Budget Cafe 2016: Fiscal responsibility key to cooperative federalism

By: | Updated: February 8, 2016 10:27 AM

In the upcoming Budget, the govt should stick to the announced fiscal consolidation path, as deviating from it will make it harder for the Centre to instil greater discipline on states and PSUs.

BUDGETIf the government were to relax the path of fiscal consolidation again, there would be a lot of risks involved.

In the run up to the 2016-17 Budget, it is good that the finance ministry has clarified it plans to stick to fiscal consolidation. Having relaxed the fiscal consolidation path once last year from a central fiscal deficit of 3.6% of GDP to 3.9%, the finance minister will lose a lot of credibility if he were to relax it again this year, especially at a time when oil prices are expected to remain low and provide India with terms of trade windfall.

If the government were to relax the path of fiscal consolidation again, there would be a lot of risks involved. First, the step could increase inflationary expectations. Seasonal food price increases signal supply bottlenecks, but higher fiscal deficits could translate these seasonal price spikes into more sustained inflation. Second, it would make RBI pause in reducing interest rates—which it should do—and further slow down economic recovery. Third, it would scare foreign investors, who are already worried about the slow pace of reforms, and increase capital outflows from India, weakening the rupee faster. A weaker rupee would wipe out much of the fiscal space created by a higher fiscal deficit.


Instead of playing with fiscal consolidation, the government should focus instead on the consolidated fiscal deficit, which is the combined deficit of the non-financial public sector, also known as the public sector borrowing requirement (PSBR). It should now stick to the announced central fiscal deficit targets of 3.6% of GDP in 2016-17 and 3% of GDP by 2017-18. At the same time, the government needs to begin focusing on the consolidated public sector, especially with the 14th Finance Commission giving more funds to the states and with a large PSU sector with assets of $500 billion (almost 25% of GDP).

PSBR is defined as the sum of central fiscal deficit (central fiscal dis-savings), the combined state fiscal deficit (state fiscal dis-savings) plus the savings of the PSUs. The web of financial flows between the PSUs and the government is not easy to untangle. There are around 290 PSUs at the central level and over 1,000 at the state level. Calculating the net savings of the PSUs requires detailed data from each enterprise. Almost one-third of PSUs at the central level run losses, while overall the PSUs turn in a profit.

Using reported data, we can get a rough estimate of PSBR in two different ways. PSBR-1 uses the net domestic savings of the PSUs, which includes the net savings of the non-departmental PSUs and of autonomous institutions, as reported in the National Accounts by the Central Statistics Office (CSO).

PSBR-2 uses the net profits of the PSUs calculated from public enterprise surveys. These numbers do not include transactions between the public financial sector (state banks) and non-bank financial institutions, and the government. Fortunately, the two methods give quite similar results for PSBR for the period 1997-98 to 2014-15 (see charts).

PSBR tells us how much overall financing is needed in the economy to finance the public sector as a whole, and not just the central government. PSBR reached a peak of around 8% of GDP is 2009-10 and has declined since, but remained close to 6% of GDP in 2014-15. PSBR and the Centre’s fiscal deficit have not often in the past but lately moved in opposite directions—for example, the central fiscal deficit improved between 2012-13 and 2014-15, but PSBR increased substantially because the state fiscal deficits increased and the net savings of PSUs declined.

We are seeing considerable deterioration in the finances of the state governments and the PSUs in the last few years, a worrisome trend that is likely to continue unless there greater focus is given on it. The states with a declining trend in finances have been Bihar, Chhattisgarh, Goa, Maharashtra, Odisha, Rajasthan, Tamil Nadu, Uttarakhand and several from the Northeast. While Kerala and Karnataka have shown an improving trend, they continue to run high fiscal deficits.

Many federal countries now report a consolidated fiscal budget to their legislatures for approval, especially Brazil, Canada and the UK, among others. It is time for India to shift to a consolidated budget of the Centre, states and PSUs. There is too much attention on the central budget but increasingly it will give us only a partial picture of government finances. As the states get more fiscal autonomy, they may end up running much larger fiscal deficits, as had happened in Brazil in the 1990s, leading to a debt crisis and forcing a shift to consolidated fiscal accounts.

In the upcoming Budget, the government should stick to the announced fiscal consolidation path, as deviating from it will be dangerous for its credibility and will make it even harder for the Centre to instil greater discipline on the states and the PSUs whose imbalances have important macro-economic impacts as well. With cooperative federalism comes consolidated fiscal responsibility.

The author is a visiting distinguished professor at NIPFP and visiting scholar at the Institute for International Economic Policy at George Washington University

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