6.1 FINANCES OF GOVERNMENTS AND THEIR CAPACITY TO SPEND

                                                                                                                               Tapas K. Sen

The states account for a large part of the total government expenditures in India, and an even larger part in the functions or domains of social and economic infrastructure. In the area of social services, in particular, the states account for the bulk (more than 80 per cent) of government expenditure. Among the economic services, railways, civil aviation, ports and shipping, posts and telegraph, and telecommunication are major infrastructure areas where the central government either has exclusive jurisdiction or dominates. Power is an area where originally the states dominated, but the central government started to supplement the state-level expenditures substantially in the late 1970s, and now it has a considerable presence in this sector. But areas like irrigation, road transport, food storage and warehousing, water supply and housing are among the infrastructure services that are still dominated by the states. Clearly, the development of infrastructure as a whole, and particularly of those that cater to the immediate needs of ordinary citizens, depends heavily on the states themselves. It is not necessary that the state governments must spend out of their own budgets in all of these areas. Their constitutional responsibility is to ensure provision and not necessarily production or supply. But it is the policies that they adopt that, in a large measure, determine the development of infrastructure. Supply, of course, becomes their responsibility when private supplies are lacking or inadequate. Doing justice to so many services requires adequate financial capacity on the part of the state governments, both for investment and for maintenance of physical assets already created through earlier investments. Do they have the required capacity? This section argues

that if present trends in state finances, continue unchanged, then the states will increasingly fall behind in that capacity. Most of the states are already in financial difficulties and their indebtedness is rising. Direct and indirect (off-budget) liabilities have risen. Strong measures are urgently called for. Even for private-sector involvement, both financial and organizational capacity would have to improve substantially through Private Finance Initiatives (PFIs) and Public Private Partnerships (PPPs).

OVERVIEW OF STATE FINANCES

Table 6.1.1 provides the most telling indicators of the health of state finances in India in recent years. The debt of states as a ratio of gross domestic product (GDP) in 2001– 2 shows a rise of 4.5 percentage points over the figure for 1990– 1. What is more, the rise is by more than 6 percentage points from the low figure of 17.8 in 1996– 7 during the 1990s. If one considers the state-provided guarantees too, these liabilities are about 28 per cent of the GDP. As is seen further on in this section, there are also other liabilities of the state governments, primarily the resources withdrawn from the Public Accounts largely consisting of funds entrusted to the government in its role as a banker. Table 6.1.1 also shows the rise in interest payments as a ratio of their revenue receipts consequent to the rise in indebtedness in the1990s. The ratio went up from 13 per cent to a high of 21.8 per cent from the beginning to the end of the decade. In the latest year, it exhibits a drop, probably because of the lowering of interest rates. Along with the interest payments, primary deficit also was rising

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fast in the second half of the 1990s, but shows a reversal of the trend after 1999– 2000. The last column shows the states' own revenue (SOR) as a ratio of their aggregate expenditure, that is, the part of total expenditures financed by resources raised by them. This ratio shows a persistent fall again from 1995– 6 to 2000– 1, and shows a reversal only in the budget estimates of 2001– 2, the actual realization of which is uncertain. A state-wise overall summary measure of financial health— fiscal deficit to net state domestic product (NSDP)— is given in Table 6.1.2. The figures clearly show that it is the less-developed states like Bihar, Orissa, and Rajasthan that have the worst values of the indicator. West

Bengal among the middle-income states also exhibits a high fiscal deficit to NSDP ratio. The trend over the years varies significantly. Although the overall trend is one of rising deficits, the figure has shot up in Orissa from 6.4 per cent in 1990– 1 to 11.4 per cent in 1999– 2000, while Punjab has managed to pull the ratio down from 7.4 to 5.8 per cent during the same period. Here again a rise from 1995– 6 to date, may be seen. In some states, a fall in the ratio from 1990– 1 to 1995– 6 may also be noticed. Table 6.1.3 provides essentially the same information as in Table 6.1.1, but for selected individual states. It is to be noted that primary deficit to NSDP ratio has risen in only seven states out of 16— Haryana, Himachal Pradesh, Madhya

Pradesh, Maharashtra, Orissa, Rajasthan and West Bengal. For the other states, any rise in fiscal deficit is due only to the rising interest burden, although the latter is a general phenomenon observed in all the states except Bihar, as shown by the fall in the ratio of interest burden to revenue receipts. The highest level of indebtedness is observed for Himachal Pradesh, followed by Orissa and Bihar. Among the relatively high-income states, only Punjab exhibits an indebtedness level almost as high as Bihar.

All States Under Strain

The discussion above shows that the finances of all states are under increasing strain, though with significant differences. In this situation of fiscal strain, undertaking new expenditure on infrastructure by the state governments is highly unlikely. Fiscal stress results in expenditure compression beginning with capital expenditures. The expenditures with the least developmental impact are usually protected due to their contractual nature (for example, interest payments) and/ or strong lobbies (wages and salaries). As a result, expenditure on maintenance of assets, particularly the non-wage type, often gets compressed too. This is not to say that fiscal reform to remove fiscal imbalances is in principle not compatible with increased expenditure on infrastructure. In fact, reprioritization of expenditures should be an integral part of any fiscal reform programme at the state level, without

which any improvement will be only temporary. But a de facto substantial rise in infrastructure spending by the state governments at this stage is probably unlikely in the short to medium run. Ensuring adequate maintenance of existing assets would probably be more realistic.

FINANCING OF GOVERNMENT EXPENDITURES AT THE STATE LEVEL

Table 6.1.1 shows that own revenues of states as a whole cover only a little more than 40 per cent of aggregate expenditures. The other ways of financing would necessarily be either central transfers or those that form financing components of fiscal deficit. Taking the financing of fiscal deficit first, Table 6.1.4 provides data on the broad financing components of fiscal deficit of states. The two main sources of funds to finance fiscal deficit are shown to be loans from the central government and 'other' sources including negotiated loans, provident fund and public accounts items. Central loans accounted for between 40 and 55 per cent of the total liabilities of the states until 1998– 9. The ratio dropped suddenly from the next year because of a change in accounting practice that shifted the small savings loans out of the central government loans into a special fund created to handle all transactions relating to small-savings' collections. This sharp drop is therefore mirrored in a large increase in

the 'other' sources of resources. Apart from this reason, the 'other' loans have also risen because of increasing use of these sources of funds. Provident funds have become an important mechanism to postpone the immediate expenditure impact of the wage revisions through impounding part or whole of salary arrears payable; this also provides a way to allow rise in deficits without any liquidity requirement. Negotiated loans have been rising mainly as a result of increasing plan sizes approved by the Planning Commission, which are generally easy to finance through negotiated loans from the financial institutions. Lastly, increasing use of instruments like public ledger accounts and involuntary deposits from parastatals has provided some of the state governments with the much-needed resources to finance their deficits.

Off-Budget Items Increase

Besides the budgetary sources of funds, most state governments have resorted to increasing use of off-budget

borrowings (through guaranteed loans incurred by public enterprises and other government agencies— see (Table 6.1.5) and accumulating short-term liabilities like arrears of payments due to contractors and suppliers (an important example is the huge arrears of payments due to the National Thermal Power Corporation (NTPC) from various states towards purchase of power by the state electricity boards (SEBs)). Of these, the states have no choice but to attend to the arrear dues of public sector undertakings (PSUs) owned by the central government in the power sector as these PSUs have started a campaign to pressurize the defaulting states to pay up by withholding a part of the allotted quota of power to them. The rescheduling of these loans are linked to the pursuit of reform as suggested by the Ahluwalia Committee report. In future, the major problem could be with the guarantees provided by the state governments, which have risen substantially since the end of the 1990s to cross 6.4 per cent of the GDP today. These

non-plan grants are generally tied or conditional grants for specific schemes and programmes while the non-plan loans are a mixed bag. Plan transfers— grants and loans— are in principle to be used to finance plan schemes only, but in practice are to a large extent fungible. Table 6.1.6 provides information on the major types of transfers in the past. It may be noted earlier in this section that net loans from the central government have been considered as a source of financing fiscal deficit. The difference in the numbers are because of the difference in the coverage of the two sources of data: while the Reserve Bank of India (RBI) data in Table 6.1.4 pertain to full-fledged states only, the data in Table 6.1.6 include figures for union territories with legislature.

Shared Taxes Increase

It can be seen from Table 6.1.6 that within current transfers, shared taxes have become more prominent and statutory grants have tended to shrink as a proportion of the total transfers. Net loans from the centre have also become less significant as a source of funds for the states, as noted earlier, although they register a rise in 1999– 2000. The drop in statutory grants was a result of the relevant award of the Tenth Finance Commission, which designed the grants to taper off to zero over varying time periods (within a maximum of five years) for different states. In general, however, the Finance Commissions have lately adopted a stance that channels a greater part of the transfers awarded by them through shared taxes. Now, of course, a fixed ratio of central tax collections (not specific taxes as earlier) are to be passed on to states as their share, and hence the

are contingent liabilities with a high probability of devolving on the state governments in some form, as most of the public enterprises or local bodies that have contracted these liabilities may not be able to pay up regularly from their own resources. Any prudent assessment of the states' capacity to spend significant amounts on infrastructure must also consider the current and future limitations imposed by these liabilities. Central transfers to states consist of shared taxes (collected by the central government), grants and net loans. Both grants and loans can be plan or non-plan. Of these, shared taxes and (the bulk of ) statutory grants within the non-plan grants are completely untied transfers to be spent by the states according to their own preferences. Non-statutory,

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amount transferred through this mechanism will depend on the overall buoyancy of central tax collections. The bottom line is that net transfers to states dropped from 32 per cent of total central receipts in 1990– 1 to 24 per cent in 1999– 2000. Obviously, this is not a source of funds that can expand enough to allow any significant step-up of state expenditures on infrastructure, particularly with the centre trying to contain the deficits at its own level.

GENESIS OF FISCAL IMBALANCE AT THE STATE LEVEL

It is tautological to say that the fiscal imbalance at the state level arose because their expenditures grew faster than their receipts. But it does help to note that the annual growth of revenue (current) receipts actually rose from 15.2 per cent observed in the second half of the 1970s to 15.6 per cent in the 1980s, notwithstanding which imbalances arose for the states as a whole only in the mid-1980s. The reason, of course, is that considering the same time periods, annual growth of total revenue expenditure jumped from 14.5 per cent to 17.5 per cent (Table 8 in Anand, Bagchi and Sen, 2002, p. 30). The figures do tend to put the burden of explaining the emergence of deficits, and their gradual worsening, on the expenditure side of the state budgets. Having said that, there is no single convincing explanation of why growth of expenditures accelerated in the 1980s. Several hypotheses have been put forth in the literature that make relevant points; the truth is probably a combination of all these factors, and the timing of the accelerated growth of public expenditures may simply be explained by a fortuitous combined effect that generated a critical push for expenditure growth. The accelerated growth, as will be seen below, created a vicious circle that made fiscal correction rather difficult. Some of the factors that could explain the emergence of fiscal imbalance are summarized below. While a few are structural or institutional in nature, others are results of adopted policies— both within and outside the control of the state governments.

Rising Plan Size

Planning— both the specific features of the system as practised in India and the size— has often been advanced as an important contributory factor to state-level fiscal imbalance. It may not be only a coincidence that the beginning of the fiscal problems of the states and the massive increase in the size of the Five Year Plan from the sixth one onwards (Bagchi and Sen, 1991) both occurred in the 1980s. 1 Moreover, there were features of the system that have been

1 In current prices, the public-sector plan outlay at the state level went up from Rs 14,986 crore during the Fifth Plan (1974– 5 to

held responsible for the adverse fiscal impact on the states. Both the Tenth and the Eleventh Finance Commissions have singled out the failure of the planning system in India to clearly demarcate current and capital components, leading to imprudent financing patterns. This, in turn, is thought to have resulted in medium and long-term damage to the states' fiscal position. Budgetary imbalances at the state level can also be traced to the 70: 30 ratio applicable to central assistance for state-plan schemes, signifying the split between loan and grant components, respectively. The ratio was meant to correspond to the division of plan expenditures into the capital and the revenue account. For various reasons, the revenue expenditure component of total plan expenditures has steadily risen, and stood at above 54 per cent in 1998– 9. This implies an inherently unsustainable practice of debt financing of an increasing part of revenue expenditures on plan account. Another feature that has often been criticized as raising state expenditures is the way centrally-sponsored schemes first lure the states into certain schemes under the 'Plan' umbrella with full or partial funding from the centre, but leaving them with the entire burden of the scheme— or the difficult task of winding them up— subsequently.

Perverse Incentives in Fiscal Transfer

The system of central transfers to states also contained perverse incentives for their prudent fiscal behaviour. Most important among them is the gap-filling approach that provides grants to states linked to deficits estimated for the award period, essentially projected on the basis of actual receipts and expenditures in the base year. It has sometimes been wrongly asserted that regional fiscal equalization promotes inefficiency. Mainly because of the posturing by some political leaders that was taken up by the popular media and some commentators, the equity versus efficiency debate resurfaced after the Eleventh Finance Commission submitted its report. In fact, if transfers are linked to fully normative assessments of receipts and expenditure, both equity and efficiency objectives are served simultaneously; the challenge lies in designing such a system in a way that is generally intelligible and practical.

Budgets are 'Soft'

The weakest incentives for fiscal balance at the state level are probably to be found in the lack of a hard budget constraint, or the relative ease with which various formal constraints on deficit financing at the state level can be

1978– 9) to Rs 51,467 crore during the Sixth (1980– 1 to 1984– 5) and to Rs 91,009 crore during the Seventh (1985– 6 to 1989– 90). The bulk of these large outlays during the Sixth and Seventh Plans were debt-financed.

bypassed. Among the important reasons for the softening of the budget constraint are:

° lack of moral authority on the part of the central government to prevent imprudent levels of borrowing by states, 
° open-ended nature of sources of debt like small-savings, loans and provident fund;
 ° misuse of ways and means and overdraft facility provided by the RBI;
 ° inadequate project appraisal for financial viability by various financial institutions lending to state governments, particularly for plan schemes;
 ° periodic loan write-offs or rescheduling by the central government, either as mandated by the Finance Commission or on its own; 
° introduction of various types of off-budget borrowing mechanisms by states; and
 ° lack of any connection between the terms of lending and the credit-worthiness of individual states.

There has been some change in the institutional framework relating to the above points. Small-savings' schemes are not as attractive to the investors as they were in the past because of lower post-tax return and hence the states may not hope for a substantial amount of additional resources from this source in the near future 2 . Also, the RBI is gradually attempting to link terms for market borrowing by states to their financial condition by desisting from promoting state government bonds through various informal methods. Loan write-offs recommended by the last two Finance Commissions were also not unconditional. Some of the other reasons advanced in the relevant literature for the worsening fiscal imbalance at the state level are given herewith:

Poor Returns on Public Investment

The low, sometimes negative, rate of return on public investments financed by borrowed funds reinforces the imbalance described above. Prudent public finance requires that revenue surpluses be generated, which can be used for capital expenditure along with borrowed funds. Further, the capital expenditures incurred with borrowed funds need to be investments that have a rate of return adequate for servicing the debt incurred for the purpose. Since the investments do not actually yield such rates of return, debt servicing must be done from fresh borrowings in the absence of revenue surpluses to do so. This in turn gives rise to a spiral of ever-rising debt and interest burden.

2 The relative attractiveness of small savings remains high with the fall in nominal interest rates and bearish trends in the capital market due to inter alia the selling pressure overhang of the US 64.

Rising Salary and Wage Bill

The rising salary and wage bill growing at a rate faster than the growth of GDP has also been identified as responsible for accelerated growth of expenditures and consequent deficits; it may be noted that the present phase of imbalance in state finances surfaced after the mid-1980s when a major upward revision of pay scales took place in the states following the same at the centre. The second shock from this source came about ten years later, again after pay revisions at the centre.

Interest Burdens Rise

A rising interest burden has come about due to accumulation of debt over time, a consequence of persistent deficits that can be financed only by various forms of borrowing at the state level. The average effective rate of interest on government borrowing has also risen over the years because of both rising nominal interest rates and greater recourse to costlier debt 3 . The states also argue that the soft loans have not reached them with the same terms as originally granted to the central government, but at the same terms as applicable to other loans from the centre because of constitutionally-required central mediation in the case of loans from international agencies. But this argument ignores the exchange risk. The higher interest burden also contributes to the deficit in a vicious circle. However, the recent drop in interest rate should help decelerate the growth of interest liabilities.

Increasing Subsidies

Another pertinent factor has been increasing implicit and overt subsidies; in particular, food subsidies have become rather large in recent years in several states. While the Food Corporation of India (FCI) raised the prices of foodgrains in steps, the states found it politically difficult to pass the price rise on to their public distribution systems. Subsidies rose as a result and new schemes for low-priced foodgrain supply added to the subsidies. Some attempts at controlling the burgeoning growth of these expenditures on this count have been made by distinguishing 'below poverty line' or BPL families from others. Along with these, dwindling non-tax revenues, implying rising implicit subsidies on publicly supplied services (like road transport, irrigation, education and health) and lower realizations from natural resources under government control (like minerals and forests) further aggravated fiscal imbalances. In the last two years, however, some of the states have finally got around to revising the rates for these services. In some cases where public supply

3 These have their ultimate cause in the simultaneous pursuit of financial-sector reform that moved borrowings to market rates, and to conservative monetary targeting.

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is thought to be politically difficult to price in a way economically appropriate, privatization is being attempted. Power-sector subsidies, unlike the above-mentioned ones, do not directly show up in the budget because of the SEBs, but eventually affect the budget through various links like lower interest receipts from SEBs, various subsidies given to them, conversion of loans to equity, writing off dues from them, allowing them to retain electricity duty collected from consumers on behalf of the state government and providing guarantees to their loans that are expected to become government liabilities right at the time of contracting them.

Pension Liabilities Grow

Information given by RBI indicate that pension liabilities of states as a ratio of their revenue receipts has been on the rise in the 1980s and the 1990s, and constitute a large potential claim on the states' resources in future. From a level of a little above 2 per cent in 1980– 1, this ratio rose to about 5.5 per cent in 1990– 1 and reached an all time high of about 10.5 per cent in 1999– 2000. The reasons for this growth are probably to be found in the age profile of state-government employees, rising life expectancy and the awards of the Pay Commissions. The growth of pension liabilities varies across states over the 1990s. Against an average decadal growth of 21.6 per cent in the 1990s, several special category states and low-income states record a growth above the average, the exceptions being Manipur, Rajasthan, Tripura and Uttar Pradesh. The lowest growth was recorded in Haryana (14 per cent), while the highest was in Sikkim (about 29.5 per cent). It should be noted that in general it is the low-income states like Bihar and Orissa where the outstanding debt liabilities are high in relation to their NSDP. With high potential pension liabilities being added to the large interest burdens, scope for any developmental expenditure can get severely restricted.

State-Level Public Enterprises

State-level public enterprises usually run with periodical infusion of capital in the form of fresh shareholding of the state governments or additional loans from them. This is required mainly because of the running down of net worth through regular losses. Even in this situation, the state governments often force repayment of loans or payment of accumulated interest due on these loans, to finance their own deficits though the public enterprises can hardly afford to do so. Sometimes the transfer of resources is effected by withholding subsidies due to these enterprises against interest payment or loan repayment. 4 It should be obvious that this

4 These practices often cause non-transparencies in the budget documents, as anyone studying the financial flows between the state governments and their electricity boards would testify.

strategy leaves the state-level public enterprises with little productive capital, further worsening their financial health. These trends and the lack of professional management and autonomy have resulted in rising losses in the state-level public-sector enterprises, with consequences like large unpaid bills. Eventually, the liabilities would of course devolve on the state government. Such expenditures have actually pushed up the total expenditures of the concerned states substantially in recent years, and the trend is likely to intensify in the near future.

FISCAL IMBALANCE AND COMPOSITION OF EXPENDITURES

Capital Expenditures Suffer

Ever since the state budgets as a whole went into the red, capital expenditures have borne the brunt of the inevitable budgetary adjustments. 5 In fact, even before the deficits appeared in the budgets of the states as a whole, growth of capital expenditures had reduced to only half that of revenue expenditures. After the widespread deficits, expenditure compression largely targeted capital expenditures and net government purchases (this includes essentially repairs and maintenance of assets, and purchase of goods like medicines and equipments for hospitals). Unfortunately, these are areas where the expenditure compression should not have taken place in the interest of economic development. The reason, in all probability, is that while contractual and committed expenditures like interest payments could not be reduced, strong lobbies ensured continuation of their own payoffs (various implicit and explicit subsidies and wages and salaries are examples). Such expenditures have high short-term political returns, whereas capital and maintenance expenditures have more durable, but not necessarily short-term, economic returns. The former is, therefore, being increasingly preferred by policy-makers. Also, tokenism was widespread— a small amount of resources was spread over a vast array of development projects, making the relatively tiny budget allocations merely token gestures, adding to the cost of capital formation. Capital expenditures in real terms actually showed a negative growth in the latter part of the 1980s.

Developmental Expenditures

The beginning of the 1990s saw the country struggling to overcome the fiscal crisis and preparing a reform programme in response. But the states initially stayed out of the ambit of the reforms, which were formulated and implemented

5 See Rao and Sen (1993) for a detailed review of trends in government expenditure in India until the beginning of the 1990s.

only at the central level, despite the worsening fiscal position at the state level. The impetus to state level fiscal reforms came from the fiscal crisis that overtook the states in the 1990s, possibly because of a spurt in expenditures resulting from the salary revision of their employees, rising interest rates and the sluggish growth of receipts in the overall context of the slow growth of the industrial sector. Table 6.1.7 provides some data on the functional composition of the states' expenditure at the beginning and end of the 1990s. The data are provided in terms of developmental and non-developmental expenditures and some specific infrastructure sectors, mainly to examine some the pertinent changes in the composition of states' expenditures. Though it must be kept in mind that the definition of 'Developmental Expenditures' is rather optimistic. The first noticeable feature of the point-to-point comparison is that even the very broadly-defined developmental expenditures have fallen from about 74 per cent of the total expenditures to 63 per cent during the 1990s. Within developmental expenditures, social services accounted for a much larger part of the expenditures than economic services by the end of the decade as compared to an almost equal share at the beginning. In line with the rising share of social services, the three identified infrastructure services within social services claimed larger shares of the total developmental expenditures individually, when loans are also considered. In contrast, each of the identified infrastructure services in economic services was allotted a smaller share in developmental expenditures in

1999-2000 as compared to that in 1990– 1. Given that the share of developmental expenditures itself in aggregate expenditures dropped significantly, the share of identified infrastructure services within economic services in aggregate expenditures show a sharper fall.

Physical Infrastructure

But what about the three identified infrastructure services within social services? Although the share of developmental social services as a whole fell a little, all three identified infrastructure services maintained their share in aggregate expenditures from the beginning to the end of the 1990s. Thus, observed trends more or less accord with the prescription that the government should concentrate on basic services like education and health and induce, as well as facilitate, private investment in other services. 6 Also, it must be noted that the drop in the share of services like road transport (including provision passenger transport) do not necessarily imply smaller aggregate expenditures in those services because, in many states, the private sector played a bigger role than before. In the power sector, off-budget expenditures could have risen significantly through mobilization of borrowed resources by the public enterprises 7 .

6 Of course, to what extent nominal government expenditures translate into actual services and whether this has changed significantly or not during the period under review is another matter. 7 Much of the initial restructuring of SEBs such as hiving off of generating companies were precisely to mobilize resources this way.

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But the fact remains that both required investment and needed maintenance expenditure in physical infrastructures called for much greater amounts than were put up by the government and the private sector together. Given the large externalities and the long-term benefits that flow from infrastructural facilities, it is the responsibility of the government to ensure adequate supply. The declining investment on physical infrastructure was justified mainly on the pretext of paucity of resources, but the paucity itself was, to a significant extent, the result of the squeeze brought about by non-developmental expenditures as they rose sharply. The major problem lies in the fact that systemic factors account for the primacy of less-productive expenditures during episodes of financial difficulties; Rao and Sen (1993) adduce time-series evidence on this issue, cross-section evidence is provided by the studies of White Papers on the budgetary position of the financially most-troubled states (Orissa, Uttar Pradesh, Kerala and Punjab). Almost invariably, in all such states, less than 20 per cent of the total government expenditure is on non-establishment developmental purposes. Economic classification of government expenditure would have brought this out clearly for all states, but such data are not readily available. The data that are available bear out the above contention unequivocally. For example, the White Paper on Kerala State Finances brought out by the concerned government shows that wages and salaries (including grants for this purpose) alone accounted for 37 per cent of total government expenditure (excluding repayment of debt). Add to this interest payments (16 per cent) and pensions (15 per cent), and there is only 32 per cent left for other establishment costs and truly developmental expenditure of any kind, including that on infrastructure. Thus, for any significant rise in government expenditures on developmental purposes, in general, and those on infrastructure, in particular, there are two preconditions— a substantive improvement in the financial position of the governments concerned and a structural change that would reprioritize expenditures in favour of the desired categories including infrastructure.

STATE-LEVEL INITIATIVES AND THE IMMEDIATE FUTURE

Silver Lining

From all indications, the last bout of fiscal difficulties in states could now subside to some extent for two main reasons: the immediate cause of these difficulties can be said to be the wage revisions and the consequent surge in expenditures, particularly during the period when arrear dues are paid out, and sharply rising interest payment obligations. While the shock introduced by the higher wage

bill has in part been accommodated, the recent fall in the interest rate would also help states to keep interest costs down. Those states that can manage their debt well enough to convert old high-interest loans to new low-interest ones 8 should see the fiscal stress relaxing somewhat.

Problem is Recognized

One fallout of the widespread fiscal problems of the states was to draw attention of policy-makers at all levels to this issue. This in turn resulted in greater acceptability of various reform measures. Also, a variety of reform measures were actually examined for their desirability, feasibility and quantitative impact. States learned from each other. There has been a general recognition of the problems, and some serious attempts at restructuring 9 . Several states have been pursuing privatization of public enterprises within the constraints imposed by legal problems, resistance of employees and lukewarm reception of these proposals in the private sector. Their motivation was to reduce the drain on public resources on account of public enterprises. The most prominent examples are in the power sector (for example, in Orissa and Haryana). States like Andhra Pradesh, Gujarat, Madhya Pradesh and Uttar Pradesh are executing reform programmes thrashed out in consultation with international agencies like the World Bank and the Asian Development Bank, with financial assistance from these agencies. Other states have also undertaken their own reform programmes and some of them have received sectoral assistance after agreeing to undertake basic reforms in those sectors (for example, irrigation and power). An attrition policy is formally or informally in place in most of the states to control the growth in the number of government employees and the wage bill. A variety of other measures to control growth of expenditures have been introduced in different states, including those in the area of education and health.

Tax Reforms

Tax reforms are also being undertaken to make the state taxes more efficient and buoyant. States like Haryana and Andhra Pradesh have already revoked the prohibition imposed earlier, which had meant a steep fall in tax revenues from state excise and sales tax. The introduction of uniform floor rates in sales tax and the ban on new sales tax incentives for industrialization agreed upon by the states have certainly

Even then, and including the little private investment that materialized, the rate of growth in capacity was far smaller than in the 1980s. 8 For longer term sustainability, though real interest rates would have to fall and/ or economic growth rates accelerate.  9 For a detailed review of recent reform initiatives by state governments, see RBI (2002).

CONCLUSION

There is one important message relating to the present context that is not generally recognized. The finances of state governments have been going downhill for some time because of the various factors outlined above. Even if effective reforms are undertaken now (as is in progress in some states), they will bear fruit with a lag of a few years. In the

6.2 SOCIAL SECTOR EXPENDITURES IN INDIA: TRENDS AND PATTERNS

S. Mahendra Dev

The importance of higher levels of social infrastructure for human development and economic growth is well known. In other words, social-sector development has both intrinsic and instrumental value. A lot has been achieved in the social sector in the second half of the twentieth century . The incidence of poverty has declined from over 50 per cent in the 1950s to less than 30 per cent in the late 1990s. 10 The literacy rate has increased from less than 20 per cent in 1951 to 65 per cent in 2001. According to the recent Human Development Reports of United Nations Development Programme (UNDP), India moved from the category of 'low' human development to that of 'medium' human development and its present rank is 115. Nevertheless, the performance of India in the social sector is far from satisfactory, and could have been much better. Social-sector development depends on expenditures and effective implementation. Of course, economic growth is important for several reasons. More resources will be available

10 There is a controversy on the estimates based on NSS data for 1999– 2000.

for further investments and social development. It will also create better opportunities for the population if the growth is labour-intensive. The East Asian countries had higher growth with labour absorption. Also, the successful countries in terms of growth had better initial conditions in terms of equity. Therefore, the links among incomes, distribution and social development are strong. However, in this section the focus is more on social-sector expenditures in budgets and the budgeting processes as they are important in themselves. Budgets are the most crucial policy documents to find out the social and economic priorities of governments (Jain and Indira, 2000). In this section the social sector expenditure is defined as the total of expenditure on 'Social Services' and 'Rural Development' as given in central and state budgets. The head 'Social Services' includes, among other things, education, health and family welfare, and water supply and sanitation. The expenditure under the head 'Rural Development' (which is listed under 'Economic Services' in the budget classification) relates mostly to anti-poverty

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programmes. 11 Expenditure on food policy/ subsidy is included in some of the tables provided in this section, but not in 'total social sector' expenditure because only a part of the subsidy reaches the poor. In the discussion on budget justifications and on the budget-making process, the food subsidy/ policy is included. The discussion about the budget-making process focuses exclusively on the centre. The trends in social-sector expenditures are examined at three levels: (a) combined centre and states, (b) centre and (c) states. The expenditures refer to both plan and non-plan. Trends in plan expenditures are also examined briefly.

States Share

The combined social-sector expenditure of centre and states provides the best picture of India's commitment towards the social sector. 12 In this combined expenditure, the states contribute the lion's share. Table 6.2.1 compares the shares of the states and of the centre in the early and late 1990s.

11 This distinction between economic and social services is a bit odd and certainly suggestive. Social services, as one of our respondents said, is 'seen as what the government gives away'. Economic services are 'what is promoted'. There is a suggestion that 'economic' is more important because it is associated with longer-term economic development and that 'social' may be 'wasteful'. 12 It is difficult to get information on combined expenditure from the budgets. Simply aggregating the expenditure by the centre and by the states gives an inflated picture because the budget information does not adjust for central transfers to states. We used data from the Indian Public Finance Statistics (Ministry of Finance, Government of India), which is adjusted for transfer funds.

In 1990– 1, the states' share for the total social sector (column 8, row 11) was around 85 per cent. With regard to rural development, the states' share was as high as 90 per cent. The share of the states declined for most of the major heads in the course of the 1990s. In 1998– 9, the share of the total social sector declined to 80 per cent. There was a very substantial decline in the share for rural development: at the end of the 1990s this was only 64 per cent. In spite of the decline, the contribution of the states to total social-sector expenditure is still substantial and much larger than that of the centre. In absolute figures, in 1998– 9, India spent Rs 1183.5 billion on social services and rural development. Out of this, the states spent Rs 946.4 billion.

COMBINED CENTRE AND STATES

Table 6.2.2 gives an overview of social-sector expenditure (a) as percentage of GDP, (b) as percentage of aggregate expenditure and (c) as per capita real expenditures, all for the period 1987– 8 to 2000– 1 (columns 2 to 4). India spends around 6 to 8 per cent of its GDP on the social sector. In 1990– 1, the share in GDP was 6.78 per cent. Only in 1998– 9, a higher level was reached. Throughout the 1990s, social-sector expenditure, in terms of percentage of GDP, was lower than that in the late 1980s. The recent increase in 1998– 9 and 1999– 2000 can be partly due to an increase in salaries, as a result of the recommendations of the Fifth Pay Commission. As a percentage of aggregate expenditure, India spends between 24 to 28 per cent on the social sector. The percentage started to increase in the middle

of the 1990s. Since 1995– 6, the percentage is higher than that in the 1980s. In terms of per capita real expenditure, social-sector expenditure has continued to increase after 1993– 4. Per capita expenditure has risen from Rs 623 in 1990– 1 to Rs 959 in 2000– 1, an increase of 54 per cent in 11 years. Unfortunately, our data do not allow us to compare this increase with the increase in the 1980s. Some studies use only revenue expenditure for analysing social-sector expenditure. The proportions in columns 5 and 6 in Table 6.2.2 relate to revenue expenditures. It shows that trends in social-sector expenditure, as a proportion of GDP, are similar to those in column 2 (revenue + capital). In other words, it does not show any increase in the 1990s as compared to that in the 1980s. There are differences in the trends between column 3 and column 6. Unlike the trends in column 3, the social-sector revenue expenditure, as a proportion of aggregate revenue expenditure (column 6), has not shown any increase since the mid-1990s as compared to those for the 1980s.

Education

Education is an important head in the social sector. Table 6.2.3 provides the combined expenditure (centre + states) details on the education sector separately and on its components. Table 6.2.3 shows that in 1998– 9, around Rs 50,200 crore were allocated to the education sector from the Education Department (column 7). Out of this amount, Rs 24,500 crore, i. e., around 49 per cent were allocated to

elementary education. As per cent of GNP, the share of education declined from 3.4 per cent in 1990– 1 to around 3 per cent in the late 1990s. It may be noted that other departments also spend some part of their departmental expenditures on education. If this expenditure is added, the share of education comes to around 4.1 per cent (column 8). This share declined over time to 3.6 and 3.8 in the mid-and late 1990s respectively. This percentage is well below the international norm of 6 per cent of GNP on education 13 . Table 6.2.3 also provides intra-sectoral percentages on education for the 1990s. These expenditures relate to the funds spent by the education department. The table 6.2.3 shows that the share of elementary education increased from around 46 per cent in the early 1990s to 49 per cent in the late 1990s. There has been a decline in the shares of secondary, higher and technical education during the same period which, as will be shown later, is due to the significant increase in the share of elementary education by the central government since the mid-1990s.

EXPENDITURE BY CENTRAL GOVERNMENT

Although the share of the central government in total social-sector expenditure is low (around 20 per cent), the centre

13 The 6 per cent norm is not sacrosanct for every country. This percentage generally reflects that the countries which achieved high levels in education had, in general, high levels of expenditures closer to 6 per cent of GDP.

is nevertheless important, because it has a considerable influence on policy directions in the states. Moreover, as is shown in Table 6.2.1, the contribution of the centre to overall social-sector expenditure is increasing. Particularly in the area of rural development, the centre is now responsible for a much higher percentage of overall rural development expenditure than in the early 1990s. Table 6.2.4 gives an overview of central government expenditure between 1986– 7 and 2000– 1. As a proportion of GDP, central government expenditure for the social sector was 1.42 per cent in 1990– 1. This percentage declined in the first two years of the reform period; it started to rise from 1993– 4 onwards, and reached a peak of 1.67 per cent in 1998– 9 before declining in the subsequent two years.

The percentages in all the years since 1993– 4 were higher than in the base year, but lower than in the late 1980s (except in 1998– 9). As a proportion of aggregate expenditure, social-sector expenditure increased from 7.55 per cent in 1990– 1 to 10.48 per cent in 1996– 7. In spite of the introduction of the Basic Minimum Services (BMS), there is no further increase after 1996– 7 14 . Since 1993– 4, the shares were higher than those of the late 1980s.

14 These observations are in keeping with the sharp divide that one observes between the two periods: 1993– 8 and the one after the recession. Perhaps the recession itself could be a result of expenditure reduction due to the policies aimed at reducing fiscal deficit.

One view is that since most of the non-plan expenditures go for salaries and interest payments, we should look at

Education, Health and Rural Development

It is important to know about the intra-sectoral allocations in different sectors in order to understand the social priorities. Table 6.2.6 provides these allocations for education, health and family welfare, and rural development. It shows that there have been significant shifts over the 1990s within

EXPENDITURE BY STATES

As mentioned above, the main responsibility for social-sector expenditure lies with the states. Earlier studies by Prabhu (1997), UNDP (1997) and Chelliah and Sudarshan (1999) have shown that social-sector expenditure, either taken as a proportion of Gross State Domestic Product (GSDP) or as a proportion of aggregate expenditure, started declining for the majority of the states since the mid-1980s. This trend continued in the early 1990s. In our study, we cover the entire decade of the 1990s. The analysis is done in two steps. First, we look at the trends in the aggregate 25 states. Second, we examine trends for each of the major 15 states.

One could argue that, as compared to the centre, the performance of the states is worse in the 1990s. If 1990– 1 is taken as a base year, the centre eventually increased its expenditures on the social sector (taken as percentage of GDP, as percentage of overall expenditure or in terms of real per capita expenditure). In the aggregate, states, however, have not been able to do so. This presentation is, however, slightly misleading. One can also argue that the rise in central government expenditure is partly funded by cutting down the central allocations for the state plans. 15 As per cent of GDP, social-sector expenditures have not increased in the 1990s for almost all states. One gets a different picture when the trends are seen in terms of real per capita expenditure, rather than as percentages of GSDP. This is true because, even when percentages of GSDP remain stable or decline, per capita real expenditure may go up. But it is also true because states with a very low GSDP (like Bihar and Orissa) may top-rank in terms of proportion of GSDP spent on the social sector, but come at the bottom end when one looks at per capita real expenditure (Table 6.2.8). The per capita expenditure in Bihar was only Rs 476 as compared to Rs 879 for the average of 15 states in 1998–
15 See Sarma (2001).

COMPARISONS WITH OTHER COUNTRIES AND INTERNATIONAL NORMS

Table 6.2.9 compares India with (a) South Asia generally, (b) East Asian countries and (c) all developing countries

CONCLUSION  

Has social sector expenditure declined or increased in the 1990s? The centre has seemingly done better than the states in the post-reform period. This is, however, slightly

16 As mentioned earlier, the human development attainment depends on variables such as income represented by per capita GDP, income distribution, social-sector expenditures, efficiency in these expenditures, etc. Therefore, mere increase in social-sector expenditure is not enough

Are there any improvements in education and health expenditures? With regard to health, not much has happened. Neither the centre nor the states increased their health expenditures considerably. The first half of the 1990s was especially bleak. In the second half of the 1990s, the per capita real expenditure on health by the states increased (but there was no increase in terms of proportion of GDP or GSDP). Intra-sectoral allocations show that there has been a shift towards public health and maternal and child health. With regard to education, the share of education expenditure from all the departments declined from around 4.1 per cent in 1990– 1 to 3.8 per cent in 1998– 9. This is mainly due to a decline at the state level. The centre increased its expenditure after 1995– 6. This increase is almost completely due to increases in spending on elementary education, and to a large extent (but not completely!) related to the introduction and expansion of the midday meal programme. In short, the shifts within education and health are in the right direction (towards social-priority areas).

What are the inter state disparities in social sector expenditures? In most states social-sector expenditure has

Are the social-sector expenditures in India low or high as compared to other countries and international norms? Social-sector expenditure in India in the 1990s was low as compared to that in the 1980s and as compared to that in other developing countries, and certainly as compared to East Asian countries. It was also low as compared to the UNDP recommended ratios.

6.3 THE BUDGET PROCESS AND SOCIAL EXPENDITURES

S. Mahendra Dev

SHIFTS IN POLICIES

We bring out the main institutions involved; the preferences of the policy-makers; the interests; and the degree to which the process is participatory and democratic. We look at the central government. The study is based on secondary material and on interviews with policy-makers in various capacities, representatives of stakeholder groups, and outside observers

Persons interviewed in August 2001: C. H. Hanumantha Rao, E. A. S. Sarma, S. R. Sankaran, B. P. R. Vithal, R. Ramaswamy Iyer, Jairam Ramesh, Seeta Prabhu, Neera Burra, Pradeep K. Sharma, N. J. Kurian, John Woodall, Shankar Acharya, Arvind Virmani, H. Mahadevan, Pranob Sen, G. S. Ram, R. A. Mital, S. K. Goyal, Ajit Mozoomdar, Gajan Pathmanathan, Meera Chatterjee, G. K. Chadda, N. C. Saxena, Rohini Nayyar, Renana Jhabvala, S. P. Gupta, V. B. Eshwaran, Abhijit Sen, Amaresh Bagchi, Kuldeep Mathur, Ganshyam Shah, Patnaik, K. R. Venugopal 17 Seeta Prabhu has done a lot of pioneering work on the shifts in social-sector expenditure in India, both at the central and at the state level, but she has not looked at the budget-making process. See Prabhu (2001). Another interesting paper is Guhan (1995), on trends in central government expenditure on the social sector. 18 See, for instance, the website: www. international budget. org. There are also many studies about gender (in) budgets. See, for instance, Reeves and Wachs (1999). 19 Although a bit old and not specifically about India, we found Caiden and Wildavsky (1974) a very useful book. It helped us to frame some of the questions about the budget-making process.

'Targeted' Food Subsidy

A shift in the thinking about food policy is also noticeable. From a major instrument to combat inflation and as a general safety-net measure, the emphasis shifted to reaching the 'poorest of the poor' through targeted schemes. Food subsidy began to be seen more as a burden (even though there is no systematic increase after 1993– 4, when taken as a proportion of GDP). The budgets also remain silent on issues like employment and unemployment, inequality and agricultural tax, etc. Centrally-sponsored schemes have increased significantly since the 1990s. There are various strong vested interests in maintaining (and perhaps even enlarging) the central government sponsored schemes in the social sector. It seems unlikely that the system is going to change in the near future. During the last meeting of the

20 Budget speeches are political documents and cannot be taken at face value. They are written for particular audiences. They package messages in particular ways. They elaborate on some issues but are silent on others. In short, they reveal as well as hide. 21 See Dev and Mooij (2002). 22 This statement is based on the budget speeches and Government of India's Economic Surveys.

THE PROCESS

Much of the central government expenditure in the social sector apart from the food subsidy is on Plan expenditure. In principle, this means that once in five years, when the Plan is designed, schemes are formulated and funds are allocated. The reality, however, is different. Although the full size of the Plan is decided at the start, the annual allocation has to be renegotiated every year. These five-yearly and annual negotiations are often difficult. The Planning Commission argues for a higher outlay; the Finance Minister (who is a member of the full Planning Commission) tries to scale these down. Plan expenditure is seen as residual by many of the economists in the Finance Ministry. Only after all non-Plan budgets are made, can the annual allocation for the Plan be calculated. The final Plan has to be approved by the National Development Council. Often the Prime Minister (who is the chairperson of the full Planning Commission) has to intervene to settle the matter. After 1993– 4, the size of the Plan has come down as proportion of total government expenditure, and the size of non-plan expenditure has gone up.

Planning Commission

The Planning Commission consists of the chairperson, who is the Prime Minister, the deputy chairperson, the Finance Minister and several other Cabinet ministers, other members, and a (member) secretary. The members are appointed by the Prime Minister. There is a widespread consensus that in recent days appointments are more politicized than in the past and that 'eminence' plays a less important role. The Commission has a large staff. There are several divisions, headed by (principal) advisers, who could either be experts directly recruited or generalists from the Indian Administrative Service (IAS). Unfortunately, the trend has been towards an increasing proportion from the IAS. While some may have the relevant experience others may have been posted because they 'did not fulfil the expectations' in their previous posting. Moreover, there were several respondents who told us that within the IAS, a posting to

23 The National Development Council is an advisory body attached to the Planning Commission. It is composed of the Prime Minister (who is the chair), all Chief Ministers of the states and all members of the Planning Commission. In principle, the interests of the states are, hence, fairly well represented.

Finance Ministry

Budgets are presented at the end of February, but the preparations start a few months earlier. In the course of this preparation, all ministries and departments are consulted, and discussions are also held with several interested groups from outside the government, including small-scale industry, large industrialists, farmers and trade unions. Every year a number of separate half-day meetings are set up to discuss relevant issues with these interested groups. These consultations are almost like rituals. As one respondent said: 'The Finance Ministry has to organize them. They are useful, but the fact that it is done every year also means that one has to continue. Not doing it after so many years would look strange. ' The representatives of the trade unions also regard these meetings as annual rituals. Such organizations attend the meetings, of course, but do not expect much from them. The Finance Minister will listen to what we have to say, but he will not act upon our demands. 24

Consultation

In contrast, though, the Plan preparation is highly consultative. At the time of writing this, preparations were going on for the Tenth Plan. Each division establishes one or more working groups. The Health and Family Welfare division, for example, had 13 working groups. The working groups usually have 20– 30 members. The various ministries and departments are normally heavily represented. All working groups also include a number of academicians or other experts, NGOs, other voluntary organizations or trade unions. For instance, the working group on rural poverty alleviation includes representatives of the Self-Employed Women's Association (SEWA), BASIX, and Action Aid. The working group on elementary education and adult education includes representatives of several NGOs, including the MV Foundation. All in all, although the representation from the government's side by far outnumbers the representation of others, most working groups have a rather varied composition. The membership of the working groups is by invitation. It is often the divisional adviser of the Planning Commission who decides who will be invited to participate.

24 Trade Union organizations make use of these annual consultations to repeat their demands, not only with regard to workers in the formal sector, but also with regard to the informal sector. One of their recurrent demands, for instance, is the framing of a comprehensive law for agricultural workers.

Political Influences

In several ways politicians participate in the budget-making process. The Finance Minister and the Prime Minister play key roles in the decision regarding the Plan size. In addition to these ministers, the full Planning Commission, several other Cabinet ministers attend these meetings. Members of Parliament (MPs) come in at least once a year when the budget has to be approved by the Lok Sabha. Unfortunately, however, according to several respondents, the available expertise among MPs on budgetary matters is not sufficient, and the level of debate (and subsequent monitoring, etc.) is disappointing. Political considerations can play a major role in budget decisions. The jump in social-sector spending (especially in rural development) in 1993 is a clear case in point. Many critics inside and outside the government felt at that time that rural development had suffered too much as a result of the stabilization policies. There was a lobby from the Rural Development Ministry itself, people within the Planning Commission, and economists outside the government who all said that rural development expenditure should be stepped up. The result was a big increase in Plan allocation, indeed, but without an overall increase for the Plan outlay. It is likely that the then Prime Minister, P. V. Narasimha Rao, who was holding the rural development portfolio at that time, was himself convinced of the necessity

FOOD SUBSIDY

The food subsidy exists because the expenses incurred by the government on foodgrain procurement, storage, etc. are larger than the revenues through the sale of these foodgrains. 26 The system is as follows. The Government of

25 See, for instance Varshney (1999) for this argument regarding the reform process. He argued that the policy reformers in the 1990s could implement the economic reform policies, basically because mass political attention focused around identity issues and communalism rather than around economic policies. 26 It is important to mention again that it is actually questionable to what extent the food subsidy is part of 'social-sector expenditure'.

                                                                                           The States and Social Expenditures 161

The food subsidy benefits some consumers, but it also includes a producer subsidy and the carrying costs of the (now gigantic) stock. 27 See also Rao (2001). 28 These states contribute most foodgrains to the central pool. In 1994– 5, 50 per cent of the FCI wheat purchase and almost 40 per cent of the paddy/ rice purchase was done in Punjab; 25 per cent of the FCI wheat and 12 per cent of the paddy/ rice came from Haryana and 30 per cent of the paddy/ rice came from Andhra Pradesh. (World Bank, 1999: Annex Table 1.11)

Theoretically, it is the Planning Commission and not the Finance Ministry which decides the sectoral allocation within the Plan. Yet, almost all our respondents who were involved in policy-making in the 1990s agreed that, generally, the attitude of the Ministry of Finance mattered, and that this attitude towards social-sector expenditure was not very supportive and that attempts were made to cut down on the social sector. Among the economists within the Finance Ministry there is a strong belief that the fiscal deficit should be brought down. As a retired civil servant formulated it: 'These economists start with the fiscal deficit and they end with the fiscal deficit. They do not start with the hungry millions…. ' Expenditure on the social sector is regarded as residual. After all the other priorities are fulfilled, the government turns its attention to the social sector. The following quote from Manmohan Singh, Finance Minister in the first half of the 1990s, illustrates this point nicely. 'Some people have criticized the stabilization programme as being anti-poor. I admit that in an economy which has been living beyond its means, stabilization does hurt. … It is true that the fiscal compulsions have forced us to restrain the growth of all expenditure, including social expenditure. But considering that interest payments are a fixed contractual obligation, that defence expenditure cannot be cut beyond a point because of the security environment confronting us, that expenditure on government administration cannot be drastically reduced without a wage and Dearness Allowance (DA) freeze or a sharp reduction in employment, that various subsidies cannot be removed overnight, we had very little option but to do what I did. Those who criticize the cuts in social spending should tell us what other expenditure could be cut to make room for increased spending on social sectors. ' (Singh, 1992: 3– 4)

Expenditure Finance Committee Suggestions

Once the allocations are made, there are still various ways in which the Finance Ministry can influence expenditures. First, there is a once-in-five-years appraisal procedure. After the Plan is approved, all the schemes have to be appraised by the Expenditure Finance Committee (EFC). This committee is presided over by the Secretary for expenditure, one of the three main secretaries of the Ministry of Finance. Other members are the adviser in charge of project appraisal to the Planning Commission, and the secretary of the concerned ministry. The EFC can suggest schemes and budget modifications, measures to maximize cost effectiveness, etc. Once the scheme is approved, it will normally not have to be reappraised, except in the case of changes in the basic parameters.

Plan and Expenditure Cuts Once there is a perceived need to cut down government expenditure, it is plan expenditure which suffers the most. The non-plan expenditure consists of several items (listed above by Manmohan Singh) which are considered very difficult to reduce. Within the plan, the tendency is to cut down on what planners call 'elastic', 'incremental' or 'compressible' expenditure, such as most of the social-sector expenditure. Indian planners prefer not to cut down on capital investments. Different reasons were given by the various planners and policy-makers who were interviewed. First, there is the identification of development with capital investment. There is a strong belief that, in the long run, it is investments in power and infrastructure that will lead to development. Second, spending on physical infrastructure gives concrete results, while the results of revenue expenditure are either not, or much less measurable. So the former is preferred by officials. Even when there is corruption in capital investments, at the end of the day, there is a road or a power station. Third, there is a reluctance to spend money on salaries for school teachers and doctors 'who do not do their duty'. A fourth reason may stem from the 'contractor Raj'. Private contractors are a powerful interest group and have close connections with politicians. A lot of money is siphoned off, and disappears into the pockets of the contractors themselves or of those who were instrumental in giving them the contracts.

Underspending

Underspending hardly occurs in non-plan expenditure, but it does occur in most sectors in the plan. Labour and

Many economists and planners within the government give more weight to bringing down the fiscal deficit or capital investments than to social sector expenditure. At the same time, however, some politicians at the central level use the schemes to increase their visibility and may hope to attract voters by increasing allocations. The latter have an interest in raising social-sector expenditure and a supporting, relatively proper, implementation if voters are influenced by these expenditures. On the other hand, there are also cases where the locally powerful groups have no interest in social-sector schemes and human development generally, and actively oppose such development efforts. Literacy campaigns and universal education are a case in point. The local elites in the states and union ministers too may sometimes share an interest in the funds per se, but not necessarily in the proper utilization. In other instances, they will prefer the funds not to be used at all. 29

CONCLUSION

In the case of food policy-making, it is very clear which class interests have influenced policy decisions; in other instances it is less immediately obvious, but yet plausible that class factors play a role in policy-making. The low level of expenditure on the social sector throughout the 1990s, even lower than in the 1980s, has to be seen in the context of the economic reform process. Inter-year variabilities, however, are large. It is also clear that social-sector decision-making is influenced by the characteristics of the wider political arena. India is a democracy which has become 'increasingly democratic' but also 'increasingly difficult to govern' (Manor, 1988: 72; see also Yadav, 2000, about the increasing political participation of the socially-deprived categories of people). Although other issues (such as caste and religious identities) play a very prominent role in elections, most political parties either do not or do not want to rely exclusively on these mechanisms. The increase in social-sector spending in 1993 was, according to several of our respondents, directly related to the loss of the Congress (I) party in several State Assembly elections. Congress, as a traditionally secular and apparently socialist party, used to appeal to the majority by addressing them in class/

29 See also footnote 4 of Kurian (1989), in which he notes that the higher echelons of the bureaucracy and of politics have a 'more egalitarian outlook and sympathy for the cause of the poor' as compared to their colleagues at the grassroots level. This, according to Kurian, is because of their more cosmopolitan (educational) background and their more informed idealism, but also because 'they do not have to face the realities of the rural power equations and economic conflicts', unlike their grassroots colleagues.

International 'Influences'

And finally, there is an international dimension to policy-making. India has to defend its social as well as economic policies in various international forums: the World Bank and the International Monetory Fund (IMF) primarily when it comes to economic policies, and international conferences (Social Summit in Copenhagen, for instance), international campaigns (for example, child labour) and organizations like the International Labour Organization (ILO), UNDP, UNICEF when it comes to social policies. It is also within this international community that India (as any other country) has to seek legitimacy for its policy decisions. The trends and shifts in Indian social sector policy-making do indeed reflect the various international pulls and pushes: the emphasis on fiscal consolidation and macro-economic adjustment (as demanded by the IMF and the World Bank) on the one side, and the international emphasis on human capability development and governance issues on the other.

'Elitist' Biases

In short, we can say that, despite all the lip service being paid, there is evident an elitist bias in social-sector policy-making. In principle, most politicians and policy-makers would like to be able to spend more money on poverty alleviation and human development. 31 The difficulty is to cut down on other expenditures. The social sector is obviously not on top of the priority list of most policy-makers. There are other things that need to be addressed first. This bias is not surprising. For many planners, poverty is an abstract thing.

30 Nehru's vision was industrialization which would take care of the poor. Targeted anti-poor programmes were encouraged by Indira Gandhi in the 1970s. 31 Although, as one of our respondents suggested, there may also be a category of economists who regard the whole discussion about poverty as a 'nuisance', and who think that the importance of poverty is exaggerated by people who have developed a vested interest in its existence and continuation.

6.4 FACTS FROM FIGURES ON PUBLIC INVESTMENT IN INFRASTRUCTURE

V. J. Ravishankar ° Priya Mathur

COMPONENTS AND MEASURES OF PUBLIC INVESTMENT

The estimate of capital expenditure as recorded in the official financial accounts is not all-inclusive with regard to infrastructure investments. For instance, it does not include investments in rural roads that are financed through central

The States and Social Expenditures 165

Box 6.4.1

Off-budget Borrowing as a Means to Finance  Investment in Infrastructur 

In Maharashtra, the government has authorized various PSUs in irrigation (Maharashtra Krishna Valley Development Corporation, Tapi Irrigation Development Corporation, Vidarbha Irrigation Development Corporation, Godavari Marathwada Irrigation Development Corporation, Konkan Irrigation Development Corporation), water supply (Maharashtra Jeevan Pradhikaran), roads (Maharashtra State Road Development Corporation) and power (Maharashtra State Electricity Board) to mobilize resources through bonds, which are guaranteed, and in many cases, also serviced by the government from the budget; the resources thus mobilized are partly used to finance capital outlays in the sectors. Gross off-budget borrowing (bonds guaranteed and serviced by the state government) in Maharashtra has averaged Rs 2100 crore or 0.9 per cent of GSDP per annum over 1996/ 7– 2001/ 2; and gross guarantees given for bonds (excluding bonds which are serviced by the government) have averaged Rs 800 crore or 0.4 per cent of GSDP per annum over the same period. In Karnataka, more than one-third of the capital expenditure undertaken by the state government has been shifted off the budget. The state government has resorted to massive off-budget borrowing since the mid-1990s to finance investments in irrigation (through the Krishna Bhagya Jala Nigam Limited and Karnataka Neeravari Nigam Limited), roads (through Karnataka Road Development Corporation) and housing (through Karnataka Residential Education Institutions Society and Karnataka Police Housing Corporation Limited). As a result, gross off-budget borrowing has averaged about Rs 1050 crore or 1.1 per cent of GSDP per annum during 1996/ 7– 2001/ 2. Apart from off-budget borrowing, guarantees have also been given each year— they have averaged about Rs. 850 crore or 1 per cent of GSDP per annum over the same period.

32 An important institutional constraint on state borrowing is implicit in Article 293: Clause (3) of the Indian Constitution. According to this clause, 'A state may not without the consent of the Government of India raise any loan if there is still outstanding any part of a loan which has been made by the Government of India or by its predecessor government, or in respect of which a guarantee has been given by the Government of India or by its predecessor government. ' But since borrowings through Special Purpose Vehicles (SPVs) with state guarantees do not fall under the purview of Article 293, they provide an easy way to bypass the GoI restrictions.

allows identification of public investment in specific sectors of physical infrastructure, as shown in Table 6.4.2. One worrying aspect of the figures shown in this table is that the sub-total of infrastructure sectors has declined by as much as 1.4 percentage points of GDP during 1993– 9, whereas the non-infrastructure components of public investment (manufacturing, defence, etc.) declined by only 0.5 percentage point of GDP in the same period.

The States and Social Expenditures 167

ANOMALIES AND ADJUSTMENTS IN STATE GOVERNMENT ACCOUNTS

Government financial statements are on a cash basis and organized as three separate accounts: (1) Consolidated Fund, (2) Contingency Fund and (3) Public Accounts. The Consolidated Fund covers all revenues received by the government, loans raised by it and receipts from recoveries of loans granted by it, as well as recurring and capital expenditures incurred by it, including interest and repayment of loans. All expenditures from the Consolidated Fund require authorization from the Legislature. The Contingency Fund is an imprest to meet urgent unforeseen expenditure pending authorization from the Legislature, and is very small. The Public Accounts, by definition, include all those transactions in respect of which the state government acts like a banker. Public Accounts comprise: (1) small savings and provident fund; (2) reserve funds—( i) bearing interest and (ii) not bearing interest; (3) deposits and advances—

Data on the opposite tendency, that is, understatement of expenditure or accumulation of payables, is more difficult to access. Such information is not regularly published by the state governments or the central government and not currently required by the CAG. Such information is provided by some governments in White Papers that they publish to reveal the extent of fiscal crisis to the public. The case of Kerala is an example of payment arrears reaching such a high level during the late 1990s that contractors had started to regularly build in the payment-delay factor into the costing of their bids (see Box 6.4.2).

EFFICIENCY AND QUALITY OF INVESTMENT

It is generally assumed that higher levels of public investment would lead to faster economic growth. But there are examples of states with relatively high levels of investment in irrigation but slower than average agricultural growth. The explanation lies in the productivity of investment, or rather the lack of it. Spreading limited resources too thinly across too many projects and schemes is one of the most common factors that lower the productivity of public investment at the state level.

Box 6.4.2

PendingBills and Transfers to Public Account in Kerala 

The United Democratic Front (UDF) Government of Kerala, which succeeded the Left and Democratic Front (LDF) after the state elections in early 2001, published a White Paper on the condition of the state's finances in June 2001. The White Paper highlights the fact that there is a serious credibility crisis as payables to suppliers and contractors, and even to pensioners and to the mid-day meal scheme, are mounting. In particular, the White Paper reports Rs 750 crore (US$ 150m or 1 per cent of GSDP) of pending dues to contractors from the Public Works Department (PWD)— a result of initiating new works during the 1999– 2001 period without any regard to budget limitations or to already built-up arrears. The outstanding stock of payables as on 3 March 2002 is over 200 per cent of annual expenditure in PWD. The White Paper is also unusually candid about the cash crunch and the accounting methods adopted in recent years to show a higher level of public investment and developmental spending than actually taking place. It points out that 'transfers to the Public Account has become a method to book plan expenditure when the state does not actually have the resources for incurring the expenditure; the scale of such transfers has assumed alarming proportions in the years 1999– 2000 and 2000– 1'.

Among all the components of public investment in infrastructure in India, the components handled by the state governments are of particular concern, because they involve areas where private investment is less likely to substitute for any decline in public investment. However, it is precisely with respect to the investment incurred by state governments that there are maximum problems in interpreting the available data to arrive at the factual position.

Box 6.4.3

Zero-Based Investment Review in Orissa 

The shortfall in central tax devolution in 2001– 2, which affected the financial position of all Indian states, had a particularly debilitating effect on Orissa, which is the poorest and fiscally most dependent among the 14 major states. As a result, Orissa closed the year with a whopping deficit of over Rs 1000 crore in its cash balance with the RBI. This posed a serious problem for cash and public expenditure management in 2002– 3. In order to maximize the impact of its public investment programme when liquidity constraints threaten budget execution in 2002– 3, the Government of Orissa carried out, in June– July 2002, an exercise which it called a Zero-Based Investment (ZBI) Review, led by a high-powered committee headed by the Chief Secretary. An examination of 149 physical infrastructure projects (of over Rs 4 crore each) being implemented by six departments showed that about Rs 3600 crore of additional financing was required for their completion. Even with optimistic assumptions of funding available from external, central and institutional sources, the estimated requirement was far in excess of what was affordable. The ZBI Review began with each of the departments reviewing and ranking the identified investment schemes/ projects under four categories: (i) Full funding for fast track completion by March 2003; (ii) Funding on slower track for now, could graduate to fast track in future; (iii) Minimal funding until redesign or restructuring; and (iv) Scrap or shelve indefinitely. It is expected that at least 10 per cent of the budgeted resources of about Rs 630 crore for the subset of investment projects covered by this ZBI Review would be reallocated from the least to the highest priority projects in the revised budget for 2002– 3. The outcome would be that a significant number of investment projects would be completed by March 2003 and begin to yield benefits. There is an important lesson from the experience of this fairly successful ZBI Review conducted by the Government of Orissa as compared to similar exercises carried out in other states, where the emphasis was solely on finding schemes to close and expenditure allocations to surrender. The lesson is that an incentive has to be created for the spending department to reallocate available resources. When the total budget allocation is held constant and the spending department is asked to identify projects to be completed within the year, provided full and timely funding is available, then positive incentives are created for finding resources to reallocate. For example, the PWD claimed that it could complete eight bridges and significantly enhance the mobility of the population in several poorly connected rural areas of Orissa. To do so would require about Rs 12 crore in addition to the original budget allocation of Rs 19.8 crore for these eight bridges' construction projects. At the meeting of the High-Powered Committee on ZBI Review, the PWD was asked to find these additional resources within their given budget ceiling, which they did from within the other categories.

Any lasting solution to these problems would need to change the incentive structure, in order to be effective. Merely relying on disciplinary measures is unlikely to be effective; for example, a ban on the use of 'personal ledger accounts' on the part of state governments may lead to the emergence of the same problem in a different form, through the use of some other type of accounting trick. State governments have hitherto had an incentive to show higher levels of expenditure, in order to leverage additional resources from the central government. This has been the tradition both with respect to 'plan assistance' as well as grants and tax sharing formulae prescribed by successive Finance Commissions. Starting in the mid-1990s, there is an ongoing attempt to change the incentive structure embedded in the fiscal federalism arrangements. The essence of this attempt is to reward good fiscal performance rather than rewarding fiscal profligacy. In spite of these attempts, only a small part of centre-state transfers is linked to state performance, with the bulk still determined as a function of a 'normatively estimated' resource gap. It is expected that the Twelfth Finance Commission (2005– 10) would effect a bigger change in the incentive structure. That could be

References

Caiden, Naomi and Aaron Wildavsky (1974), Planning and Budgeting in Poor Countries, New York: John Wiley and Sons. Chelliah, R. J. and R.. Sudarshan (1998), Income, Poverty and Beyond: Human Development in India, , , , , New Delhi: : : : : Social Science Press. Currie, Bob (2000), The Politics of Hunger in India. A Study of Democracy, Governance, and Kalahandi's Poverty, Basingstoke and London: MacMillan Press Ltd. Dev, S. Mahendra and Jos Mooij (2002), 'Social Sector Expenditures and Budgeting: An Analysis of Patterns and the Budget making Process in India in the 1990s', Working paper No. 43, Hyderabad: Centre for Economic and Social Studies. Dreze, Jean and Amartya Sen (1995), Economic Development and Social Opportunities, New Delhi: Oxford University Press.

172 India Infrastructure Report 2003