Federalism, Fiscal Space, and Public Investment Spending: Do Fiscal Rules Impose Hard Budget Constraints?

Working Paper No. 872

Federalism, Fiscal Space, and Public Investment Spending:

Do Fiscal Rules Impose Hard Budget Constraints?*

Pinaki Chakraborty

Levy Economics Institute of Bard College

August 2016

* Paper presented at the workshop “Central Local Government Relations: Fiscal Sustainability,” organized by the ADB Institute (ADBI),

Tokyo, Japan, and Zhongnan University of Economics and Law, Wuhan, China, and held at Zhongnan Univerisity on October 24–25,

2015. The author is grateful to ADBI for the opportunity to write this paper for the workshop. Comments received from Naoyuki

Yoshino, Jorge Martinez-Vazquez, Peter Morgan, and Fang Ying are gratefully acknowledged. The author is also grateful to Abhishek

for research assistance and to Antra Bhatt for helping with the review of literature. Lekha Chakraborty also made very useful suggestions

for improving the draft, and Usha Mathur provided able secretarial assistance. Contact: [email protected].in.

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ABSTRACT

The primary objective of rule-based fiscal legislation at the subnational level in India is to

achieve debt sustainability by placing a ceiling on borrowing and the use of borrowed

resources for public capital investment by phasing out deficits in the budget revenue account.

This paper examines whether the application of fiscal rules has contributed to an increase in

fiscal space for public capital investment spending in major Indian states. Our analysis shows

that, controlling for other factors, there is a negative relationship between fiscal rules and

public capital investment spending at the state level under the rule-based fiscal regime.

Keywords: Fiscal Deficit; Revenue Deficit; Fiscal Rule

JEL Classifications: H00, H6

India is a federal country of 29 states and 7 centrally administered union territories. It has a

highly decentralized federal fiscal structure in which state governments spend more than 56

percent of total public spending but their share of combined revenue is only 38 percent.

Although there are multiple channels of transfers, this gap between revenues and

expenditures is met primarily through vertical transfers from the Union to the states through

the statutory Finance Commission.

Burgeoning fiscal deficits at the subnational level were a

major fiscal management issue for India during the 1990s and early 2000s. During this

period, piecemeal attempts were made to bring fiscal discipline to the state level, both at the

insistence of the central government and in the form of state-specific interventions by

multilateral institutions (e.g., the Asian Development Bank and the World Bank).

In order to ensure fiscal discipline, the 12th Finance Commission of India (Finance

Commission 2004) recommended rule-based fiscal controls at the state level. This also

created a mechanism for providing performance incentive–based transfers for better fiscal

management.

Performance incentives in the form of debt consolidation and relief were

linked to reductions in state-level fiscal and revenue deficits

relative to the gross state

domestic product (GSDP) within a rule-based fiscal framework.

This process of legislative

control over deficits was further reinforced by the 13th Finance Commission (Finance

Commission 2009) by providing separate performance incentive grants.

As per the recommendations of the 12th Finance Commission, if a state enacted a Fiscal

Responsibility Act (FRA) specifying 3 percent of GSDP as the upper bound for its fiscal

deficit and eliminated its deficit in the current account of the budget (i.e., revenue deficit)

within a specific time period (by 2008–09), the state became eligible for debt rescheduling. If

a particular state adhered to those targets specified in the act, a part of the state’s debt to the

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The Finance Commission is a statutory constitutional body appointed by the President of India quinquennially

for the distribution of the net proceeds of taxes of the Union government between the Union and the states and

establishing principles that should govern the grants in aid of the revenues of the states out of the Consolidated

Fund of India. Apart from the Finance Commission, resources to the states are transferred through Planning

Commission and various ministries of the Union government. Finance Commission–recommended transfer

continues to be the primary channel of resource transfer to the states.

Prior to the recommendations of the Finance Commission in 2004, a few states introduced FRAs on their own.

A few of them did it as a part of the subnational structural adjustment lending program support provided by the

Asian Development Bank and the World Bank. A review is available in Rao and Chakraborty (2006).

Revenue deficit is the difference between revenue receipts and revenue expenditure and fiscal deficit is the

total borrowing or the aggregate resource gap in the budget.

Although state-specific FRAs have other commitments (such as reduction in guarantees given by the state

governments, the level of contingent liabilities, and in some cases, level of debt), the incentive-based transfers

from the Union government structured by the Finance Commission were linked to the reduction in revenue and

fiscal deficits. Thus we primarily focus on these two indicators.

federal government would be written off. All the states in India now have adopted FRAs. The

provisions included in these acts are more or less similar across states, particularly with

regard to revenue and fiscal deficit reduction. As specified in the state-specific acts, states

cannot borrow more than 3 percent of GSDP and are required to eliminate their revenue

deficit within a specified time frame. Since the primary objective of the act is to phase out

revenue deficits and to put an overall cap on borrowing, the core emphasis therefore is to

improve public capital investment. Thus, if revenue deficit is zero, public capital investment

will be equal to government borrowing. If there is revenue surplus, investment will be equal

to borrowing plus the revenue surplus. The fixed borrowing limit of 3 percent of GSDP on

the other hand is to ensure overall fiscal sustainability of subnational debt through a hard

budget constraint. State-specific acts also imposed limits on government guarantees,

associated contingent liabilities, and off-budget borrowing.

The main objective of this paper is to examine whether the application of a fiscal rule resulted

in an increase in the fiscal space for public capital investment spending in Indian states. The

focus is state-level capital spending, reflected in state budgets, although it does not include all

public sector investment in a state, as data are not readily available. For aggregate public

sector investment in a state, there are measurement issues regarding intra-public sector

transactions and investments. It is therefore difficult to arrive at a precise estimate and these

transactions are not considered in the present analysis.

Although macroeconomic stabilization is a federal government function, subnational deficit

controls have implications for both macrostabilization and overall fiscal management in

India, since the central government and the states are co-equal partners in public spending

and both the levels of governments have large fiscal imbalances. In other words, fiscal and

macroeconomic stability in a large federation like India depends not only on the fiscal deficit

of the central government but also on the states’ deficits. In India, states in the pre-FRA

period had a combined fiscal deficit almost equal to that of the federal government. The

average state fiscal deficit was 4.5 percent of GDP during 1998–99 to 2003–04, while the

central government’s fiscal deficit was 5.2 percent of GDP for the same period. Since the

combined state deficits are large, and given the multilevel fiscal structure, overall deficit

reduction may not be fully achieved if deficits are not controlled for by each level of

government. From this standpoint, this research paper adds value to understanding the

complexities of macro fiscal policies in a large federal system.

FISCAL RULES: ARE THEY USEFUL?

Rules may be necessary to restrain governments that engage in discretionary policies which

have a deficit bias (Buchanan and Wagner 1977), and to promote consistency in policy

commitments (Kydland and Prescott 1977). Koptis (2001) argued for a well-designed rule-

based fiscal policy for mitigating a country’s susceptibility to a crisis. According to Koptis,

an inconsistency between a country’s fiscal stance and its exchange rate regime played an

important role in the currency crises of many countries (e.g., Russia, Brazil, and Ecuador).

These crises were also due to capital outflows where foreign investors’ perceptions about

government solvency were an important factor. Khemani (2008) argued that in decentralized

economies, the implementation of fiscal rules could be useful for incentivizing better fiscal

performance by state and local governments, and thus promoting fiscal prudence. However,

the incentive structure may need to be designed in such a way that local governments do not

circumvent transfer conditionalities, and in doing so not follow fiscal rules. The extant

empirical literature, such as Krogstrup and Walti (2008), Feld and Kirchgssner (2006), and

Schaltegger (2001), shows that fiscal rules have a significant impact on budget balances. A

few studies carried out using US data show that the strength of the fiscal rule was directly

proportional to a reduction in unexpected deficits (Poterba 1995; Alt and Lowry 1994;

Alesina and Bayoumi 1996). In the case of Canadian provinces, a few studies indicate that

provincial legislation to limit deficits led to stronger budget balances, ceteris paribus (Tellier

and Imbeau 2004). The literature on the impact of fiscal rules on fiscal performance in

emerging-market economics is rather scanty (Chakraborty and Dash 2013).

WHY FISCAL RULES MAY NOT WORK

Milesi-Ferreti (2004) analyzed the effectiveness of fiscal rules in light of “creative

accounting.” Creative accounting is defined as a measure by means of which an improvement

in the fiscal balance is observed without an accompanying actual improvement in the

intertemporal budgetary position of the government. Using a two-period model developed by

Hagen and Harden (1996) and assuming that fiscal rules are being imposed on the

“measured” fiscal balance and that a penalty must be paid if creative accounting is detected, it

is observed that budget transparency is inversely proportional to creative accounting.

Additionally, even if the costs of engaging in creative accounting are large, tighter rules may

still induce creative accounting. Manasse (2007) discussed the incentive effects of budget

limits. According to this study, when limits are imposed on the deficit-output ratio,

governments keep the deficit just below the limit to avoid sanctions and have no incentive to

practice fiscal consolidation during “good times.” These rules then also indirectly have large

negative effects on welfare.

Apart from rule-based fiscal controls, there have been wide-ranging international experiences

with structural adjustment lending for fiscal consolidation with mixed outcomes. A World

Bank (1992) review

observed that adjustment lending was associated with fiscal deficit

reduction and an increase in revenue, but the general spending cuts were often at the expense

of critically important operation and maintenance and there was too much spending on

salaries relative to non-salary inputs. Mavrotas and Quattara (2003), while analyzing the

effect of development assistance on public sector behavior, observed that official

development assistance (as measured by the OECD) reduced revenues in the short run but

raised them in the long run. The study by Gupta et al. (2003) of foreign aid in 107 countries

during the period 1970 to 2000 observed that while concessional loans were associated with

higher domestic revenue, mobilization grants had the opposite effect.



APPROPRIATE STRUCTURE FOR FISCAL RULES

The key goal of a fiscal rule is to achieve higher credibility for fiscal policy by reducing

discretionary intervention in the conduct of macroeconomic policies. With regard to design, a

fiscal rule should be well defined, transparent, focused, consistent with macroeconomic

policies, simple, flexible enough to accommodate cyclical fluctuations, enforceable, and

supported by efficient policies (Kopits and Symansky 1998). It has been argued that a fiscal

rule indicator needs to be operationally simple, flexible, growth oriented, and easily

monitored.

In the case of decentralized economies, two approaches are generally adopted: an

autonomous approach and a coordinated approach. In the case of a coordinated approach, all

subnational governments are subject to the same rule. In the case of India, the fiscal rule as

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Cited in World Bank (2005)

imposed is also simple and has been applied with uniform deficit reduction targets across

states. The European Union and emerging economies focused on targets that are numerical

and uniform across countries (the autonomous approach).

A key component of the design of fiscal rules is ensuring their sustainability and deciding on

an optimal level of fiscal rule indicators. The literature on sustainable fiscal rules has evolved

since the 1990s, when rules were considered to be appropriate if they respected the

intertemporal budget constraint. Spaventa (1987) finds that a design where the sustainability

of a fiscal rule is based on the satisfaction of the budget constraint does not take into account

the financial situation of the public sector. Using a sovereign debt framework (which assumes

that the government cannot choose the duration of its debt), Hatchondo, Martinez, and Roch

(2012) show that implementing a debt ceiling may prove beneficial for the government, as an

expectation of a lower debt level would lead to a decline in interest rates. They also find that

lower debt ceilings lead to less responsiveness in the interest rate to income shocks, and

consumption becomes less volatile as fiscal policy becomes less procyclical. Pappa and

Vassilatos (2007) and Poplawski Ribeiro, Beetsma, and Schabert (2008) find that debt

ceilings may be better indicators than a ceiling on the government’s deficit.

A more recent framework by Bertelsmann (2013) supports the establishment of independent

fiscal institutions (IFIs) as an important component of ensuring that the fiscal rules are

adhered to and that the mechanism includes design factors to ensure strong monitoring and

evaluation of rules on a continuous basis. These IFIs could exercise an advisory role, report

the true magnitude of government liabilities, and project the long-term implications of fiscal

policy and new fiscal policy announcements. Arguments in favor of IFIs include the

following: better transparency in public finances; at a more sophisticated level, an IFI can

also undertake the task of monitoring and ensuring compliance with a fiscal rule, as well as

include sanctions for nonobservance of a debt ceiling; and finally, IFIs can also encourage

and assist governments with publishing public finance data at regular intervals and placing

these data in the public domain.



SUBNATIONAL FISCAL RULES IN INDIA

In India, at the instance of the World Bank and the Asian Development Bank, fiscal rules

were introduced by a few states prior to the recommendations of the 12th Finance

Commission. This was done through multilateral structural adjustment lending to the states

by these banks (Rao and Chakraborty 2007). The 12th Finance Commission’s

recommendations became operational in fiscal year 2005–06. The states that enacted FRAs

prior to this and in accordance with the recommendation of the 12th Finance Commission are

shown in appendix table A2.

The incentive structure of the FRA proposed by the 12th

Finance Commission is the following:

[E]ach state should enact fiscal responsibility legislation. This

has been stipulated as a precondition for availing the debt-

relief scheme. This legislation should, at a minimum, provide

for (a) eliminating revenue deficit by 2008–09; (b) reducing

fiscal deficit to 3 percent of GSDP or its equivalent defined as

ratio of interest payment to revenue receipts; (c) bringing out

annual reduction targets of revenue and fiscal deficits; (d)

bringing out annual statement giving prospects for the state

economy and related fiscal strategy; (e) bringing out special

statements along with the budget giving in detail number of

employees in government, public sector, and aided institutions

and related salaries.



To avail themselves of the debt consolidation and relief facility under the act, all the states

(except Sikkim and West Bengal) enacted their FRAs with a uniform deficit target (both

revenue and fiscal deficits) following the submission of 12th Finance Commission report in

2004. Already existing state-specific FRAs were amended to comply with the

recommendations of the 12th Finance Commission. It is important to highlight that the 12th

Finance Commission emphasized that all states only needed to enact an FRA as prescribed to

receive debt consolidation. However, to be eligible for debt relief, states were required to

adhere to the targets of deficit reduction prescribed in the act. In addition to adhering to the

Commission’s prescription of numerical deficit targets, several states volunteered to impose

different fiscal restrictions on themselves, such as targeting outstanding liabilities,

institutional rules for expenditure management, and timely review of fiscal performance, as

summarized in Simone and Topalova (2009). The process of fiscal consolidation continued

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The 12th Finance Commission’s report was submitted in November 2004 and the recommendations became

operational beginning in the fiscal year 2005–06.

for the period from fiscal years 2005–06 to 2009–10, the five-year award period of the 12th

Finance Commission.

The 13th Finance Commission also proposed an incentive framework

to ensure that the states remain within the FRA deficit targets. There was some apprehension

that maintaining fiscal prudence post–global financial crisis would be a challenging task.

As articulated in 13th Finance Commission Report, in 2009–10 the combined (Union and the

states) debt-to-GDP ratio remained high (82 percent) despite fiscal correction through the

implementation of fiscal responsibility frameworks during the period from 2005 to 2010. The

13th Finance Commission proposed a target of 68 percent for the combined Union and state

debt-to-GDP ratio by the year 2014–15, with the central government’s debt-to-GDP ratio

reaching 45 percent. The Commission had taken the elimination of the revenue deficit as the

long-term and permanent target for both the Union and the states. The Commission’s

prescribed fiscal consolidation path for the central government required a decline in the

revenue deficit from 4.8 percent of GDP (as projected for the fiscal year 2009–10) to a

revenue surplus of 0.5 percent of GDP by 2014–15. These prescriptions of fiscal

consolidation in turn allowed for acceleration in capital expenditures to 3.5 percent of GDP

by 2014–15. As assessed by the 13th Finance Commission, the proposed fiscal consolidation

path was growth promoting, as it focused on the elimination of the revenue deficit to ensure

that net public borrowing was exclusively used for growth-enhancing public investment.

As noted in the 13th Finance Commission Report, 26 states (operating under their FRA)

reached their expenditure and debt targets ahead of the scheduled timeframe proposed by the

12th Finance Commission and showed significant fiscal correction. According to the 13th

Finance Commission, the main reason behind this fiscal correction was the benefit of higher

shares of federal taxes due to the high federal tax growth and improvement in state tax

revenues. State debt-to-GSDP was also reduced sharply during this period to below 30

percent of GDP. However, there were wide variations in fiscal performance among the states

(an issue we discuss later). In order to continue to strengthen the process of fiscal

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As per the Indian Constitution, the Finance Commission is a temporary body appointed quinquennially to

recommend devolution of taxes and grants to the states for five years.

The Commission recognized that states were permitted to borrow more than the Fiscal Responsibility and

Budget Management Act (FRBMA) targets in 2008–09 and 2009–10. This specific relaxation of targets for two

years was a part of the fiscal stimulus package announced by the central government to increase government

spending to contain the adverse impact of the global financial crisis. Due to this relaxation of target, the

Commission allowed one year (i.e., 2010–11) as a year of adjustment and recommended fiscal consolidation

from 2011–12 (Finance Commission 2009: 25).

consolidation at the state level, the 13th Finance Commission made the following

recommendations:

The Medium Term Fiscal Plan should make explicit the values

of the parameters underlying expenditure and revenue

projections and the band within which these parameters can

vary while remaining consistent with FRBMA targets.

The FRBMA should specify the nature of shocks which would

be required before any relaxation of FRBMA targets.

States should amend/enact their FRBMAs to build in the fiscal

reform adopted by the state. State-specific grants

recommended for a state should be released upon compliance

with fiscal reform goals. (Finance Commission 2010: 6)



KEY FISCAL INDICATORS: THE LONG-RUN TREND

In 1991, a large combined fiscal deficit on the order of 9.9 percent of GDP (i.e., the Union’s

fiscal deficit of 6.6 percent and combined state deficit of 3.19 percent) and a huge external

current account deficit, coupled with dwindling foreign exchange reserves, are considered to

be the factors that contributed to the macroeconomic crisis and the subsequent economic

reforms in India. One key component of the big-bang economic reform was fiscal

consolidation. Fiscal reform was a combination of tax reforms, expenditure control, and

reforms in the management of public debt. We will discuss these very briefly.

As part of the fiscal reform, a major tax reform initiative was undertaken to overhaul

the country’s complex tax system. Simplification and moderation in the tax rate and

modernization of the tax administration system were the main components of tax reform. The

peak rate of personal income tax was reduced from 50 percent in 1991 to 30 percent in 1997–

98.

The reform of indirect taxes was comprised of a reduction in the customs tariffs and the

Union excise duty structure. A sharp rate reduction in indirect taxes contributed to the decline

in indirect tax revenue during the 1990s, but direct tax revenue had shown commendable

growth during this period. As the share of indirect taxes was much higher than direct taxes,

the increase in the direct tax could not offset the revenue loss from indirect taxes.

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Currently India has one of the lowest income tax rates in the world.

As revenues were not rising, in the initial years of economic reform fiscal consolidation was

achieved by reducing discretionary development spending through reducing capital

expenditure for public investment. However, the success achieved in containing the deficit

during first half of 1990s was short lived. The impact of the Fifth Pay Commission award

created an explosive fiscal imbalance at the federal level, as well as in the states, taking the

combined fiscal deficit to 9.39 percent of GDP in 1999–2000 (see figure 1). However, the

fiscal deficit started declining gradually from 2002–03 and reached an all-time low of 4

percent in 2007–08. This was a spectacular improvement in the fiscal situation of all levels of

government compared to 1991. This phase was also characterized by high growth in

revenues. During 2003–04 to 2007–08, central government revenues grew at the rate of 18.58

percent, and the states’ revenues grew at the rate of 16.46 percent. GDP growth during the

same period was 8.89 percent per annum.

In 2003, the central government enacted the Fiscal Responsibility and Budget Management

Act (FRBMA). As mentioned earlier, the states also enacted their state-level Fiscal

Responsibility Acts (FRAs) on the recommendation of the 12th Finance Commission. All of

the states, except West Bengal and Sikkim, enacted their respective FRAs during this period.

Many public finance specialists attributed the decline in deficits in the years leading up to

2007–08 to FRA legislation. However, with the global financial crisis, India again

experienced high levels of fiscal imbalance (see figure 1), especially at the level of the central

government. The changes in the fiscal deficit as a percentage of GDP for the period from

1990–91 to 2014–15 (budget estimates) is given in figure 1. However, states remained

fiscally prudent during the post–global financial crisis period. The outstanding-debt-to-GDP

ratio also declined significantly in recent years and fell well below the targeted level

recommended by the 13th Finance Commission, both for the central and state governments.



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The Fifth Pay Commission award was a pay hike for the government employees, representing a consequent

increase in government expenditure.

Figure 1: Fiscal Deficit as Percentage of GDP



Figure 2: Outstanding Debt as Percentage of GDP

Although key indicators of fiscal prudence (viz., deficit and debt as a percentage of GDP)

declined for the states over the years, it is important to examine the expenditure profile of the

central government and states. As evident from figure 3, the aggregate expenditure-to-GDP

ratio (all states) declined gradually until 2011–12 and started increasing in 2012–13. If we

Percent

Year

Combined Central State

Percent

Year

combined Central State

consider capital expenditure alone, it is evident that there has been a decline in the Union’s

capital-expenditure-to-GDP ratio from 2003–04. However, since 2002–03 the capital

expenditure of the states in relation to GDP is higher compared to the central government

(see figures 3 and 4). In other words, post-FRA, state governments have become the primary

drivers of capital spending, both for the social and economic sector, while the central

government’s capital-expenditure-to-GDP ratio continued to decline during this period. It

needs to be highlighted that in the pre-FRA period, the central government was the primary

driver of capital spending, but this is no longer true. This shift in capital spending at the state

level is an important development and one needs to examine how this shift plays out in the

medium term in terms of the composition and quality of public investment spending.

Figure 3: Total Expenditure as a Percentage of GDP

Percent

Year

Combined Central State

Figure 4: Capital Expenditure as a Percentage of GDP



Our analysis shows that the era of rule-based fiscal control witnessed a sharp reduction in the

overall fiscal imbalance at the state level. This improvement in fiscal health can be

characterized as an intertemporal reduction in both the fiscal- and revenue-deficits-to-GDP

ratios. As they evolved up to 2007–08, the fiscal positions of the state generated a revenue

surplus and brought down the gross fiscal-deficit-to-GDP ratio below the 3 percent FRA

target. This also implies that states have overadjusted their fiscal deficits. At the state level,

fiscal consolidation has been achieved through: higher state tax revenue mobilization, largely

due to introduction of a value added tax (VAT) at the state level in 2005; increased central

devolution due to the growth in federal taxes; and a reduction in the revenue- and

expenditure-to- GSDP ratios, primarily due to the decline in economic and social services

expenditures and interest burden.

It is argued that improved fiscal balances have also

contributed to the increase in fiscal space at the state level. Although, in the post–global

financial crisis years there was fiscal expansion at the central government level, resulting in a

sharp increase in the fiscal deficit of the central government, the states continued with fiscal

restraints and in the aggregate state fiscal deficits remained below the FRA target between

2008–09 and 2014–15 (budget estimates). However, differences were observed in the

interstate fiscal imbalance profile. Though the rate of increase of deficits varied across states,

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It is observed that the decline in the interest burden in the last couple of years is due to the softening of

interest rates on government securities. It is also argued that measures, such as debt swap schemes in a low-

interest regime, have benefited the states in reducing the interest burden.

Percent

Ye a r

Combined Central State

most of the states were able to generate revenue surpluses and successfully reduced their

fiscal deficits below 3 percent of GSDP during the post-FRA period. It needs to be

emphasized that the states that achieved a revenue surplus and a fiscal deficit level below 3

percent of GSDP were also the ones that had a reasonably better history of fiscal management

and fiscal prudence (table 1). A comparison of the fiscal imbalance profile ex ante–FRA and

ex post–FRA is given in figures 5.1 to 5.9. In these figures states are categorized as high-,

middle-, and low-income states. Fiscal imbalance profiles for special category states are

shown in figures 5.10, 5.11, and 5.12.

As is evident, most states overadjusted their fiscal

deficits. Our data analysis also suggests that low-income states have adjusted their deficits

more compared to high- and middle-income states. In other words, these states have

borrowed less than the prescribed limit of borrowing under the FRAs, with exceptions in a

few states (e.g., Kerala, Punjab, and West Bengal). These three states had to borrow to

finance the deficits in their revenue accounts.



Special category states are the states in north east India and other hilly states in the northern part of India with

special federal fund dispensation due to their higher fiscal and cost disabilities.

Table 1: Major Fiscal Indicators (as a percent of GSDP)

Revenue Deficit Fiscal Deficit Primary Deficit

Average

before

FRBM

Average

after

FRBM

Average

before

FRBM

Average

after

FRBM

Average

before

FRBM

Average

after

FRBM

Group A

Goa 1.7 -0.5 4.6 2.8 1.7 0.8

Maharashtra 2.4 -0.3 4.1 1.6 2.0 -0.1

Haryana 1.4 0.5 3.3 2.3 0.9 0.9

Gujarat 3.2 0.0 5.1 2.4 2.3 0.4

Tamil Nadu 1.7 -0.2 2.8 2.0 1.0 0.4

Group B

Kerala 2.7 2.2 4.2 3.4 1.7 1.0

Punjab 3.3 2.3 4.8 3.3 1.2 0.4

Karnataka 0.9 -0.8 3.1 2.5 1.4 0.8

Andhra Pradesh 1.6 -0.4 4.1 2.4 1.3 0.5

West Bengal 4.9 2.5 5.1 3.3 1.7 0.3

Group C

Rajasthan 3.3 -0.1 5.7 2.1 2.0 -0.4

Jharkhand 1.3 -1 6.1 2.7 4.5 0.8

Chhattisgarh 0.4 -2.5 2.7 0.7 0.6 -0.4

Madhya Pradesh 2.3 -2.5 4.9 2.2 2.1 0.1

Odisha 3.7 -2.2 6.0 0.0 1.7 -1.9

Uttar Pradesh 3.0 -0.4 5.0 3.4 1.7 0.6

Biha

2.1 -2.6 5.6 2.2 1.2 -0.1

Special Category States

Sikkim -10.1 -6.2 5.0 1.3 1.5 -0.7

Uttarakhand 2.1 -0.7 4.7 2.7 2.2 0.6

Himachal Pradesh 5.9 -0.1 9.2 3.7 3.7 -0.5

agaland -6.1 -5.3 3.6 3.6 0.0 0.5

Tripura -0.8 -7.5 5.4 -0.1 1.7 -3.0

Mizoram 2.9 -3.3 14.5 6.4 8.3 2.0

Meghalaya -0.5 -1.6 4.3 2.7 1.8 0.9

Arunachal Pradesh -4.6 -13.5 7.8 2.9 3.2 -0.5

Jammu and Kashmir -3.2 -5.7 4.9 5.3 0.3 1.3

Manipu

1.8 -12.1 8.3 4.8 3.6 0.8

Assam 1.4 -1.8 3.2 0.6 0.6 -1.3

Note: The timeframe of the state-specific average differs across states, as different states introduced

their FRAs at different points in time. For details, see appendix A2.

Note: The “-” sign indicates a surplus.

Source: Reserve Bank of India Study on State Finances 2014–15





Our state-specific descriptive analysis of fiscal balances also suggests that the overall state-

level fiscal balance has improved with the introduction of a fiscal rule. However, state-

specific fiscal imbalances are different across states, especially with regard to revenue

deficits. A few states continued to have deficits in their revenue accounts, implying borrowed

resources were being used for financing revenue or current expenditure. On the other hand if

we consider fiscal deficits, most states remained within the prescribed 3 percent FRA target.

This descriptive analysis does not conclusively establish the exact impact of a fiscal rule on

fiscal balances, the way state-level fiscal consolidation has been achieved, or the nature of the

relationship between different state-level macro and fiscal variables. One needs to control for

such factors to examine the impact of a fiscal rule on fiscal balances and spending. The

descriptive analysis also does not help in understanding the process of fiscal adjustment in a

rule-based fiscal control regime across states. Due to multiple factors, panel data analysis,

which is well suited to the studies that deal with dynamic changes, is used to address these

issues. Our analysis used a dataset of 14 major non-special category states

spread over 15

years (from fiscal year 2000–01 to 2014–15) to examine the fiscal rules and public

investment spending at the state level. We have used the Arellano Bond Panel estimation.



THE ECONOMETRIC ESTIMATION

The final model has been defined to include two different determinants (per capita gross state

domestic product and per capita central government transfer) and two different dummies

(VAT and FRA), with the FRA dummy being the most important variable of interest.



These states are Andhra Pradesh, Bihar, Gujarat, Haryana, Karnataka, Kerala, Madhya Pradesh, Maharashtra,

Orissa, Punjab, Rajasthan, Tamil Nadu, Uttar Pradesh, and West Bengal. Small and/or special category states

are ignored in this study as they are overreliant on assistance from the central government. Overdependence on

transfers from the central government severely constrains the fiscal autonomy of such states, and hence, it

affects their public finance management ability.

Arellano and Bond (1991) suggested that if one is considering the orthogonality condition that exists between

lagged values of the dependent variable and the disturbance variable, then the additional instrument can be

obtained in the dynamic panel data model.

Econometrically, the model can be specified as follows:

i,t

= K

i,t-1

+ 



gpc

i.t

+ 



igft

i,t

+ 



.vat + 



. fra +u

i,t

~ IID(0, 





)

Where: K = per capita capital outlay

gpc = gross state domestic product in per capita (in nominal terms)

igft = per capita intergovernmental fiscal transfers

.vat = 0: ex ante VAT

= 1: ex post VAT

.fra = 0: ex ante FRA

= 1: ex post FRA

Table 2: Fiscal Impact on Capital Outlay

Variable Per-capita Capital Outlay

L.K

0.526

***

(5.35)

Igft

0.167

***

(6.58)

Gpc

0.00413

(2.52)

VAT

164.0

***

(2.64)

FRA

-135.6

(-1.91)

Const.

-34.6

(-0.88)

No of observations = 190

Wald chi2(5) = 1522.11

Prob > chi2 = 0.000

Source: Author’s computations based on Reserve Bank of India Study on State Finances

(various dates). Available at: https://rbi.org.in/scripts/AnnualPublications

Note: t-statistics in parentheses

*p < 0.1, **p<0.05, and ***p< 0.01

Our analysis shows that the lag of per capita capital outlay, per capita transfer (igft), and per

capita gross state domestic product (gpc) have a positive and significant impact on an

increase in per capita capital outlay, and the VAT dummy also has a positive and significant

effect on per capita capital outlay. However, we observed a negative relationship between the

FRA dummy and the capital outlay at the state level.

SPENDING INERTIA



This result is not surprising. We would like to emphasize that states in the post–FRBMA

period are extremely cautious in spending, as reflected in their overcorrection of deficits. This

has, in turn, depressed capital spending in the states. This spending inertia has also

contributed to a large accumulation of cash surplus holdings by states. The Reserve Bank of

India’s “Study on State Finances: 2011–12” observed that:

The surplus cash balances of the states stood at Rs. 852 billion

as on March 11, 2012. These cash balances get automatically

invested in the central government’s 14-day intermediate

treasury bills as well as in auction treasury bills (ATBs) where

states are non-competitive bidders, without any ceilings/

limits. Consequently, there is a spillover of the surplus

position of the states to the liquidity position of the Centre.

The build-up (and volatility) of the central government’s cash

surplus, in turn, reflects the unintended absorption of liquidity

from the banking system which poses a challenge to the

reserve bank’s monetary management.

The same study also pointed out that in its report submitted in fiscal year 2009–10, the 13th

Finance Commission “advised the state governments to first utilize their cash balances before

taking recourse to fresh borrowings, to finance their deficits so as to reduce the interest

burden.”

However, in practice, this did not happen.



http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/7CHSF300312.pdf

CONCLUSIONS

Though during the post-FRA period there was a reduction in the fiscal and revenue deficits of

the states, our econometric estimates show that capital spending for public investment was

negatively related to the FRA dummy. It needs to be highlighted that a one-size-fits-all

uniform rule across states came under criticism. Since different states operated at different

levels of sustainable deficits, imposing a uniform rule implied constraining capital spending

unless large revenue surpluses were generated. Our expenditure model shows that Indian

states have contained their public investment spending to comply with a fiscal rule once the

regression has controlled for the growth of intergovernmental transfers and other state-

specific factors. However, most states have overadjusted their fiscal deficit, resulting in the

accumulation of cash surpluses. The impact of the decline in investment spending on growth

is an area for further research.

To conclude, this phenomenon of accumulation of a cash surplus under a rule-based fiscal

regime at the subnational level was addressed by the 14th Finance Commission by changing

the design of the fiscal rules. The 14th Finance Commission has proposed that for the Union

government, the fiscal deficit ceiling will be 3 percent of GDP from fiscal year 2016–17

onwards. However for the states, there is flexibility for 0.25 percent over and above 3 percent

of GSDP for a given year if the debt-to-GSDP ratio is below 25 percent. Also if the states

limit their interest obligations as a percentage of revenue receipts below 10 percent, an

additional 0.25 percent of GSDP is allowed as extra fiscal space for capital spending. States

will be eligible for these flexibilities in borrowing only if there is no revenue deficit. One

needs to see how much the 14th Finance Commission’s recommendations are going to

change state-level fiscal behavior and the utilization of borrowed resources for capital

spending within the existing federal fiscal framework of transfers.

APPENDIX

Table A1: Instruments and Nature of Fiscal Rule: A Cross Country Comparison

Country Year Name and Nature of

Act

Numerical

Targets

Description

USA 1986

1990

2010

2011

Gramm-Rudman-

Hollings Act (GRH)

Budget Enforcement Act

– Expenditure rule

Pay-As-You-Go

(PAYGO) Act

Balanced Budget Rule –

Expenditure based

Yes

Specified a series of annual deficits targets with

a balanced budget to be achieved in 1991 and

subsequently moved to 1993.

Annual appropriations limit adopted for

discretionary spending.

Deficit-raising policies must be financed by

other measures over a specified time period.

Exempt programs included legislation with an

“emergency” designation, Social Security, and

the Bush tax cuts for the middle class.

Discretionary spending caps were introduced.

Additional spending cuts came into effect in

March 2013. These additional cuts are expected

to reduce US$1.2 trillion over a decade with

one-half coming from defense spending and the

other half from domestic programs, excluding

Social Security, Medicaid, parts of Medicare,

and certain other entitlement programs.

Japan 1947

1997

2006

2010

Balanced Budget Rule

Fiscal Structure Reform

Act

Expenditure Rule

Fiscal Management

Strategy

Yes

Current expenditure should not exceed

domestic revenues.

Revised balance budget rule: Reduce overall

government deficit to 3 percent of GDP;

numerical targets by spending category (public

investment, Social Security).

Any major increases in expenditure or

decreases in revenue need to be accompanied

by permanent expenditure reductions/revenue-

raising measures.

Canada 1991

1998

2006

Federal Spending

Control Act

Debt Repayment Plan

Target-based Plans

Yes

C$3 billion debt reduction and limitation in

program spending except self-financing

programs.

Eliminating net general government debt by

2021 and federal debt by 2013/14

EU 1992

2005

2012

Maastricht Treaty

Stability and Growth

Pact

Golden Rule

Yes

Debt and deficit ceiling: 60 and 3 percent of

GDP, respectively.

Country-specific medium-term objectives are

set for structural budget balance.

Annual pace of debt reduction (no less than

1/20th of the distance between the actual debt

ratio and the 60 percent threshold) starting

three years after a country has left the current

excessive debt procedure (EDP).

Argentina 2000

2004

Fiscal Responsibility

Law (FRL)

Implementation of

Revised FRL

Yes

Balanced budget rule: Balance revenue and

expenditure excluding social and infrastructure

expenditure. Additionally, for provinces debt-

servicing costs cannot exceed 15 percent of

current revenues after transfers deduction.

Expenditure rule: Primary expenditure cannot

grow more than nominal GDP; Federal Fiscal

Responsibility Council was instated in 2000,

however its activities were suspended in 2009.

Peru 2000

2009

2013

Balanced Budget Rule

Law 30099

Yes

Deficit ceiling for the non-financial public

sector. The ceiling was set at 2 percent of GDP

for 2000 and 2003, 1.5 percent of GDP for

2001, 2002, and from 2004–2008. Real growth

current expenditure ceiling of 2 percent (2000–

02), 3 percent (2003–08).

New limit of 2 percent for balanced budget was

set. Real growth of current expenditure limit

was at 4 percent, structural deficit limit at 1

percent of GDP.

Expenditure on maintenance of infrastructure,

goods, and services of social programs covered

by the performance-based budgeting scheme;

equipment intended for public order and

security were excluded from current

expenditure and were out of the ambit of the

stipulated limits.

Mexico 2006

2009

2013

Balanced Budget Rule –

Cash basis

Balanced Budget Rule

Expenditure Rule

Yes

Rule applies to the federal public sector which

includes the central government, social

security, and key public enterprises.

Status quo with exclusion of investment outlays

of the state-owned oil company, Pemex, from

the balanced-budget rule. Although sanctions

were also thought of, escape clauses also

existed.

Cap on structural current spending (SCS)

defined as current primary expenditure

including transfers to state and local

governments for capital but excluding those

outlays governed by automatic rules (pensions,

subsidies for electricity, and tax devolution);

SCS cannot grow faster than 2 percent in real

terms through 2017.

Australia 1985

1998

Expenditure Rule

Charter of Budget

Honesty Act

Yes

Expenditure Rule, Balanced Budget Rule,

Revenue Rule

Achieve budget surpluses over the medium

term; keep taxation as a share of GDP below

the level of 2007–08. Improve the

government’s net financial worth over the

medium term. Commitment to restrain real

growth in spending to 2 percent per year since

2009.

Brazil 2000 Fiscal Responsibility

Law

Yes Expenditure rule: Personnel expenditure is

limited to 50 percent of net current revenue for

the federal government, and 60 percent for

states and municipalities.

Debt rule: New borrowing must be at most

equal to public investment.

Cameroon 2002

2008

Balanced Budget Rule

Revised Balanced

Budget Rule

The Central African Economic and Monetary

Community (CEMAC) sets the fiscal rule.

Structural fiscal balance and non-oil basic fiscal

balance, respectively, as a percentage of

nominal GDP should be in balance/surplus.

Indonesia 1967

2004

Balance Budget Rule

Debt Rule

Yes

The consolidated national and local

government budget deficit is limited to 3

percent of GDP in any given year as per State

Finance Law and Government Regulation

23/2003.

Central and local government debt should not

exceed 60 percent of GDP.

India 2004

2009

Budget Balance Rule

Revised Budget Balance

Rule

Yes

Fiscal Responsibility and Budget Management

Act (FRBMA): reduce the fiscal deficit to 3

percent of GDP by 2008.

FRBMA was suspended in 2009. All states

barring three had met the targets; however, the

central government had not achieved the

stipulated targets.

Kenya 1997 Debt-based Rule Yes The debt-to-GDP ratio in net present value

terms should be below 40 percent and/or total

nominal debt to be below 45 percent of GDP (a

goal of their medium-term debt-management

strategy); government overdraft at the central

bank is limited to 5 percent of previous year

revenue; revenue should be at 21–22 percent of

GDP.

New

Zealand

1994 Fiscal Responsibility

Act

The government needs to run operating

surpluses annually until “prudent” debt levels

are achieved. Once these are achieved on

average total operating balances should not

exceed total operating revenues. In case of

deviations from the principles, the government

needs to specify the reasons; specific fiscal

targets should be set by the government for

three-year and ten-year objectives, typically in

percent of GDP.

Russia 2007

2009

2012

Balanced Budget Rule

Oil-price-based Fiscal

Rule

Russia’s legal fiscal framework relied on the

non-oil balance as a key fiscal indicator. The

budget included a long-term non-oil deficit

target of 4.7 percent of GDP. This was

suspended in April 2009 as a result of the

global financial crisis, and formally abolished

in 2012.

The rule sets a ceiling on expenditures (oil

revenue at the “base” oil price, plus all non-oil

revenues, plus a net borrowing limit of 1

percent of GDP). Once the reserve fund reaches

this threshold, at least half of excess oil

revenues should go to the National Wealth

Fund, while the remaining resources would be

channeled to the budget to finance

infrastructure and other priority projects.

Singapore 1991

1995

2008

Debt Rule

Balanced Budget Rule

(BBR)

Amendment to BBR

Spending to not exceed 50 percent of net

investment returns on reserves held by the

Monetary Authority of Singapore (MAS) and

the Government of Singapore Investment

Corporation (GIC).

Budget to be balanced across government term

of office (usually 5 years).

The rule was amended in 2008 to change the

benchmark to “expected long-term net real

investment returns.”

Table A2: Date of FRBMA and Period for Calculating Average

Sl. No State

Month of

FRBM

Period before FRBM Period after FRBM

1 Karnataka Sep 2002 1992–93 to 2001–02 2003–04 to 2012–13

2 Tamil Nadu May 2003 1994–95 to 2002–03 2004–05 to 2012–13

3 Kerala Aug 2003 1994–95 to 2002–03 2004–05 to 2012–13

4 Punjab Oct 2003 1994–95 to 2002–03 2004–05 to 2012–13

5 Uttar Pradesh Feb 2004 1994–95 to 2002–03 2004–05 to 2012–13

6 Gujarat Mar 2005 1998–99 to 2004–05 2006–07 to 2012–13

7 Mahrashtra Apr 2005 1998–99 to 2004–05 2006–07 to 2012–13

8 Himachal Pradesh Apr 2005 1998–99 to 2004–05 2006–07 to 2012–13

9 Rajasthan May 2005 1998–99 to 2004–05 2006–07 to 2012–13

10 Madhya Pradesh May 2005 1998–99 to 2004–05 2006–07 to 2012–13

11 Andhra Pradesh Jun 2005 1998–99 to 2004–05 2006–07 to 2012–13

12 Odisha Jun 2005 1998–99 to 2004–05 2006–07 to 2012–13

13 Tripura Jun 2005 1998–99 to 2004–05 2006–07 to 2012–13

14 Haryana Jul 2005 1998–99 to 2004–05 2006–07 to 2012–13

15 Manipur Aug 2005 1998–99 to 2004–05 2006–07 to 2012–13

16 Chhattishgarh Sep 2005 2000–01 to 2004–05 2006–07 to 2012–13

17 Assam Sep 2005 1998–99 to 2004–05 2006–07 to 2012–13

18 Uttarakhand Oct 2005 1998–99 to 2004–05 2006–07 to 2012–13

19 Arunanchal Pradesh Mar 2006 1998–99 to 2004–05 2006–07 to 2012–13

20 Meghalaya Mar 2006 1998–99 to 2004–05 2006–07 to 2012–13

21 Bihar Apr 2006 2001–02 to 2005–06 2007–08 to 2012–13

22 Goa May 2006 2001–02 to 2005–06 2007–08 to 2012–13

23 Jammu and Kashmir Aug 2006 2001–02 to 2005–06 2007–08 to 2012–13

24 Mizoram Oct 2006 2001–02 to 2005–06 2007–08 to 2012–13

25 Jharkhand May 2007 2002–03 to 2006–07 2008–09 to 2012–13

26 Nagaland Jan 2010 2006–07 to 2008–09 2010–11 to 2012–13

27 West Bengal Jul 2010 2008–09 to 2009–10 2011–12 to 2012–13

28 Sikkim Sep 2010 2008–09 to 2009–10 2011–12 to 2012–13

Source: Reserve Bank of India Study on State Finances, 2014–15

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