Reforms to India s Federal Transfer and Borrowing Regime Proposed by the Twelfth Finance Commission: what will they mean for the states?

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1 Reforms to India s Federal Transfer and Borrowing Regime Proposed by the Twelfth Finance Commission: what will they mean for the states? Stephen Howes Lead Economist (India) World Bank.

2 Structure of presentation. Analysis of transfers Aggregate Distribution Analysis of borrowing regime

3 Aggregate transfers Using projections of the 12 th FC, by 2008/09 transfers to the states will be up by 0.6% of GDP compared to 2004/05: 0.1% in grants, and 0.5% in taxes. The 0.5 percentage point increase in taxes will only happen if GoI tax/gdp increases: the increased share to the states gives an increase of only 0.1% of GDP. NB: This is also dependent on GoI revenue/gdp increasing through tax/gdp increases. In 05/06, GoI tax/gdp increase is 17% v. 04/05 BE but increase in devolution 15%. Large increase this year due to front-end loading of 12 th FC grants. 12 th FC grants increase by 0.3 percentage points over the same period, so overall benefits to states may be greater, i.e. 0.8% of GDP.

4 Grants and tax devolutions to the states over the next 5 years (% GDP) 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 05/06 06/07 07/08 08/09 09/10 taxes grants transfers

5 Distribution of transfers For tax devolutions Compare 04/05 BE and 05/06 BE For grants Compare annual average grants of the two Commissions. Analysis of distribution of transfers only covers the general category major states.

6 The distribution of transfers: grants have become more progressive; tax devolutions less so Incr in Grants (TFCover EFC) Incr in Tax dev (06 over 05) % Incr in Grants (TFC over EFC 600% 500% 400% 300% 200% 100% 0% % Incr in Tax dev (06 over 05) 50% 40% 30% 20% 10% 0% Per capita GSDPin (current prices) Per capita GSDPin (current prices)

7 Overall, transfers have become slightly less progressive. Incr in Tax dev + grants (06 over 05) % Incr in Tax dev + grants (06 over 05) 100% 80% 60% 40% 20% 0% Per capita GSDP in (current prices)

8 The richest states are the biggest gainers % Incr in Tax dev + grants (06 over 05) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 90% 59% 44% 39% 38% 36% 32% 28% 25% 23% 19% 19% 18% 8% Punjab Gujarat Haryana Maharashtra UP + Utt MP + Chh Orissa Bihar + Jh Tamil Nadu Rajasthan AP Kerala Karnataka West Bengal

9 Another way of showing that FC transfers have become slightly less progressive Concentration of Transfers : The 11th & the 12th Finance Commission Cumulative Distribution of Transfers Cumulative Distribution of Per Capita GSDP 11th Finance Commission 12th Finance Commission 45 Degree Line

10 Removal of old anomalies; creation of new? Normalized per capita transfers Orissa Bihar+Jh UP + Utt MP+Chh Rajasthan AP West Bengal Kerala Karnataka Tamil Nadu Punjab Gujarat Haryana Maharashtra 12 FC 11 FC

11 But note that poor states are still the biggest gainers relative to their economy Incr in Tax dev + Grants (by 12 FC) as a % of GSDP Incr in Tax dev + Grants as a % of GSDP ( current prices) 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Per capita GSDP in (current prices)

12 Borrowing regime GoI to stop lending to states But small savings continue. External assistance back-to-back Annual borrowing limits 3% by 09/10 (Ch 4) 4.13% 05/06, 3.75% 06/07, 3.38% 07/08, 3.0% 08/09, 3.0% 09/10 (Appendix 4.1) Containment of fiscal deficit to 2004/05 level (Ch. 12) 3.6% 04/05, 3.2% 05/06, 2.9% 06/07, 2.6% 07/08, 2.3% 08/09, 2.0% 09/10 How will limits be institutionalized and enforced?

13 Debt restructuring and relief More benefit to highly indebted states, but harder for them to qualify. Proportional benefits rather than zero-one. Given base (01/02 and 02/03 actuals, and 03/04 revised estimates), states should find it easy to qualify initially. Base is about 2.5% of GDP for revenue deficit. Revised estimate for revenue deficit for 11 states for 2004/05 is 1.3% of GDP. Will principal repayment write-offs allow greater net borrowing?

14 Summary & Conclusion Large increase in transfers to the states, but dependent on increased tax/gdp effort by GoI. Despite expressed intention to make transfers more progressive, they have been made slightly less so, at least for major states. Proposed shift to annual borrowing limits will greatly harden budget constraints facing states. With more transfers and less borrowing, states may not end up as net winners from the 12 th Finance Commission, but their resource position will be much improved: reversal of the adverse scissors trend of the nineties. If both transfer and borrowing recommendations implemented, external resource position of the states will revert to its mid-80s level: good prospects for achieving state-level fiscal adjustment. Risks: (i) GoI tax/gdp will not increase; (ii) borrowing limits will not be implemented.

15 Resources other than own-revenue used by state governments to finance expenditure /86 86/87 87/88 88/89 89/90 90/91 91/92 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 03/04RE 04/05BE Percent of GDP Borrow ed funds Transferred Funds (from GoI)

16 Thank you!