As the Union government prepares to abolish revenue deficits under the Fiscal Responsibility and Budget Management Act by next year, development spending has come under the hammer. The Centre has proposed that states bear the burden of social sector spending -- a move unacceptable to states. Development economists offer a way out: keep such spending out from the revenue expenditure account.

Sandip Das and Neha Sakhuja
Natural Resource Management and Livelihood Unit, CSE

A less social Act?
In the forthcoming Union budget, state governments may have to take substantial financial commitments for the Centre’s vast kitty of development programmes. The Union government is planning partial withdrawal of its budgetary support to development schemes. For the Centre, the next fiscal year (2007-08) is the penultimate to meet targets under the Fiscal Responsibility and Budget Management Act (FRBMA).

FRBMA stipulates zero revenue deficit and containing overall fiscal deficit to 3 per cent of the gross domestic products (GDP) by 2008-09. Since 2003-04, both revenue and fiscal deficit have been declining (See Graph: Indian government’s fiscal and revenue deficit trends). So the government’s commitments under the Act should be reflected in the forthcoming budget.

The Centre treats all development schemes as revenue expenditure, thus bringing them under the FRBMA scanner. To meet the revenue deficit target under FRBM, it has to either reduce spending on such schemes or extend the target through legislative means. Going by the current discussions on budget preparation in the Union ministry of finance, the Centre has decided that instead of extending targets, it will ask state governments to share expenses for development schemes.

The ministry of finance has opposed any extension of targets under FRBMA, as it would give wrong signals on India’s fiscal management. Sources in the ministry say that the Centre is already debating the schemes that should be put to state governments for funding.

The Union government is caught in a Catch-22 situation. Although the ruling United Progressive Alliance (UPA) government had substantially hiked social sector outlays from Rs 57,724 crore in 2004-05 to Rs 82,381 crore in 2006-07 , it will be difficult for it to continue with the programmes without support from states in face of the FRBMA targets. At stake are the UPA’s flagship programmes like the National Rural Employment Guarantee Scheme (NREGS), Sarva Shiksha Abhiyan, Mid-day Meal Scheme, Total Sanitation Campaign, National Rural Health Mission, Integrated Child Development Services (ICDS) and Bharat Nirman.

Declining deficits: at what cost?
In the last four years, both revenue and fiscal deficits have come down, with revenue deficit registering a nearly 50 per cent decline



Source: www.indiabudget.nic.in
Note: Deficit as percentage of GDP

States are rich but unwilling to spend 
The Centre’s decision to pass on the burden to states is based on the fact that states have surplus cash reserves (See Graph: Rising state surplus), which could be channelised for social sector funding. Besides, the Centre argues that states should now not only implement central schemes but also own them for effective results.

Financial conditions of most of the states have improved considerably due to the implementation of the Twelfth Finance Commission (TFC) recommendations, including debt restructuring and waiver and their efforts in implementation of Value Added Tax (VAT) across the country.

In its latest report State finances: a study of budgets of 2006-07, the Reserve Bank of India (RBI) says that states have cash surpluses of Rs 38, 983 crore (See Graph: Rising state surplus). In the report, the bulk of responsibility pertaining to expenditure on the social sector is given to state governments. This is done with the view that improvement in quality and delivery of the social sector will hep raise cost recovery in respect to these services.

 

Rising state surplus

Cash surplus reserves of states have gone up by over nine times in the last five years



Source: www.rbi.org.in
Note: Data includes figures from 26 states

According to the RBI report, states like Karnataka, West Bengal, Uttar Pradesh, Tamil Nadu, Maharashtra, Haryana, Gujarat and Bihar have surpluses of around Rs 3,000 crore each. Other states also boast of considerable surpluses.

During the last decade, states have also hiked their allocations to the social sector significantly. The allocation by states to the social sector was doubled from Rs 35,132 crore during 1990-91 to Rs 73,610 crore during 1996-97. The social sector budget rose to Rs 1,49,629 crore during 2003-4 and as per budget estimates, states had a provision of Rs 2,33,217 crore in the current fiscal (2006-7). (See Graph: Rising state allocation for social sector).

“According to the accounting principle followed by the central government, funds from the Centre to the states are classified as revenue expenditure. Since the revenue expenditure target has to be reduced to 0 per cent under FRBMA, there exists an upper limit for the Centre to support the states,” says Pronob Sen, principal advisor to the Planning Commission. Sen argues that states implement substantial number of social sector programmes in terms of physical work. Since the Centre does not have the institutional mechanism to implement such projects, it supports the states in terms of funds and guidelines to ensure ‘a certain degree of uniformity.’


Will the states agree for more?
States are spending increasingly on the social sector but hesitate to take up further burden



Source: www.rbi.org.in
Note: These figures include expenditure on social services, rural development, food storage and warehousing under revenue expenditure, capital outlay and loans and advances by state governments. All figures in Rs (crore).


Union Vs states over FRBMA

The Centre and states are at loggerheads over the proposal. State governments vehemently oppose the very idea of bearing the cost of social sector programmes. For them, it would mean sacrificing overall development for fiscal prudence. Also, the FRBMA mandates the states to reduce the revenue and overall fiscal deficits. States argue that to meet the targets they also need to reduce spending in the social sector. So any financial burden from the Union government will result in failure to do so. Since the National Development Council (NDC) meeting in the first week of December last year, all the states have been opposing this move. While addressing the NDC meeting, Prime Minister Manmohan Singh said, “High level of public spending are needed in many areas but they should and they must be achieved through improvements in revenue mobilisation and greater efficiency in expenditure.”   

“Due to the precarious fiscal position, we will not meet the target set under FRBMA. The Centre needs support for carrying on with social sector initiatives,” says Thomas Isaac, finance minister, Kerala. “FRBM targets shouldn’t come in between poverty alleviation grants. The Centre must make concessions to backward states like Orissa and provide more central funds. We will oppose any such move to curtail funds,” says Prafulla Chandra Ghadei, finance minister, Orissa.

In fact, the current proposal is a spill over from the recent fight between the Union ministry of finance and the Planning Commission over increased government spending on programmes like the National Rural Employment Guarantee Act (NREGA), Sarva Sikhsha Abhiyan etc for the 11^th Five-Year Plan. The Planning Commission had opposed giving preference to FRBMA over social spending. It had suggested that responsibilities should be shifted to states to enable the Centre to fund flagship programmes for the next five years as well as meeting fiscal targets.


Accounting problems

The controversy over FRMBA has triggered some interesting questions about the Indian accounting system. Should development schemes be treated as revenue expenditure as many of them also create capital? Secondly, is fiscal deficit such a menace as it is considered? Should we curtail social spending to bring down revenue deficit? Particularly when defence is also revenue expenditure, and the government refuses to reduce defence spending using certain exemptions under FRBMA. Development economists feel that social sector spending should be kept out of the revenue expenditure account.

Take for example, NREGA. Using guaranteed jobs, it creates ecological as well as physical capital. So, ideally, instead of being treated as revenue expenditure, it should be capital expenditure. “In the long term, social sector spending creates social and economic capital. So terming it revenue expenditure is not sensible,” says C P Chandrashekhar, an economist with Delhi-based think tank Economic Research Foundation.

In its approach paper to the 11^th Five-Year Plan (2007-12), the Planning Commission has warned that the plan focus on education, health and agriculture might be “defeated if the FRBM discipline were insisted upon with the current definition of revenue deficit”. The Planning Commission, while stressing the need for restructuring the role of the government, says that with diminishing public resources to the private sector under the competitive market system, the government should focus its attention towards the social sector and specifically towards expanding rural infrastructure.

Arguing against FRBMA, Jayati Ghosh, professor, Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi, says, “Reducing deficit may well have depressing effects on economic activity.” She adds that large-scale fiscal deficits do not necessarily lead to higher inflation as inflation is caused by excess demand against supply. “There is nothing wrong in maintaining large-scale fiscal deficits if resorting to public debt is done only to meet investment requirements as long as their social rate of return is higher than the rate of interest,” says Siba Sankar Mohanty, research analyst, Centre for Budget and Accountability, a Delhi-based advocacy and research group.

The Parliamentary Standing Committee on Finance, which examined the FRBM bill in its report in 2000, had suggested that planned deficit financing per se is not harmful to the economy as long as it resulted in creation of assets and adequate returns from these assets to the economy at large. Arguing for greater flexibility in FRBMA targets, the committee had said, “Although the Act permits the government to exceed a specified level of revenue and fiscal deficit in the event of national security and national calamity, these alone cannot be the only areas of concern and there could be other circumstances due to which it may be extremely difficult for the government to achieve specific targets.”

With cash-rich but hesitant states on the one hand and political compulsions in the wake of the forthcoming assembly elections in Uttar Pradesh, Punjab and Gujarat on the other, it will be interesting to see how the UPA government strikes a balance between the ‘aam admi’ programmes and fiscal prudence.

“The Centre’s resources have been going to areas which are the primary responsibility and concern of the states. Such programmes must involve a significant state contribution to total costs. This would enhance a sense of ownership, a sense of partnership and also efficiency in implementation,” said Prime Minister Manmohan Singh during his inaugural speech at the NDC meeting in December last year.

Watch out for the Union Budget 2007-8.