States should be encouraged to make fiscal discipline a habit

States should be encouraged to make fiscal discipline a habit

New Delhi: States should be nudged through financial incentives to continue along their path of fiscal consolidation to meet consumption expenses entirely out of their current revenue, and limit fiscal deficits to 3% of economic activity by 31 March 2015, the 13th Finance Commission (TFC) has recommended.

The proposals on fiscal consolidation are part of TFC’s overarching aim to free resources to enhance the level of public investment, and thereby, drive growth. “There is a two-way relationship between growth and fiscal consolidation, where fiscal consolidation leads to higher growth due to higher levels of public and private investments," the report said.

The recommendations are tailored to the needs and development of individual states. The pace of recommended reform varies according to the categorization of a state. Special-category states, which are largely hill states and those of the North-East, have longer adjustment periods. However, all states are required to reach the same milestone by March 2015.

Also See | Two-way relationship (Graphic)

The recommendations on states’ fiscal consolidation have been linked to the consolidation path the Centre has been asked to follow. However, the road map over the next five years for states is easier than that of the Centre as states have already made significant fiscal progress over the last five years.

As a group, states have to trim their fiscal deficit to 2.4% of gross domestic product (GDP) by end 2014-15, which is just 40 basis points lower than what they are expected to record at the end of the current fiscal. A basis point is one-hundredth of a percentage point. In the case of revenue deficit (excess of current expenses over current revenue), the states have been asked to collectively bring it down to zero.

The road to states’ fiscal consolidation would be backed by legislation. All but two states, West Bengal and Sikkim, have enacted a Fiscal Responsibility and Budget Management (FRBM) Act. TFC recommends that states codify the new targets in their existing FRBM or introduce it if they do not have one.

To make sure states move further along the path of fiscal consolidation, TFC has recommended an architecture with a set of in-built incentives. Some of the state-specific grants received from the Union government are linked to relevant amendments to existing FRBM plans. In addition, the Union government has been asked to set borrowing limits for states.

The Centre’s action taken report on TFC, which was also tabled in Parliament on Thursday, said it accepted this recommendation “in principle". The architecture proposed by TFC supplements incentives with suggestions on structural reforms in government debt mechanisms to lessen the burden on states.

Deposits in small savings schemes such as public provident fund are collected by the Centre, but largely transferred to states in the form of loans at almost 2 percentage points over what the Centre borrows at from the bond market. TFC has recommended loans to states from small savings be priced at 9%, which is up to 1.5 percentage points lower than what they currently pay. States would collectively reduce their interest by Rs13,517 crore over a five-year period on account of this recommendation. Simultaneously, TFC recommended, small savings schemes’ interest rates be brought in sync with market rates instead of being fixed administratively. The Centre has accepted both the recommendations in principle as an internal committee will need to be set up to work out the details.

TFC has also suggested that loans from the Union government to the states, administered by ministries other than finance, be written off. The Centre’s action taken report has promised to consult all the ministries on this recommendation.

Graphic by Yogesh Kumar / Mint