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Subnational Fiscal Sustainability Analysis: What Can We Learn from Tamil Nadu?

This paper presents a framework for subnational fiscal sustainability analysis and emphasises the differences between fiscal adjustment at the national and subnational levels. Using the case of Tamil Nadu that experienced an unprecedented fiscal deterioration - a part of the widespread fiscal stress in Indian states in the late 1990s - the analysis attempts to take into account uncertainty and discusses the key components of the state's fiscal accounts and how they respond to reforms and shocks. It illustrates that risks to the state's fiscal outlook include interest rate shocks, pressures on the primary balance, and contingent liabilities, reflecting the interplay of subnational and national policies. The analysis is relevant for other Indian states and countries.

We thank Craig Burnside, Vikram Nehru, Dana Weist, Brian Pinto, Sona Varma, James Hanson, and an anonymous referee for their useful comments. The substance of the paper also benefited from extensive discussions with the government of Tamil Nadu. The findings and conclusions expressed herein are those of the authors and do not reflect the views of the World Bank group.

Elena Ianchovichina (eianchovichina@worldbank.org), Lili Liu (lliu@ worldbank.org), Mohan Nagarajan (mnagarajan@worldbank.org) are at the World Bank.

december 29, 2007 Economic & Political Weekly112Sage AD
Fiscal Deficit Revenue Deficit Primary Deficit
SPECIAL ARTICLEdecember 29, 2007 Economic & Political Weekly114Table 1: Debt Dynamics – Tamil Nadu’s Case (% ofGSDP) 1994199519961997199819992000200120022003Stock of debt (b) 16.6 16.4 16.3 16.3 17.3 20.5 22.2 24.9 28.0 27.8(A) Actual change in debt (db) -0.2 -0.1 0.0 1.1 3.2 1.7 2.6 3.2 -0.3Decomposition of change in debt (1) Interest payments (i) 1.8 1.8 1.7 1.8 2.1 2.2 2.4 2.7 2.8(2) Primary balance (x) 0.2 -1.0 -0.6 -2.3 -2.5 -1.8 -1.1 -1.9 0.3(3) Growth effect (gb/Z) -0.5 -0.7 -1.2 -0.7 -1.0 -1.4 0.5 -0.6 -1.4(4) Inflation component (πb/∏) -1.5 -1.3 -1.1 -1.3 -0.1 -0.7 -0.8 -1.2 -1.2(P) Predicted change in debt* -0.4 0.7 0.0 2.1 3.5 1.8 3.2 2.7 -0.2(A)-(P) Residual term 0.2 -0.8 0.0 -1.1 -0.3 -0.2 -0.6 0.5 -0.1Effective interest cost (per cent of GSDP) 0.2 0.5 0.6 0.5 2.0 1.5 1.6 1.5 1.5As a percentage of debt 1.4 2.8 3.7 2.8 11.7 7.1 7.3 6.1 5.4The years shown in this and subsequent tables and graphs denote fiscal years, e g, 1994 stands for fiscal year 1994-95. * Predicted change in debt is computed by the authors’ following equation (2) as (1)-(2)+(3)+(4). state revenue in Mexico. The predictability and size of transfers depend on the transfer system. In India, the constitutionally mandated Finance Commission (FC) convenes every five years to determine revenue sharing between the centre and states based on a formula using non-constant weights for various relevant fac-tors such as population, income disparity, area, tax effort and fis-cal discipline. Sixth, the central government can affect the fiscal sustain-ability of subnationals through policies, which impact subnational fiscal balances and economic growth. Examples include the cen-tral government’s policies on wages and pensions in Brazil and India, and the ceilings on debt services and debt stock set by the central government in Colombia, Peru, Russia and Mexico. In In-dia, many projects and policies that affect the growth potential of the subnational economy, such as investment in major infrastruc-ture, investment and labour policies and regulation, are largely or exclusively within the purview of the central government.Expected bailouts by the central government influence sub-national debt dynamics. Market participants may tolerate un-sustainable subnational fiscal policy if past history backs their perception that the central government implicitly guarantees the debt service of the subnational government. Central govern-ment’s implicit guarantees for local government bailouts contri-buted to the widespread subnational defaults in Russia in the late 1990s and in Mexico in the mid-1990s. Finally and not least importantly, fiscal risks are associ-ated with the borrowing regime. In India, a number of policy loopholes have softened state budget constraints [Rajaraman, Bhide and Pattnaik 2005].6 Although subnational borrowing is subordinated to prior approval by the centre, the states negoti-ate bilaterally with the centre the size of plan spending. The por-tion uncovered by central loan/grant assistance and by the states’ own resources is therefore left for states to cover through loans from other sources,7 but no sustainability analysis is carried out before the negotiated limits for additional borrowing by each state are approved, and no systematic procedures are in place to ensure that the limits are not exceeded. There has also been an automatic entitlement of states to loans against small savings collections within the jurisdiction of each state.8 Furthermore, many states circumvented the borrowing limits by accumulating arrears or issuing guarantees to support the market borrowing of SOEs or special purpose vehicles. Progress has been made in addressing the borrowing regime particularly with the Twelfth FC whose recommendations include mandatory fiscal responsi-bility legislation by states and central incentives for states fiscal adjustment.92 Fiscal Crisis and Reforms in Tamil NaduAt the end of the 1990s, Tamil Nadu’s fiscal deficits grew rapidly,10 and so did its debt and contingent liabilities (Figures 1 and 2). The quality of fiscal spending deteriorated. A high and growing portion of net borrowing financed wages, pensions, subsidies and interest payments, while capital expenditure remained low. The latter was a special concern. Since the 1990s, Tamil Nadu’s capital-outlay-to-GSDP ratio has been on average 1.6 per cent and much lower than the 2 to 3 per cent in comparable states. The traditional measure of the fiscal deficit did not capture the quasi-fiscal activities, and therefore masked the depth of the fis-cal decline. Specifically, the budget did not capture the financ-ing gaps of SOEs. MostSOEs in Indian states were not creditworthy,11 hence their borrow-ings were backed by government guarantees. The financial losses of the state electric-ity boards posed the most significant fiscal threat [World Bank 2005b]. Although efficient compared to the elec-tricity boards of many other Indian states, the Tamil Nadu’s Electricity Board(TNEB) had financial losses that rose steadily beginning in the late 1990s, owing to increasing subsi-dies to agriculture and domestic consumers and rising supply costs. To capture the im-pact of these losses, theTNEB’s accounts were consolidated with the state’s fiscal accounts. The impact of the power sector on the budget was significant. In 1999-2000, the consolidated deficit, defined as the sum of the non-power fiscal deficit of the govern-ment and TNEB’s total financing requirements, was 6.7 per cent of GSDP compared with the traditional measure of fiscal deficit 4.6 per cent ofGSDP.12Tamil Nadu’s fiscal deterioration was not an isolated pheno-menon. The combined fiscal deficit of the Indian states rose from 2.9 per cent of GSDP in 1997-98 to 4.3 per cent of GSDP in 2003-04, with states accounting for about one-half of India’s general fiscal deficit. This deficit figure would have been higher if it included off-budget liabilities and arrears not reflected in official statistics. The pattern of fiscal deterioration – rising revenue deficits, gov-ernment guarantees, and significant off-budget activities – was similar across Indian states. In relative terms, Tamil Nadu’s fiscal performance was better than that of most other states. While the debt-to-GSDP ratios of Indian states were not high (average was 25 per cent of GSDP in 2001-02) compared to that of the national government (65 per cent of GDP in 2001-02), Tamil Nadu’s ability to meet debt service obligations was eroding. Inter-est payments as a share of revenue rose to about 20 per cent in 2003-04, reaching a threshold of “debt distress” as defined by the central government.The rapid fiscal deterioration was attributed to a number of reasons, common to all states with varying degrees. Expendi-tures on salaries, retirement benefits, and pensions grew rapidly
SPECIAL ARTICLEEconomic & Political Weekly december 29, 2007115Table 2: Baseline Simulation as Proposed in Tamil Nadu’s MTFPAssumptions 2003 20042005 2006200720082009 20102011 2012 20132014Real interest rate (r) 5.5 5.5 5.5 5.5 5.0 5.0 5.0 5.0 5.0 5.0 5.0Real growth rate (g) 8.5 6.5 6.0 6.0 6.0 6.0 6.0 6.0 6.0 5.8 5.7Primary surplus (x) -0.3 -0.5 -0.1 0.5 0.8 0.5 0.5 0.5 0.5 0.5 0.5Debtdynamics Debt (% of GSDP) (b) 27.8 27.3 27.5 27.5 26.9 25.8 25.1 24.4 23.7 23.0 22.3 21.7 2015 20162017 2018201920202021 20222023202420252026Realinterestrate(r) 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0Real growth rate (g) 5.5 5.3 5.2 5.0 4.8 4.7 4.5 4.5 4.5 4.5 4.5 4.5Primarysurplus(x) 0.5 0.5 0.5 0.50.50.50.5 0.50.5 0.5 0.5 0.5Debtdynamics Debt (% of GSDP) (b) 21.1 20.5 20.0 19.5 19.0 18.6 18.2 17.8 17.4 17.0 16.6 16.2Source: Authors’ simulation based on equation (3).following the implementation of the pay commission award.13 Subsidies grew rapidly. Tamil Nadu’s share in central tax devo-lution declined further following the EleventhFC’s award. New borrowing to support the growing revenue deficit added to the debt and interest burden. Finally, growth in contingent liabilities associated with fiscal support to the public sector units, coopera-tives, and statutory boards exacerbated the fiscal risks.14 Based on equation (2) in Section 2, Table 1 (p 114) identifies the key determinants of Tamil Nadu’s state debt. Growth in state liabilities reflected both growth in fiscal deficits and accumula-tion of interest payments on outstanding debt, while growth and inflation were offsetting factors.In response to the fiscal crisis, fiscal reforms were undertak-en by Tamil Nadu from 2001-02 to 2003-04 to control recurrent expenditures, improve the efficiency of the tax system, restruc-tureSOEs, and improve fiscal transparency.15 Tamil Nadu’s Fiscal Responsibility Act, which laid down the principles of fiscal adjustment, became opera-tional in May 2003. One of the commitments un-der the act was a medium-term fiscal plan(MTFP) stating how the targets under the act were going to be achieved. The MTFP was presented to the state legislature in February 2004. The fiscal adjustment aimed to achieve a primary balance, eliminate the revenue deficit and reduce the consolidated fiscal deficit to 2 per cent of GSDP. While reducing the consolidated fiscal deficit, the fiscal reform expect-ed re-orientation of expenditure from salaries, pensions, and sub-sidies to non-wage operation and maintenance (O&M) and capital investments and deepening of tax reform.Tamil Nadu’s multiyear adjustment framework explicitly in-corporated important off-budget and contingent liabilities. Off-budget borrowing serviced by the state government was inte-grated with the state’s public debt.16 Capital works executed in the public account but financed by off-budget borrowings de-posited in the public account were fully integrated within the fiscal framework. Comprehensive estimation of accrued pension liabilities and cash flow needs based on the inherent demograph-ics of the workforce replaced the incremental cash budgeting. As mentioned earlier, the accounts of the TNEB were consolidated with the fiscal account.On the expenditure side, reform efforts were made at control-ling the growth of pensions and wages, reducing major subsidy programmes and improving their targeting. These efforts resulted in a slowdown of growth in pensions, subsidy, salaries and inter-est expenditure whereas expenditure on non-wage operations and maintenance expenditure and transfers grew because the state could better utilise resources under central schemes. On the revenue side, a major tax reform effort, including the preparation for the introduction of a value added tax (VAT), was aimed at improving the efficiency of the sales tax system, which suffered from multiple layers of taxes and a complex rate struc-ture, cascading, frequent and ad hoc changes, and extensive ex-emptions. The state reformed its stamp duty system, lowered the tax rate on property transactions and improved its administra-tion in an effort to reduce tax evasion. On the non-tax side, the government’s efforts to increase cost recovery had some success but was limited due to political considerations.As a result of these reforms, a large portion of arrears (2 per cent ofGSDP) was cleared in 2002-03. Furthermore, the consolidated fiscal deficit was reduced from the peak of 6.7 per cent ofGSDP in 1999-2000 to 3.3 per cent in 2003-04.17 The fiscal adjustment was largely attributed to an increase in the ratioofthestate’s own tax revenue to GSDP (from 8.6 per cent in 1999-2000 to 9.4 per cent in 2003-04) and a reduction in the ratio of salaries to GSDP (from 6.5 per cent in 1999-2000 to 4.7 per cent in 2003-04). Unfortunately, capital outlays and net lending suffered a reduction of 0.4 per cent of GSDP due largely to lack of financing.The financial performance of the TNEB also improved mainly due to improvements in operational efficiency, bill collection, and anti-theft measures. The net loss before subsidy decreased from Rs 18.54 billion in 2001-02 to Rs 3.90 billion in 2003-04. The net losses of the state transport units were reduced by 98.6 per cent between 1999-2000 and 2002-03. Outstanding guarantees fell from 7.5 of GSDP in 1999-2000 to6.4 per cent in 2003-04, when they were lower than those of many Indian states.Since April 2004, some critical reforms have been rolled back.18 Strong revenue growth enabled the state to absorb the current expenditure impact of the reform reversals momentar-ily. The revenue growth was driven by stronger than anticipat-ed growth in state’s own tax revenue, due to a strong upturn in the state’s economy, and much more robust devolution from the centre. On the expenditure side, higher than projected subsidies and transfers due to the reform rollbacks were more than com-pensated by lower than projected outlays on salaries and pen-sions as the government withheld inflation-indexed salary and pension increases.3 Subnational Fiscal Sustainability Analysis We start by assessing Tamil Nadu’s fiscal sustainability in a base-line covering the period 2003-04 to 2026-27 and in the context of India’s macroeconomic policies and intergovernmental revenue-sharing system. Given the long-run nature of fiscal sustainability analysis we look at outcomes over a period of 23 years. Recognis-ing the uncertainty associated with the projected values of key variables in the model we supplement the analysis with sensitiv-ity tests that examine the impact of adverse shocks on deviations from the baseline. We also explore whether there is “fiscal space” for infrastructure investment.
Baseline Capital expenditure increase

Rising interest expenditure in the period 1991-92 to 2000-01 contributed to the fiscal deterioration of the state. The rise was associated with an increase in borrowing and a rise in interest rates associated with financial market deregulation. From 2000-01 to 2004-05 interest rates declined as a result of changes in monetary and fiscal policy and the decline in international interest rates. Reductions in bank and risk-free interest rates in turn reduced the average borrowing cost to 10.7 per cent and stabilised interest expenditure at 20 per cent of revenue in 2003-04 for the fiscal account of Tamil Nadu.

The risk of rising interest rates however is real. The persistent combined centre and state deficit (8.3 per cent of in 2004-05), especially the combined revenue deficit (2.6 per cent of in 2004-05),27 is the most significant macroeconomic risk in India. Since the late 1990s, the pressure of government borrowing has not translated into higher interest rates due to expansionary monetary policy and sluggish investment demand from the private sector. However, the recent recovery of the manufacturing sector and higher overall economic growth could lead to increased demand for credit. The interest rate risk has also increased following an upturn in international interest rates. In Tamil Nadu, a hypothetical 3 percentage point increase in the real average borrowing cost after 2007-08 will double the debt burden expected in 2026 compared to the baseline (Figure 4) and lift debt service spending as a share of revenue up to the stress level of 20 per cent.

The debt maturity structure has an important bearing on rollover risks. One trigger of the Mexican debt crisis in the mid-1990s

Interest rate increase Other expenditure increases Combined policy risks Base line Wage increase

was the short maturity of subnational debt – 6.6 years on average at the end of 1994, combined with floating interest rates. Rapid currency depreciation, a sharp rise in interest rates, and a sharp contraction in the pool of shared revenues eventually triggered subnational debt crisis.

In Tamil Nadu, and other Indian states, disaggregate data on debt maturity are not yet readily available. However, the roll over risks for Tamil Nadu are low because interest rates are fixed and maturities of different types of debt are long. The debt owed to the (14 per cent of total debt as of 2004-05) and the liabilities of the provident fund (14 per cent of total debt as of 2004-05) have maturities of 10 to 20 years. Market financing (72 per cent of debt as of 2004-05), which includes government bonds, small savings borrowing and institutional loans, also has relatively long maturity. The original maturity for government bonds is about 10 years. Institutional loans have a maturity between five and 10 years depending on source. National small savings loans have a maturity of 25 years with a moratorium of five years.

Adjustment in the primary balance also faces constraints. The forces that triggered the fiscal crisis in the late 1990s could again threaten the state’s fiscal sustainability. Moreover, the Twelfth

, which mandates the states to eliminate revenue deficits and reduce fiscal deficits, does not spell out the compliance and enforcement mechanism of the process, thus leaving open questions about the quality of fiscal adjustment.

On the expenditure side, the risk is that the next central pay commission may increase wages and pensions. Since the central pay commission’s decisions have been historically emulated by states, a hypothetical 20 per cent increase in civil servants’ salaries is likely to lead to a 20 per cent increase in Tamil Nadu’s wage bill after 2008-09. Assuming strong growth and moderate borrowing costs, as in the baseline, and no corresponding downward adjustment in employment, the wage shock will not increase the debt level in 2026-27 relative to its 2008-09 level but will increase it relative to its 2026-27 level in the baseline.

Political impulse could also push up the number of civil servants and backtrack or slow down pension reform. The magnitude of pension liabilities is a major concern for Indian states as it is difficult to reduce these liabilities due to the long-term nature of pension policies, acquired rights of existing employees, aging civil service force, and need for the government to contribute to a newly defined contribution scheme.

Another source of expenditure pressure comes from various subsidies. Such pressure would intensify if cost recovery for public utilities continues to be politically difficult. If distortions in the public power sector persist, more industry groups may exit the public power grid, thus intensifying the power company’s financial problems, which will put further pressure on the state to extend assistance to the power company.

The potential for substantially increasing the state’s tax revenue is limited, and in part depends on the evolution of the intergovernmental finance system. Tamil Nadu’s own tax revenue effort is already among the highest compared to other Indian states, about 10 per cent of Moreover, the central government reserves the right to tax the service sector, which is the fastest growing sector in Tamil Nadu. Successive central s had reduced Tamil Nadu’s share in the pool of net shareable central taxes from 8 per cent (Seventh ) to 5.4 per cent (Eleventh ). The contribution of the share of central taxes to Tamil Nadu’s revenue declined from 21 per cent in 1992-93 to 15 per cent in 2002-03.

The Twelfth has also departed from its tradition of greater weight to equity than economic performance. For Tamil Nadu, this implies reversing the past trend of diminishing state’s share in the pool of sharable tax revenue. Nonetheless, it is unclear how the future s will decide on the distribution of sharable revenues in light of growing economic disparities among Indian states.

Our analysis suggests that revenue stagnation,29 a decrease in central devolution,30 and an increase in subsidies (food, power and s)31 may constrain fiscal balances and result in a primary deficit of 0.5 per cent of after 2008-09, even if we assume strong growth and moderate borrowing costs, as in the baseline. In response to this hypothetical fiscal deterioration, the debt burden will slowly increase to 35 per cent of in 2026-27.

Individually, the policy risks discussed so far may not threaten fiscal sustainability but their combined effect may have serious consequences for debt sustainability. A 3 percentage point increase in the baseline real borrowing cost, a percentage point decline in the baseline real growth, and a deteriorating primary balance, reflecting revenue stagnation, decrease in central devolution, subsidy increases after 2008-09, and the wage shock after 2008-09, will result in dramatically worsened debt dynamics.32 Under this hypothetical scenario in 2026-27 the debt service payments are expected to be 51 per cent of revenue

– a ratio that is nearly three times the debt stress threshold of 20 per cent, while the debt burden is expected to be nearly 80 per cent of (Figure 4).

In 2002-03, the government’s guaranteed debt in Tamil Nadu was estimated at 8 per cent of .33 Although this share is lower than in some other Indian states, an unexpected realisation of these liabilities would augment state government debt, leading to higher effective borrowing costs and possibly a fall in real output. Suppose the realisation of the liabilities triggers a 2 percentage point increase in nominal effective interest rate and a 1.5 per cent drop in real growth after 2006-07. In this case, the government will need to run a primary surplus of 1.2 per cent of in order to ensure that state debt will not rise above the debt to

in 2006-07.

SPECIAL ARTICLEEconomic & Political Weekly december 29, 2007119Notes 1 Revenue deficit is the amount of current expenditure (such as wages, pension outlays, subsidies, transfers, and operation and maintenance) net of total rev-enues. Consolidated fiscal deficit captures off-budget activities and hidden liabilities, including off-budget borrowing serviced by the state government, capital works executed in the public account but financed by off-budget borrowings deposited in the public ac-count, and the financial accounts of the state power utility. 2 The fundamentals of fiscal sustainability have not changed since the classic work by Domar (1944). 3 In the future Indian states could be subject to adverse risks of foreign exchange fluctuations since in 2005, the Twelfth Finance Commission proposed that all new external assistance to be passed on to the states on the same terms and conditions attached to such assistance by external funding agencies. The recom-mendations relating to state governments’ manage-ment of exchange rate risks is yet to be implemented and mechanisms such as individual and collective hedging against foreign exchange risks are being ex-plored by the GoI. The direct exposure to foreign ex-change risks is expected to be limited as Indian states are not allowed to borrow from external commercial sources other than multilateral lending agencies. 4 Interest rates on government bonds until recently were the same for all states independent of credit-worthiness. The Reserve Bank of India (RBI) report-edly pushed creditors to buy a mix of state bonds with the better-managed states subsidising the worse-managed states. Recently, interest rates started to differ by state, though they are not yet completely determined by the market. 5 In countries with a three-tier system (federal – state – provincial levels), the third-tier government receives transfers from the second-tier government or also from the central government. 6 Soft budget constraints have been one of the biggest topics in fiscal federalism studies since the 1990s. For more details on the subject see Rodden et al (2001), Wibbels (2005) and Liu and Waibel (2007). 7 Indian states borrow from the market, central gov-ernment, and employees’ provident fund. Market borrowing – from the bond market, national small savings fund, and negotiated loans with public sector financial institutions – has increased in importance and recently accounted for over half of all subnation-al borrowing. But market discipline is weak. “Market loans” are dominated by public commercial banks which have persistently exceeded the statutory re-quirement of holding government bonds. 8 Some states carry ways and means advances or overdrafts from the RBI almost throughout the year. These reflect cash flow mismanagement – a problem that is to some extent independent of fiscal sustain-ability but nonetheless one that calls for increased coordination and information exchange between the states, centre, and RBI [Rajaraman, Bhide and Pat-tnaik 2005]. 9 For more discussions on the recommendations of the Twelfth FC, see Rajaraman, Bhide and Pattnaik (2005). One main challenge, according to the authors, is that although the Twelfth FC supports a cap on all borrow-ing through a centrally-constituted loan council, it will be difficult to ensure consistency between such an ex-ogenous control on net new borrowing and the states’ autonomy in setting their own fiscal deficit correction paths as part of their fiscal reform legislations. 10 For a detailed account of fiscal crisis and reforms in Tamil Nadu, see World Bank (2005a).11 There are three types of SOEs in Indian states: public sector undertakings (PSU) covering firms in a broad range of sectors, statutory boards mostly in utilities and infrastructure, and cooperatives.12 The consolidated fiscal deficit needs to include all SOEs in which the state has controlling shares or is financially involved, and local governments (third-tier governments). Producing a completely consoli-dated budget however is time consuming due to data constraints. The consolidation of the power sector finance took care of a dominant source of off-budget liabilities, as borrowing by local governments is regu-lated by the state government and the amount of bor-rowing is small. 13 Every 10 years the Indian government appoints a Central Pay Commission to recommend a wage struc-ture for central government employees. States either adopt the commission’s recommendations or set up their own individual pay commissions. Tamil Nadu followed the recommendation of its Sixth Pay Com-mission along the lines recommended by the Fifth Central Pay Commission. 14 Although these systemic factors were prevalent even before the crisis, the implementation of the Sixth State Pay Commission’s recommendations in 1998 triggered the fiscal crisis because of the large payouts and their retroactive effect to 1996. The annual aver-age growth of salary and pension expenditure accel-erated from 14.5 per cent during 1990-91 to 1997-98 to 26.7 per cent during 1997-98-1999-2000.15 A new government of Tamil Nadu was elected in 2001 and launched an ambitious fiscal reform programme. The government’s White Paper (August 2001) analysed the systemic causes of the fiscal deterioration and ar-ticulated the need for fiscal reform and stabilisation in the state.For a more detailed analysis of Tamil Nadu’s reform programme, see World Bank (2005a).16 The off-budget borrowing was 2 per cent of GDP in 2002/03. It was small relative to other states but incor-porating it into the budget increased transparency.17 The deficit in 2003-04, included partial clearance of the pension arrears.18 The rollback included restoring free power to all farm-ers, reducing power tariffs for domestic consumers, re-storing free/subsidised bus services to private schools and college students, withdrawing income ceiling for public distribution systemaccess, and eliminating rice coupons.The exogenous shock to the state from the tsunami in 2004 has been cushioned mainly through grants from the centre, hence it has had little impact on the borrowing requirement of the state. 19 The baseline follows World Bank projections of real interest and inflation rates in India [World Bank 2004], and the state government’s projections for real GSDP growth rates and primary fiscal balances as specified in the government’s MTFP in September 2005. More recent projections by the World Bank on real interest and inflation rates do not differ much from those in the 2004 report. We are less interested in fine-tuning the numbers than in how the model can be applied more generally. 20Most fiscal sustainability studies use modelling frameworks without uncertainty [Burnside 2004].21 The average, annual real GSDP growth in Tamil Nadu in the 1990s was 6.4 per cent.22 The average, real interest rate in Tamil Nadu in the period 1991-2001 was 2.3 per cent. 23 We assume that revenue will grow so that its share of GSDP remains at 12.5 per cent, its projected value for 2008-09 in the MTFP.24 It is difficult to determine the likelihood of a one standard deviation shock without knowing the prob-ability distribution. Assuming a normal distribution, the probability of a one standard deviation, com-bined shock to the primary balance, real interest and growth rate is 15.9 per cent if the shocks are perfectly correlated. If the shocks are perfectly uncorrelated, the probability declines to 0.4 per cent.25 In other words, it may manage to keep its debt burden at its 2006-07 value of 27.5 per cent of GSDP.26 This simulation does not take into account any posi-tive effects on state revenue. If these effects are taken into account, the required increase in growth will be smaller than 1.6 percentage points.27 The reported deficits do not account for arrears, off-budget liabilities of public sector units, and contin-gent liabilities. 28 Tamil Nadu, for instance, can have as much as Rs 17.17 billion of central government debt written off between 2005 and 2009.29 We assume that the buoyancy of Tamil Nadu’s own tax revenue stays at 1 after 2008-09 – close to the value of 1.02, estimated by Rajaraman et al (2005) for the period 1981-2002. This implies constant tax-to-GSDP ratio after 2008-09. Similarly, we assume that the state’s own non-tax revenue is a constant share of GSDP after 2008-09. 30 We assume that in 2008-09 the share of Tamil Nadu’s central taxes in GSDP goes down and remains at 2.8 per cent – a bit lower than its lowest value (2.86 per cent in 2001-02) for the period 1990-91 to 2001-02.31 As a share of GSDP subsidies jump up to 1.8 per cent – the average for the period 1990-91 to 2004-05, and by 2026-27 gradually decline to 0.65 per cent – the value envisioned in the government’s MTFP in 2006-07. 32 Under this scenario the primary deficit is expected to deteriorate to above 1 per cent of GSDP between 2008-09 and 2018-19, before it returns to 0.9 per cent of GSDP after 2018-19.33 Source: Government of Tamil Nadu.ReferencesBurnside, C (2004): ‘Assessing New Approaches to Fiscal Sustainability Analysis’, mimeo.Celasun, O, X Debrun and J Ostry (2006): ‘Primary Sur-plus Behaviour and Risks to Fiscal Sustainability in Emerging Market Countries: A “Fan-Chart” Ap-proach’, IMF Working Paper, WP/06/XX.Domar, E (1944): ‘The “Burden of the Debt” and the National Income’,American Economic Review 34(4).International Monetary Fund (2002): ‘Assessing Sustain-ability’, manuscript, Policy Development and Review Department, International Monetary Fund, May 28. – (2003): ‘Sustainability Assessments – Review of Ap-plication and Methodological Refinements’, manu-script, Policy Development and Review Department, International Monetary Fund, June 10.Liu, Lili and Michael Waibel (2007): ‘Subnational Borrow-ing, Insolvency and Regulation’, mimeo, World Bank.Rajaraman, I, S Bhide and R Pattnaik (2005): ‘A Study of Debt Sustainability at State Level in India’, Reserve Bank of India, August.Rodden, Jonathan, Gunnar Eskeland and Jennie Litvack (2001) (eds):Decentralisation and the Challenge of Hard Budget Constraint, MIT Press, Cambridge. Wibbels, Erik (2005):Federalism and the Market: Intergov-ernmental Conflict and Economic Reform in the Devel-oping World, Cambridge University Press, New York. World Bank (2005a):Economic Growth and Poverty Alle-viation in Tamil Nadu. – (2005b):State Fiscal Reforms in India. – (2004): India Development Policy Review. World Bank and the Confederation of Indian Industry (2002):Competitiveness of Indian Manufacturing Re-sults from a Firm-Level Survey. – (2005): Second India Investment Climate Analysis Report.suggests that fiscal adjustment in Tamil Nadu has left fiscal space for increases in infrastructure investment, which may be achieved without threatening fiscal sustainability. Risks to the fiscal outlook include interest rate shocks, fiscal pressures on the primary deficit through wage shocks, subsidy increases, or de-clines in central revenue transfers. This paper discusses subnational finance issues and is subject to all the caveats pertaining to fiscal sustainability analysis at the national level. One missing piece of information is the maturity structure of government debt in Tamil Nadu. We did not have this information at the time of analysis but in the case of Tamil Nadu this is not a problem because of the relatively long maturity of, and fixed interest rates on, state public debt. Finally, it may be useful to compare Tamil Nadu, or Indian states in general, with subnational governments in other countries but we decided not to embark on this task as comprehensive subnational finance data are not yet available and key fiscal data are not defined in a consistent way across countries. We however think that such comparisons based on comprehensive data and a consistent framework are important and merit further work.

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