Nirupam Bajpai and Jeffrey D. Sachs

Development Discussion Paper No. 719 September 1999

Abstract

The financial condition of the state governments in India has been a cause for concern for sometime now. Over the years, the consolidated financial position of the state governments has shown a marked deterioration in some of their major deficit indicators. One of the fundamental weaknesses of state government finances in India can be attributed to the increases in non- developmental expenditure, particularly the revenue component of the non-developmental expenditure, and interest payments as a proportion of revenue receipts. Structural imbalances in the form of large revenue deficits, rising interest burden, increasing distortions in the pattern of expenditure, and very slow growing non-tax revenues are major problem areas for state finances.

These problems have been aggravated a great deal over the past few years because of a variety of reasons. The resource constraints in state finances have been accentuated by a near stagnant tax-GDP ratio, rising share of non-developmental outlay in the total expenditure, large volumes of hidden or implicit subsidies and increasing financial losses of state enterprises. A growing pressure on state finances has also stemmed from the rising demand for public services. Furthermore, the fiscal situation in the states is likely to come under much greater pressure with the acceptance of the Report of the Fifth Pay Commission by several state governments in India. Be that as it may, the critical problem in state finances is not only one of high levels of expenditure, but also one of increasing distortions in the pattern of expenditure.

The three different methods of intergovernmental fiscal transfers have resulted in an inefficient transfer mechanism that has increased bureaucracy at the state level, accommodated numerous interest groups, and delinked plan requirements of states from actual transfers. Similarly, better fiscal performance is not acknowledged with higher transfers, instead the gap filling approach of the Finance Commission discourages fiscal discipline in the states.

In the area of expenditure reduction, we have identified several potential areas for controlling expenditure of the state governments. In our view, by raising user charges on water in accordance with the costs incurred in providing water, and aligning tariff rates of the SEBs in line with their costs, the state governments could significantly cut their budgetary losses. In addition, a freeze on state government employment can help save scarce resources to be used for productive purposes elsewhere in the states.

JEL Code: H72, H77
Keywords: Indian states, sub-national finances, intergovernmental transfers, expenditure reform

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