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Macro Policy Reform and Sub-National Finance: Why Is the Fiscal Space of the States Shrinking?

Macro Policy Reform and Sub-National Finance: Why Is the Fiscal Space of the States Shrinking?

In the post-economic liberalisation era, financial sector and fiscal reforms by the central government have adversely affected sub-national finances. The centre's fiscal consolidation measures have contributed to the sharp decline in vertical transfers and the financial liberalisation-induced increase in interest rates has widened the resource gap of the states through an increase in the interest outgo on the stock of debt. This paper examines the effect of the fiscal imbalance on the sub-national fiscal space. Econometric estimates reveal that though the effect of the cost of debt on total expenditure is expansionary, it is negative with respect to the fiscal space. As the sub-national fiscal space has been shrinking, corrective measures are required to increase the states' ability to fulfil developmental fiscal needs.

SPECIAL ARTICLEApril 4, 2009 vol xliv no 14 EPW Economic & Political Weekly38Pinaki Chakraborty (pinaki@nipfp.org.in), Anit N Mukherjee and H K Amarnath are at the National Institute of Public Finance and Policy, New Delhi.Macro Policy Reform and Sub-National Finance: Why Is the Fiscal Space of the States Shrinking?Pinaki Chakraborty, Anit N Mukherjee, H K AmarnathIn the post-economic liberalisation era, financial sector and fiscal reforms by the central government have adversely affected sub-national finances. The centre’s fiscal consolidation measures have contributed to the sharp decline in vertical transfers and the financial liberalisation-induced increase in interest rates has widened the resource gap of the states through an increase in the interest outgo on the stock of debt. This paper examines the effect of the fiscal imbalance on the sub-national fiscal space.Econometric estimates reveal that though the effect of the cost of debt on total expenditure is expansionary, it is negative with respectto the fiscal space. As the sub-national fiscal space has been shrinking, corrective measures are required to increase the states’ ability to fulfil developmental fiscal needs. 1 IntroductionIn federal countries, the fiscal relationships across levels of governments are broadly defined in terms of functions and finances with a specified design of intergovernmental trans-fers to correct for vertical and horizontal imbalances.1 However, within this broad defined relationship, there could be an asym-metric impact of exogenous shocks on a particular tier of govern-ment compared to the other tiers, depending on the nature and the process of shocks. Such shocks could be many, for example, changes in macroeconomic policy, financial liberalisation and deregulation of the interest rate or a fiscal restructuring programme. There could also be shock-induced changes in the nature and the degree of interdependence across levels of governments.2There has been a macro policy reform and a large-scale fiscal restructuring programme underway both at the central and state level in India over the past one and half decades. The reform pro-gramme was initiated due to the unprecedented macroeconomic crisis of 1991 reflected in burgeoning public sector deficits and debt, widening current account deficits in the external account and dwindling foreign exchange reserves.3 In the face of this cri-sis, the central government has undertaken a large-scale fiscal reform programme since the beginning of 1990s and different states have undertaken fiscal consolidation measures at different points of time during the 1990s and also during the current dec-ade.4 The fiscal restructuring programmes at both levels of gov-ernments are aimed at achieving fiscal sustainability through restructuring of tax and expenditure policy of both tiers of gov-ernment. Fiscal restructuring at the central level comprises rapid reform in direct and indirect taxes, expenditure restructuring and disinvestment of public sector enterprises. In the face of a declining tax toGDP ratio, the fiscal correction at the central level was achieved through a large cut in discretionary government expenditure, primarily, capital expenditure.5 Also during this period, there was a decline in the central transfers to the states, particularly the transfers through grants, which has adversely affected the states’ fiscal situation.The fiscal reforms affecting sub-national finances in India in the last one and half decades are many and relate to all aspects of sub-national fiscal policy, viz, tax, expenditure and debt manage-ment and interest rate policies and intergovernmental transfers. It has been observed that economic liberalisation since the early 1990s has unleashed competition among sub-national governments, and this has brought to the fore the central role of incentives inensuring sound fiscal practices at all levels of governments
1980-81 1982-83 1984-85 1986-87 1988-89 1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 Transfers Revenue Receipts Own Revenue
0 0 0 1981-82 1983-84 1985-86 1987-88 1989-90 1991-92 1993-94 1995-96 1997-98 1999-00 2001-02 2003-04 RE
45 55 65 75 85 95 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 Percentage of Revenue Expenditures Percentage of Revenue Receipts Percentage of Total Expenditures
BiharUttar PradeshOrissaAssamMadhya PradeshRajasthanWest BengalAndhra PradeshKarnatakaTamil NaduGujaratKeralaHaryanaPunjabMaharashtra Debt/GSDP Per capita/GSDP
SPECIAL ARTICLEEconomic & Political Weekly EPW April 4, 2009 vol xliv no 1443satisfactory, it is generally better for the latter. The parameter estimates are also robust to alternative specifications, and no random changes in signs are noticed. We can therefore say with confidence that our model captures in a significant way the im-pact of state level own revenue, transfers and average cost of debt on the fiscal space.Coming to the specific estimate for total expenditure in Table 5, we observe that there is no significant difference in parameter estimates between the fixed effects regression and GLS1. However, they are sensitive when we control for heteroskedastic panels and for autocorrelation. For GLS2, the estimated elasticity of own revenue and transfer vis-à-vis total expenditure is reduced, while that of the average cost of debt rises significantly to more than one. If we correct for autocorrelation inGLS3, the estimated elasticities of own revenue and transfer increase, while that of average cost of debt falls significantly. The best fit as determined by Wald chi-square statistics however is forGLS2, which indicates a high positive and significant impact of average cost of debt on fiscal space in terms of total expenditure by sub-national entities.In Table 6, the estimates for primary expenditure are far more robust. This might be due to the construction of the proxy for fiscal space, where we net out interest payments from total expenditure. The most striking difference is that the estimated elasticity of primary expenditure and the average cost of debt is significantly negative. This would point to a differential impact of financial market liberalisation on fiscal space as defined by total expenditure and primary expenditure. The parameter estimates show an increase betweenGLS1 and GLS2 for own revenue, while it is the opposite in the case of transfers. The negative impact of the average cost of debt is strengthened when we control for heteroskedasticity across panels. For this proxy of fiscal space also, GLS3 gives the best fit among all the alternatives considered.To summarise, the impact of own revenue, transfers and cost of debt on total expenditure is unambiguously expansionary. The highest partial elasticity is either for own revenue or the average cost of debt, depending on the chosen specification. Our model selection criterion based on Wald test indicates that the impact of the cost of debt is significantly above unity.The impact of own revenue and transfers on primary expendi-ture is positive and significant. However, in contrast to total expenditure, the elasticity of primary expenditure vis-à-vis the average cost of debt is unambiguously negative of the order of around 3.8%. Therefore, in the past two decades, the sub- national fiscal space as defined by primary expenditure has been shrinking in the face of an increase in their cost of borrow-ing by states. 5 ConclusionsOn the basis of the above findings it can be concluded that in the post-economic liberalisation era in India, fiscal reforms at centre and the financial sector reforms have adversely affected sub- national finances. The centre’s fiscal consolidation measures con-tributed to the sharp decline in the vertical transfers and the financial liberalisation-induced, increase in interest rates has widened the states’ resource gap through an increase in interest outgo on the debt stock. This paper has examined the effect of the shock-induced increase in the fiscal imbalance on sub- national fiscal space. Though there are sharp interstate differences, the analysis revealed that fiscal and macro-policy shocks have reduced the fiscal space across states with varying degrees. It has also been revealed that the problem is more for low per capita income states with a larger stock of outstanding debt vis-à-vis high and middle-income states. The econometric estimates revealed that the impact of own revenue, transfers and cost of debt on total expenditure is expansionary, but the elasticity of Table 4: Summary StatisticsVariable ObservationsMeanStandardDeviationMinMaxTotal expenditure 322 17.60 2.68 11.11 30.47Primary expenditure 322 15.49 2.22 9.83 24.53Own revenue 322 8.79 2.09 4.47 20.43Transfer 322 4.882.39 1.28 15.74Average cost of debt 322 9.80 2.56 0.78 15.8Table 5: Estimation Results for Total Expenditure Fixed Effects GLS1 GLS2 GLS3Constant 1.371 (13.54) 1.317 (12.57) 0.573 (13.85) 1.394 (14.89)Lnownrev 0.464 (10.72) 0.464 (11.01) 0.145 (15.76) 0.532 (14.56)Lntransf 0.205 (7.19) 0.205 (7.39) 0.061 (6.13) 0.134 (5.42)Lnacdebt 0.083 (5.30) 0.083 (5.44) 1.221 (4.85) 0.033 (2.29)R-squared 0.425 Wald Chi-sq 741.41 843.50 477.59Table 6: Estimation Results for Primary Expenditure Fixed Effects GLS1 GLS2 GLS3Constant 1.442 (15.33) 1.407 (14.45) 1.328 (15.41) 1.361 (14.48)Lnownrev 0.470 (11.66) 0.470 (11.98) 0.526 (14.37) 0.519 (13.56)Lntransf 0.238 (9.01) 0.238 (9.26) 0.218 (9.53) 0.194 (7.82)Lnacdebt -0.032 (-2.19) -0.032 (-2.25) -0.038 (-3.41) -0.030 (-2.22)R-squared 0.611 Wald Chi-sq 839.34 892.35 575.51Medical Pluralism in Contemporary India(Forthcoming – April/May 2009)The Patient as a Knower: Principle and Practice in Siddha Medicine V SujathaMedicine as Culture: Indigenous Medicine in Cosmopolitan Mumbai Leena AbrahamMedicine, State and Society: Indigenous Medicine V Sujatha, and Medical Pluralism in Contemporary India Leena Abraham ‘Commercialising Traditional Medicine’: Ayurvedic Manufacturing in Kerala M S HarilalRecovering from Psychosocial Traumas: Bhargavi V Davar, The Place of Dargahs in Maharashtra Madhura LohokareStrengthening Childbirth Care: Can the Maternity Services Open Up to the Indigenous Traditions of Midwifery? Mira Sadgopal
SPECIAL ARTICLEApril 4, 2009 vol xliv no 14 EPW Economic & Political Weekly44Notes1 The vertical imbalance arises due to the asym-metric assignment of functional responsibilities and financial powers between different levels of governments and horizontal inequalities are the existing disparities in the revenue capacity across the constituent units of federation, which mainly arise due to the differences in their levels of in-come.2 A fiscal restructuring shock and associated fiscal austerity measure at the central government level could reduce the volume of transfers to the lower tier of government and thus the degree of depend-ence. This has particularly been the case in India after fiscal reform was introduced. 3 For a detailed analysis of the factors contributed to the crisis of 1991, see Joshi and Little (1994). Also see Buiter and Patel (1992, 1996, 1997), Srini-vasan (2001). 4 For an account of the state-level fiscal reform see World Bank (2005).5 For an analysis of the fiscal reform outcome see Joshi and Little (1997), Pinto and Zahir (2004) and Mohan (2000). 6 The central government has signed MOUs with most of the states and introduced additional in-centive-based bailout schemes such as the accel-erated power development programme and accel-erated irrigation programme (Rao 2002).7 The debt to GDP ratio of the centre increased from 40.44 to 63% between 1981-82 and 2002-03. Dur-ing the same period, the increase in the debt ratio of the states was from 16.77 to 27.80%.8 Chakraborty (2005) noted that in the deregulated interest rate regime, the structure of the out-standing market loans of the state government is heavily skewed towards high cost loans compared to the central government and that the debt con-tracted at a higher rate by the states vis-à-vis cen-tre has increased the interest cost of debt in a sig-nificant manner.ReferencesBuiter, W and U Patel (1992): “Debt, Deficits and Infla-tion: An Application to the Public Finances of India”, Journal of Public Economics,47, pp 171-205. – (1996): “Solvency and Fiscal Correction in India: An Analytical Discussion” in S Mundle (ed.),Fis-cal Policy in India (New Delhi: Oxford University Press). – (1997): “Budgetary Aspects of Stabilisation and Structural Adjustment” in M Blejer and T Ter- Minassian (ed.),Macroeconomic Dimensions of Public Finance: Essays in Honour of Vito Tanzi (London and New York: Routledge), pp 363-412.Chakraborty, Pinaki (2005): “Debt Swap in a Low Interest Rate Regime: Unequal Gains and Future Worries”,Economic & Political Weekly, 1 October, pp 4357-62. GoI (2000):Eleventh Finance Commission Report (New Delhi: Government of India). – (2004): Twelfth Finance Commission Report (New Delhi: Government of India).Heller, P (2005): "Back to Basics – Fiscal Space: What It Is and How to Get It”, Finance and Development http://www.imf.org/external/pubs/ft/fandd/2005/06/basics.htm#authorJoshi, Vijay and I M D Little (1994): India-Macro-economics and Political Economy, 1964-1991, First Edition (New Delhi: Oxford University Press). – (1997): India’s Economic Reforms, Second Edition (New Delhi: Oxford University Press).Mohan, Rakesh (2000): “Fiscal Correction for Eco-nomic Growth: Data Analysis and Suggestions”, Economic & Political Weekly, 10 June, pp 2027-36. Pinto, Brian and Zahir Farah (2004): “Why Fiscal Adjustment Now”, Economic & Political Weekly, 6 March, pp 1039-48. Rao, M Govinda (2003): “Incentivising Fiscal Transfers in the Indian Federation”,Publius:The Journal of Federalism, 33, pp 43-62. –(2002): “State Finances in India: Issues and Challenges”, Economic & Political Weekly, 3 August, pp 3261-71. Srinivasan, T N (2000): “India’s Fiscal Situation: Is a Crisis Ahead?”, http://www. econ.yale.edu/~ srinivas/FiscalSituation.pdfWorld Bank (2005): State Fiscal Reforms in India: Progress and Prospects, First Edition (New Delhi: Macmillan).1. Ford Foundation Chair in Women and Food SecurityJob Description: Develop and carry out a programme of research and education, guide research, conduct training and orientation for policy makers and trainers, and undertake advocacy in the area of women and food security.Qualification: Ph.D. in any Social Science (preferably Economics) and at least ten years experience, with evidence of strong interest in women’s/gender studies, and good record of work in research and teaching, and /or field programme related to women’s/gender issues and food security. Qualifications in women’s/gender studies will be an advantage.Salary scale: Appropriate level in 22000-1000-30000 grade, with permissible allowances (under revision).2. Coordinator, The Hindu Media Resource CentreJob Description: Identify communication strategies to use massmedia as a tool for communication; prepare theme-based films; organize media workshop/seminars/lectures/public forum on topical scientific issues; establish network with universities, colleges, media houses, organizations, NGOs and other related institutions; training and capacity building on development journalism; image management, media relations, strengthen science and society linkages through media. Qualification: Candidate should possess Post graduate in JMC/Media Science/Visual Communication/Public Relation with 4-5 years of relevant experience. Strong language skills in English, Hindi and Tamil and operational knowledge in computer packages, such as, MS Office, are mandatory. Candidates should also have strong inter-personal skills.Salary scale: Appropriate level in 17000-1000-25000 grade, with permissible allowances (under revision).Application should include complete biodata showing academic record, area of specialization, field and duration of experience, names and addresses of two referees who during the last five years have had close familiarity with the candidate’s professional strength and address of past employers, if any. Application should be sent to Manager (P&A), M. S. Swaminathan Research Foundation, 3rd Cross Road, Taramani Institutional Area, Chennai 600 113, email: hari@mssrf.res.in before April 15, 2009.primary expenditure vis-à-vis the average cost of debt is negative of the order of around 3.8%. Thus, it can be concluded that in the past two decades, the sub-national fiscal space has been shrinking in the face of an increase in the cost of borrowing. Cor-rective measures are required to widen the fiscal space for devel-opmental fiscal needs.

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