2.7 Debt stock 28.5 30.2 31.6 32.9 34.1 RDIRR 22.9 22.9 22.9 22.9 22.9 III. A States' Reform Package 5.6. In this section, we briefly summarize the revenue and expenditure reform package which emerges from the analysis in Chapters 2 and 3 of this report and focuses around revenue mobilization, expenditure reprioritization and sustainable fiscal savings in the area of salaries and subsidies. 5. 7. Key revenue reforms are suggested in Table 5.2 below, which also indicates which reforms can be undertaken by the states only (S), which states by the centre (C), and which require joint action (CIS). 77 Table 5.2: Key revenue reform recommendations Area Problem reform Sales tax Distortionary, many • Implement VAT (CIS), possibly on a voluntary rates, narrow base, tax basis with floor rather than harmonized rates. exportation (CST), • Eliminate CST (C/S) reduce evasion and • Remove concessions and improve information corruption across states. (S) • Amend constitution to permit concurrent taxation of services, and start transferring service taxation to states. (C) • Introduction of functional organization, large tax-payer units Professions tax Non-existence m many • Introduce professions tax in all states. (S) states, low ceiling • Amend constitution to raise ceiling and allow further future increases. (C) Stamps and registration High rates lead to low • Lower conveyance rates. (CIS) compliance • Increase rates on substitute transfer transactions (C/S) • Ban physical stamps • Improve procedure for establishing guidance rates. Transport tax Buses overtaxed; private • Raise tax rates on private 2 and 4 wheelers vehicles undertaxed relative to buses (S) Other taxes Minor levies are • Remove entry tax, turnover tax, and surcharges distortionary and non- (S) transparent • Merge entertainment tax, registration fees and luxury tax with VAT on services (S) • Remove concessions Non-tax revenues Significant deterioration • Reform system of mineral royalties and sale of in revenue performance forest produce (CIS) • Improve performance of user charges by close monitoring and more regular adjustments and better collection Cross-cutting Weak accountability • lnter•state coordination needs to be Administrative reforms institutionalized • Improve enforcement technology and procedures coupled with computerisation, staff incentives, management flexibility and effective anti-corruption institutions. 5.8. Modelling the impact of revenue reforms We assume that, if these reforms are implemented, the revenue/GDP ratio will rise. Of course, a fair amount of guess work is involved, but the following are the assumed impacts of the above reforms: o The implementation ofVAT in 2005 raises revenues by 0.2 percentage starting in 2006/07 and a further 0.2 percentage points in 2007/08. o Reducing stamp duty rates on sales and raising rates on substitute transactions, strengthening professions tax, and reforming of motor vehicles tax will increase revenues by an additional 0.2 percentage point of GDP in 2004/05 and a further 0.1 percentage point in 2005/06. o Taxation of services starting in 2006 will increase revenues by 0.2 percentage points starting 2007/08. o Cross-cutting institutional reforms will lead to a 0.1 percentage point increase annually. 78 o Non-tax revenues will increase by 0.1 percentage point in 2005/06 and 2006/07. In aggregate, revenue rises from 11.8% ofGSDP in 2003/04 to 13.3% by 2007/08. 5.9. Modelling impact of expenditure reforms. Projecting the quantitative impact of all of the above expenditure reforms is difficult. The main fiscal rationale from public enterprise reforms, for example, is not, in most cases, to make large, immediate budgetary savings, but to prevent a further unproductive investments being made in the public-sector and future losses accumulating. However, the short-term budgetary impact of some of the key reforms can be modeled, as summarized below: o Hiring and pay restraint leads the wage bill to fall by an additional 0.2 percentage point annually (see 2.15). o As argued in Chapter 2, the pension bill is kept constant as a ratio of GDP over the next 5 years in spite of increased retirement on account of parametric reforms. o The impact of subsidy reforms is difficult to quantify. There are problems both estimating the existing level of subsidies and the likely impact of reforms. For sake of analysis, we estimate explicit subsidies at 1%. We assume very gradual reduction, even under the reform scenario, because of the large amount of power subsidies currently off-budget: in 2001-02, the subsidy was only 20% of the government's subsidy obligation (see Figure 2.1 ). Thus even with a reduction in the subsidy obligation, actual subsidy payments are likely to fall much less. 5.10. Proposed expenditure reforms. The key expenditure reforms from Chapter 2 are summarized below in Table 5.3. Table 5.3: Key expenditure reform recommendations Area Problem Suggested reform Expenditure Restructuring Salaries Salary bill is large and crowding out • Maintain a policy of no real wage increases and no other forms of productive spending net hiring. • Required hiring in priority areas to be offset by downsizing in non-priority areas • No new pay commission Pensions Pension spending is a rapidly mounting • Short-term parametric reforms include: (i) use of liability. Short-run parametric reforms longer averaging periods for the calculation of are needed as well as longer-term benefits: (ii) use of higher discount rate; (iii) structural reforms reduction in leave encashment limits: (iv) reduce scope for commutation. • Shift from the current pay-as-you-go system to a defined contributions scheme. • A crack-down in pension abuse . Subsidies Subsidies are fiscally costly and poorly • Continued sectoral reform (power, irrigation) to targeted. improve commercial discipline, e.g. in the power sector through privatization, more widespread metering, greater enforcement of collection, a crackdown on theft • Selective Tariff increases to reduce cross- subsidies. • Strengthen subsidy management and limiting government's liabilities. Public Limit the fiscal burden of public • Continued privatization and restructuring. enterprise enterprises on the budget and improve • Limit generosity of VRS schemes reforms their nPrtnrm 79 Interest Debt service accounts for a major share • In addition to fiscally responsible behavior, payments of recurrent spending prepayment of high-interest loans where possible to reduce interest rates on outstanding debt. Priorhy non- Have been squeezed by the fiscal crisis • Protect and enhance, subject to fiscal constraints, salary while paying due attention to improving expenditures exp{!J1,~i~ure efficiency: Exp~!lditure quality reforms Agency reforms Poor expenditure quality undermines • Agency reforms including transfer of service Enabling government effectiveness; caused by responsibility to the private sector or local framework low accountability, and weak public government PEM reforms expenditure management. • Promoting cost recovery and commercial discipline, encouraging citizen demand for better services, increasing transparency, cracking down on civil service transfers, and establishing strong and independent anti-corruption commissions. • Budgeting realistically, implementing the budget as passed, enhancing departmental accountability and flexibility in the budget process, tightening budgetary controls over open-ended obligations and capital projects, tightening accounting and audit IV Reform Scenarios: do the reforms add up? Under the reform scenario, states can stabilize their debt, and achieve the fiscal deficit target, but cannot eliminate revenue balance until several years after the Go I target date of 2007/08. 5.11. We run reform scenarios which implement the reform package described in the previous section (otherwise taking the assumptions described in Box 5.1 ). We use the scenarios to test this reform package against three different widely accepted fiscal targets: • Debt-stabilization. In this scenario the goal is to stabilize the debt-GDP-ratio by cutting the primary deficit. • Fiscal deficit stabilization - say at a pre-crisis level of around 3% of GDP. • Revenue deficit elimination. 5.12. We take 2007-08 as the target date for achievement of these targets, since is this the year by which Go I has committed to eliminate its revenue deficit under the central FRA. Several state governments have committed to achieve revenue balance by an earlier data under their respective FRAs. The goal of the Figure 5.1: All state debt-to-GDP ratio under three Fiscal Reforms Facility is to eliminate revenue different fiscal targets balance by 2004-05. 32.0 5.13. The debt path under each of these three reform scenarios is illustrated in Figure 31.0 5.1. As illustrated by this figure, the three 30.0 --+- Debt stabilization fiscal targets ordered in terms of the severity 29.0 Fiscal deficit 3% of the adjustment they require, with the third 28.0 Revenue balance target, i.e. eliminating the revenue deficit, requires the tightest adjustment. 27.0 26.0 5.14. Table 5.4 below illustrates the impact v L{) v L{) 9 - 34 s c. Study for restructuring Kerala Water Authority dropped 25,847 1,740 CFIC-Rural TF022457 2040115 25,847 1,740 1,740 - 1,740 - - 35 IS d. Software prototype for M&E ofRWSS national programme Dec-03 5,762 5,882 CFID-Rural TF022457 2038770 5,762 5,882 - 4,400 4,400 - 1,482 1,482 I-- Dan ida TF052065 ~ - 36 p e. M&E system pilots in 2 States (Tamil Nadu, Uttar Pradesh) Jul-04 123,803 202,009 CFIC-Rural TF022457 2039876 123,803 202,009 1,070 109,955 111,025 39,560 54 51,424 f-- 37 N f. Ja1 Manthan on the RWSS National M&E system Apr-04 26,274 4,300 CFIC-Rural TF022457 2040116 26,274 4,300 - - - - - 4,300 I-- IS 18/SA/IN: 38 IS g. State-level review ofRW programs in 3 states Jun-04 23,005 20,552 CFIC-Rural TF022457 2040117 23,005 20,552 12,475 2 12,477 - - 8,D75 Sustainable I-- rural water .. ~ CFIC-Rural TF022457 2038772 46,535 7,826 7,829 7,829 - (3) ·- --- - --- tdternatfUO~: exhausted/2nd priority: not ~9ropped;_l6 WSP-SA - FY04 PROJECT/PRODUCT FINANCING. BUDGET AND ACTUALS 10 lased to use cldsed Pre-MYR I!' t> Original Revised Variable FY04 Pending 0 Revised Order MYR Staff Cost Actual as ·~, Cl , Budget MYR Costs as Commitm Reposti Balance as PROJECT PM PIN $ . u " e 0. Product Description completi on Date (July/Aug 03) Budget (Jan03) SOF TF# 10# allocation (as of allocation (Jan03) as of 30th April04 of 30th Apr of 30Apr2004 ents as of ngs of 30th . ,.I 04 30 Apr 04 with Apr04 I Dec03) RMA services - Apr '~ 39 LE h. 10 training programs on the use ofPRA technics in RWSS projects Nov03 4\:i,OJO ,tiLt> Dan ida TF052065 ~ I 03 to Jun-05 - (Year l of2) DFIO-Rural 40 IS i. Advisory support to GOI Ongoing TF022457 2038774 14,885 86,232 33,693 11,082 44,775 - 19,534 41,4571 14,885 86,232 Canida TF052065 ~ - I - 41 LE j. National workshop on Gol Swajaldhara programme I Social fund Jan. 04 25,885 31,247 DFID-Rural TF022457 2040118 25,885 31,247 11,171 9,062 1-- 20,234 243 - 10.110 I k. Policy workshop on performance-based financing options for RWS 42 PS LE Mar-04 !____ national orograrns 23,228 17,057 DFID-Rural TF022457 2040119 23,228 17,057 - - 17,057 I. Policy Support to states, including support (on-going) by State DFID-Rural TF022457 2038776 87,211 174,879 42,137 60,958 103,095 - 34,230 71,7841 43 Contd. coordinators in 3 States 87,211 174,879 - f..---- 44 LE m. Workshop on institutional implementation structure in Andhra Pradesh Sep. 04 Dan ida TF052065 ~ - I 10,518 72,365 DFID·Rural TF022457 2040120 10,518 72,365 17,133 23,420 40,553 26,052 5,760 45 - n. Policy dialogue initiated in other States Contd. 33,699 138,814 DFID-Rural TF022457 2039877 33,699 138,814 12,790 1,711 14,501 - 353 124,313 a. Study on institutional options for Multi-VIllages WS schemes 46 s Dec-04 manaoo:>n1ent in AP 14,148 28,518 DFID·Rural TF022457 2040121 14,148 28,518 1,740 - 1,740 26,778 - b. Jal Manthan on institutional options for Multi-Villages WS schemes 47 FN dropped I mana!:!ement in AP 13,019 - DFID·Rural TF022457 ~ 13,019 - - - CFID·Rural TF022457 2038778 20,873 28,339 - 13,659 13,659 6,703 769 7,977 48 s c. Study (ongoing) on fluoride mitigation in Maharashtra Aug-04 !____ 20,873 28,339 Canida TF052065 ~ - FN d. Field note on Fluoride/Arsenic issues similarities Jan 04 5,285 2,371 DFID-Rural TF022457 2038780 5,285 2,371 468 2,928 3,396 774 - (1,799) ~ Canida TF052065 ~ - 50 s e. Study on bacteriological contamination in Kerala May-05 79,869 57,727 DFID-Rural TF022457 2039874 79,869 57,727 28,762 28,762 2,775 54 26,189 ~ 19/SAIIN: AusAIC TF052137 2038782 53,497 6,423 1,260 2,351 3,611 3,384 - (573) 51 s f. WTP study (ongoing) on Arsenic mitigation in West Bengal Dec-04 Supporting 83,497 91,423 DFID-Rural TF022457 2039878 30,000 85,000 497 6,208 6,705 20,333 78,295 ~ innovations g. Study (ongoing) on the evolution of the World Bank supported RWSS Canida TF052065 200ll7ll3 and learning 52 s Jul-04 VS KM projects design 15,248 7,222 DFID-Rural TF022457 2040123 15,248 7,222 - - - - 7,222 inRWSS- ~ - h. Innovative approaches to institutional arrangement for RWS services Apr-03 lo Jun 53 FN dropped mana!l.ement in 2 States 9,418 - DFID-Rural TF022457 2009879 9,418 - 04 ~ 54 FN i. Innovative approaches for scaling up sanitation services Jun. 04 11,646 21,435 DFID-Rural TF022457 2040124 11,646 21,435 435 5,073 5,509 15,927 (Year l of l) I-- j. Review of water conservation measures- situational analysis on 55 FN dropped knowled!l.e and oractices across India 8,630 - DFID-Rural TF022457 ~ 8,630 - I-- Au sAIDTF052137 :lOOS+ll4 - 56 s k. Assessment of technology options for safe and hygienic sanitation May-04 I-- 20,241 25,616 DFID-Rural TF022457 2040126 20,241 25,616 1,740 25 1,765 - - 23,851 Oct03; Danida TF052065 ~ - 57 FN 1. Three "Jalvaani" newsletters MM Revised Order MYR Staff Cost Actual as Budget MYR Costs as Commitm Reposti Balance as PROJECT PM PIN " Product Description completi SOF TF# 10# allocation allocation as of 30th of $ "" ., ., e (July/Aug Budget of 30th Apr ents as of ngs of 30th D.. on Date (as of (Jan03) Apri104 30Apr2004 0 03) (Jan03) 04 30Apr04 with Apr04 Dec03) RMA f. Identification of technical and institutional options of modem MSWM 94 s Jan-04 for a cluster of small towns in l state 28,018 15,522 SIDA TF051599 2038758 28,018 15,522 - - - - - 15,522 FN a. Field Note on wealth creation in the context of slum upgrading Feb-04 32,249 6,945 Au sAID TF052137 2038707 32,249 6,945 5,881 1,238 7,119 - (173) r-2L 96 p b. Scaling up of an ongoing pilot on community based rural sanitation (*) Apr-04 3,000 3,000 Dan ida TF052065 2038708 3,000 3,000 - - - - - 3,000 r--- c. W &S roundtable on experiences in transition to mainstream best BB BB 2038709 16,712 21,390 5,241 16,150 21,390 14/SA/PA: 97 KM LE Jul-03 :p_ractices 33,424 21,390 Dan ida TF052065 2041149 16,712 - Operationalizi r---- d. Field Note on mgmt ofW&S between village based & union council or ng systems 98 FN Dec-03 multi-village based systems 15,245 14,245 Au sAID TF052137 2038710 15,245 14,245 - - - - 14,245 and e. Implementation support to AJK-CISP & Policy advice on design on procedures for 99 IS Cont. IS decentralization framework ofW&S services(*) - (") - improved 1-Joo IS f. Desi~n support for NWFP & Balochistan CIP(*) Cont. - - n service RRA g. Policy advice support to DFID RWSS Project on implementation of delivery in a 101 IS W &S service delivery in the context of devolution, and establishing Cont. decentralized linkages with a capacity building framework 8,593 6,311 SDC-P TF051523 2039108 8,593 6,311 2,935 184 3,119 - - 3,192 environment- r--- h. Sharing of experience and "best practices 11 among Local Governments 102 LE Jan-04 Jul-02 to Jun- on large city W &S utilities 29,431 38,622 Au sAID TF052137 2038712 29,431 38,622 4,037 11,946 15,983 2,394 - 20,245 - PS 05 (Year 2 of i. Policy support on W &S or SWM to City Districts and TMAs (Utilities 103 IS Cont. 3) reforms including regional utilities, PPP, regulation, etc.). 27,013 14,785 Au sAID TF052137 2038713 27,013 14,785 3,653 2,612 6,265 - - 8,520 - j. Policy and technical advice support to theW &S component of 104 s Oct-03 ,_____ Devolution ESW 10,812 2,912 Au sAID TF052137 2038714 10,812 2,912 2,912 123 3,035 - (123) 105 FN k. Decentralization: creating space for W &S sector reform Dec-03 3,755 3,755 SDC-P TF051523 2038715 3,755 3,755 - 1,611 1,611 - - 2,144 a. ESA roundtable(s): capacity building framework and programs in a 106 N Nov-03 decentralizing environment 12,500 1,730 SDC-P TF051523 2038716 12,500 1,730 _4fi,1. - 461 - - 1,268 - RJai 15/SA/PA: SDC-P TF051523 2038717 _28,800- ----38,00o 18,511~: '113,053 31,566 23,965 - (17,531) b. Dera Ismail Khan pilot on strengthening of local governments for Capacity p 107 KM developing and implementing multi-year W &S plan within a framework of Mar-04 Au sAID TF052137 2041105 51,491 51,491 building of - t:~ - - - IDPforaTMA institutions Dan ida 54,856 10,000 8,753 4,449 13,203 (3,203) 83,656 99,491 TF052065 2038718 (including - FMK 108 c. W &S roundtable: challenges in scaling up HH sanitation and bringing local govts.) N Feb-04 about behavioral change 38,560 42,697 Au sAID TF052137 2038719 38,560 42,697 1,269 2,144 3,413 4,176 35,108 for improved d. Advocating support to new SDC Capacity Building initiative and other W&S service 109 IS IS Cont. ongoing initiatives 24,361 21,253 SDC-P TF051523 2038720 24,361 21,253 18,959 2,892 21,852 - - (599} delivery (Year e. Preparation of detail manual on systems and procedures for 2of3) 110 s Dec-03 operationalizing decentralized W &S service delivery 19,147 16,705 Dan ida TF052065 2038721 19,147 16,705 4,090 4,629 8,719 1,511 - 6,475 - PS f. Policy support to GoNWFP on Capacity Building framework for Local Ill IS Cont. Governments 25,355 32,981 SDC-P TF051523 2038722 25,355 32,981 12,698 2,994 15,692 - - 17,289 a. Produce and disseminate quality knowledge and communications products, and receive feedback through ACCESS newsletter, Annual 112 FN Jun-04 Danida TF052065 2038723 14,156 24,376 3,149 6,059 9,208 - 15,168 report, SA website, SA & Country Brochures, translations of selected 23/SA/SAR products in regional languages. 28,311 24,376 Dan ida TF052065 ~ 14,155 - Communicati r---- b. Develop SA communication strategy on the basis of assessment of on and 113 s Sep-04 effectiveness of WSP-SA's communication products and tools dissemination- VM KM 18,591 18,591 Dan ida TF052065 2038724 18,591 18,591 - - - 18,591 July2003 to r---- c. Support to WSS initiatives eg. WWDay, IAWG, UN Events, 114 N Jun-04 June2006 exhibitions/conferences etc. 18,296 18,896 Dan ida TF052065 2038725 18,296 18,896 1,398 11,333 12,731 - - 6,165 (Year I of3) r---- d. Software enhanced, management of the public in formation center and 115 N dropped Dan ida TF052065 ~·. 11,764 - - water help desk 23,527 - Dan ida TF052065 ~ 11,763 ~ Visual Imagery Project: to provide visual expression to the Program's 130 41,748 Dan ida TF052065 2041106 44,250 41,748 - - - 41,748 lm;";on 116 LE a. Regional knowledge sharing and exchange on WSS services reform Aug-03 44,250 59,898 Au sAID TF052137 2039104 11,122 59,898 28,769 35,801 64,570 19,512 (24,183) ~ - 117 KM s b. Study on economic analysis of rain water harvesting dropped 11,122 - SDC-R TF051521 ~ 17,317 - - 17/SA/SAR: r--- 118 FN c. Documenting various approaches for dealing with water quality issues ' Regiona] such as arsenic, fluoride etc dropped 17,317 - SDC-R TF051521 ~ 49,997 - knowledge d. Bring international experience on innovative ways of delivering WSS to JKA 119 sharing and LE the region- Jan2004 Oct-04 49,997 30,508 SDC-R TF051521 2038660 49,320 30,508 11,308 3,700 15,008 - 15,500 exchange- - e. Exploring reform opportunities in existing WSP-SA countries of July2002 to 120 PS operation and seeking to expand WSP-SA operations in other SAR June2006 countries Contd. 49,320 35,659 Au sAID TF052137 2038661 18,523 35,659 614 582 1,196 10,000 - 24,463 (Year 2of 4) - £ Exploring partnerships with other local infrastructure agencies to support 121 N ~RJain: direct investment in the WSS sector Contd. 18,523 18,817 Au sAID TFO 10 mapping J!662 18,817 1,416 - 1,416 - 17,401 alteinate u:):' exhausted/2nd priority: not ;,~iOppeti~ f¢r~ ~ WSP-SA- FY04 PROJECT/PRODUCT FINANCING , BUDGET AND ACTUALS newiO ,closed to use ctri~fL' 2f"'' Pre-MYR ~ Revised Actual as Revised Original I Order MYR Staff Cost Variable FYO~ Pendin~~Available I I 0 MYR Costs as f Commotm Reposto Balance asl PROJECT PM I PIN .., "" Product Description completi Budget SOF TF# 10# allocation allocation I as of 30th I 0 ~ e on Date (July/Aug Budget of 30th Apr A r2 ents as of ngs of 30th 0.. (as of (Jan03) April04 I 30 004 0 "' 03) (Jan03) 04 P 30 Apr 04 with Apr04 Dec03) RMA 134 s g. Regional Sanitation Study 20,027 N a. Liaison with client governments to seek their approvals and buy-in for 24/SNSAR: 122 WSP activities 25,352 39,272 47,204 21,496 68,701 (~9,429) Sector 1- N Ib. Dialogue with local donors for securing funds and keeping them Dan ida TF052065I~ 18,353 Coord~nation, I I 123 shifted informed of sector developments and reporting for trust funds 36,706 Dan ida TF0520651'~ 18,353 reportmg and JK.A ~ monitoring- Rlain: ~5 9,821 33,243 56,382 740 57,121 ~3,878 124 N Ic. Coordination with Bank operations and sector work Jan2003 to Contd. 19,642 33 243 10 mapping to be 9,821 (,__ . uevelopment ot annual busmess plan, mtd year revtew, year end revtew ' changed in WPA ~ June2006 _1 28,170 (Year 1of3) 125 and other monitoring reports; creation of new trust funds and preparation o shifted Bank TF renorts 56,340 Danida TF052065I ~~ 28,170 Liaison with Donors and Fund Raising (Donor Reports, Drafting of 135 Contd. funding proposals, handholding) 50,695 Dan ida TF0520651:;; 50,695 63,757 4,092 67,849 (17,154 25/SNSAR. Personnel Management (OPE, recruitment, etc) Contd. Secretariat 13,909 Dan ida TF052065I 2038892 13,909 9,200 9,200 4,709 JKA Sustaining Workprogram Management (Business Plan, Mid-Year Review, Year end Costs 7 Contd. @ Review) 49,985 Dan ida TF052065~~ 49,985 72,130 9,128 81,258 878 (32,151) Financia~ Management (Budget Planning exercise, Mid-Year Review, YeariContd. 138 End Rev1ev.:l_ 56,000 Dan ida TF052065I 2038894 56,000 33,273 6,455 39,729 16,271 TOTAL PROJECTS 5,265,822 4,726,763 5,265,825 1 4,726,769 1,096,482 1,344,917 1 2,441,398 566,556 83,415 11,718,815 Secrateriat I JKA I 126 Management Jun-03 102,996 Canida ITF052065I ~ 102,996 11,346.81 667.81 I 12,015 (12,015) Training JKA 135,792 198,827 36,338 76,601 I 112,939 85,888 . . Jun-03 I 127 TralDIDg I 214,363 _ 198,827 78,571 I... Resource JKAI ACS staff time 2028645 Management RM staff time 2025135 NON PROJECTS 317,359 198,827 317,359 198,827 47,685 77,269 1 124,953 73,873 I I TOTAL 5,583,181 4,925,590 5,583,184 1 4,925,596 1,144,167 1 ,422,185 1 2,566,352 566,556 83,415 1 1,792,688