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Most states achieved and maintained the target fiscal deficit level (3 percent of GSDP) and eliminated the revenue deficit soon after the introduction of their Fiscal Responsibility Legislation (FRL). The responsible factors are- the acceleration of GDP growth, increased transfers from the Centre, decline in interest payments and increased central CSS expenditure contributed significantly to such consolidation.
India like several other countries, embarked in the mid-2000s on an ambitious project of fiscal consolidation, adopting fiscal rules aimed at curbing fiscal deficits and the Fiscal Responsibility and Budget Management (FRBM) Act, adopted by the centre in 2003.
The financial position of the states improved considerably after 2005, the average fiscal deficit was curbed to less than 3 percent of GSDP, just as the FRL had mandated.
The overall deficit reduction owes much too favourable exogenous factors:
• An acceleration of nominal GDP growth (of 6 percentage points on average) helped boost states’ revenues by about 1 percent of GSDP.
• Increased transfers from the centre of about 1 percent of GSDP both because of the 13th Finance Commission recommendations and the surge in central government revenues;
• Reduced interest payments of about 0.9 percent of GSDP on account of the debt restructuring package offered by the centre; and
• Reduced need for spending by the states— estimated at about 1.2 percent of GDP—as the centre took on a number of major social sector expenditures under the Centrally Sponsored Schemed (CSS).
The first five states which adopted FRL earlier- Karnataka, Kerala, Uttar Pradesh, Punjab and Tamil Nadu- enacted their legislation even before the central government did so in 2003 while in a few states legislation did not fall into place until 2010.
Impact on deficits after adoption of FRL:
• Comparing the 11 years before FRL to the 10 years afterwards (the period for which we have a balanced sample of states), fiscal deficits fell by almost half– from an average of 4.1 percent of GSDP on average to 2.4 percent of GSDP.
• Revenue deficits also fell sharply from 2.1 percent of GSDP on average to -0.3 percent of GSDP after the FRL.
• The FRL had a significant impact is that states kept a tight rein on wage and salary expenditure instead, they expanded more discretionary spending, which would be easier to scale back if needed to achieve the deficit targets.
• Another area of positive impact of adopting FRL was on the states’ budgeting process by generating accurate forecasting of revenues and expenditures which did not force them to make large spending adjustments at the end of the year to meet their deficit targets.
• After the FRL, there is sharp drop in the magnitude of the revenue forecast errors like the pre-period budget estimates of own tax revenue are on average 5.9 percent higher than actual own tax revenue which means that states were on average very optimistic when preparing their budgets.
• Another sign of increasing caution after FRL is the rise in state cash balances as they have tried to smooth their expenditures by holding large cash balances.
The largest reductions in fiscal deficits came from states like Orissa, Punjab, Madhya Pradesh and Maharashtra which lowered their deficit by more than 3 percentage points and also showed some of the largest reductions in revenue deficit by these states.
Lesson from Future Fiscal Rules
The Fourteenth Finance Commission (FFC) attempted to shift toward incentives by relaxing some of the FRL limits for better-performing states.
The greater market-based discipline on state government finances which is very important but it is now missing as reflected in the complete lack of correlation between the spread on state government bonds and their debt or deficit positions.