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Students Corner - A Decade of Economic
Reforms in India - A Review

The down slide in the fiscal performance of the States has assumed serious proportions. Several factors have been identified by a number of studies for the widening fiscal gap of the State Governments. Evidence set out in Box IV.3 indicates that expenditure on wages, salaries and pension, growing size of interest payments, inability to levy adequate user charges and falling buoyancy in Central transfers are the prominent reasons for the deterioration of State finances.

Analysis of the data since 1980-81 suggests that an inverse relationship prevails between cost recovery and the fiscal deficit (Chart IV.15). On the other hand, co-movements between expenditure (on both interest payments and on wages and salaries) and the fiscal deficit indicated positive relationship. A rise in interest payments or wages and salaries generally exert upward pressure on fiscal deficit. The positive relationship between interest payments and GFD was, however, not observed during the first half of the 1990s. Similarly, transfer ratio, which is defined as the proportion of total expenditure which is not met by Central transfers also exhibits a positive relationship showing that with a fall in Central transfers, the fiscal deficit of the States, in general, worsens.

Following the discussion above, four factors responsible for the deterioration of fiscal condition of the State Governments have been identified. These are rising interest payments (IP), inadequate recovery of costs or lower user charges (COSTR), rising expenditure on wages and salaries (WS) and sluggishness in the Central transfers to States (TFR).8, 9, 10 All these factors, except COSTR are expected to have a positive sign. The estimated panel regressions take the following form:

Equations have been estimated in double log form. In order to assess the impact of reforms and decipher the relative importance of the factors responsible for the deterioration, the estimates have been made for the 15 major States, separately for the period, 1980-81 to 1989-90, and for the period, 1990-91 to 1999-2000

Although the studies surveyed identify nearly the same set of factors, they differ in terms of the relative importance attached to each of the factor. There are large disparities across the States in terms of level of income and the tax and expenditure policies pursued by the respective Governments. Accordingly, the impact of various factors (as enumerated above) are likely to vary across the States. Any sluggishness in central transfers would impact more on the States whose fiscal conditions are weak. Similarly, the level of revenue receipts in each State would depend upon the level of income, quality of tax administration and the policies pursued by the Government regarding user charges. Therefore, recognising that there is a need to track the changes, both, over the period and across the States, a panel data exercise for the 15 major States over the period from 1980 to 2000 has been undertaken to assess the relative strength of factors affecting the State finances.

Results of estimated fixed effect models are presented below.

Period 1980-81 to 1989-90

GFD/NSDP    =    0.06    IP    +    3.08    TFR        1.18    COSTR    +    0.88    WS

                         (0.56)                 (3.54)**                                      (-2.95)**                     (2.15)**

R2 = 0.53, X2 = 4.48

Period 1990-91 to 1999-2000

GFD/NSDP    =    0.35    IP    +    2.50    TFR        -        0.35    COSTR    +    0.25    WS

                         (2.18)                 (5.12)**                                      (-3.75)**                     (1.81)**

R2 = 0.68, X2 = 24.00

** significant at 1 per cent level, * significant at 5 per cent level, # significant at 10 per cent level.

The exercise does reveal that spending on interest payments, which had no significant impact during the 1980s turned into a prominent determinant of the fiscal deficit of States during the 1990s. On the other hand, all other factors viz., the transfer ratio, user charges and spending on wages, salaries and pension, while continuing to be significant factors determining the fiscal deficit of States in both the periods, were relatively less important (in terms of value of coefficients) during the 1990s. Notably, this finding is contrary to the general belief that rise in expenditure on wages and salaries has been the major cause for deterioration in the fiscal condition of the State Governments during the 1990s.

The underlying theoretical notion of fiscal stability and sustainability is that real interest rate must not exceed the real output growth of the economy to ensure that debt/output ratio does not grow to explosive proportions. If the interest rate exceeds the output growth rate, and the larger is the gap between the two rates, the higher would be the growth in debt-GDP ratio. This would require generation of adequate primary surplus equivalent to the gap between the interest rate and the output growth rate to stabilise the debt-GDP ratio. Conversely, by this condition, even if the rate of output growth exceeds the interest rate, a large primary deficit can still lead to rise in the debt-GDP ratio. Thus, the positive differential between the output growth rate and the interest rate is not the sufficient condition for sustainability. Sufficient condition for sustainability requires that the initial debt stock equals the present discounted value of primary surpluses in the future (Blanchard, 1980). The latter condition which is popularly termed as the inter-temporal budget constraint or the ‘present value constraint approach’ ensures that the debt-GDP ratio does not grow inexorably. This approach essentially brings to the fore that it is the behaviour of the lenders to the Government that ultimately determines the sustainability of fiscal policy. The underlying notion is that, in the wake of explosive rise in debt-GDP ratio, lenders may lose confidence in the ability of the Government to honour its commitments and may become unwilling to subscribe to Government debt any more.

In the Indian context, a number of studies have empirically tested sustainability of public debt. Amongst the earlier studies, Seshan (1987) found that the internal debt of the Government that had evolved by the mid-1980s was unsustainable. Analysing the alternative modes of financing Government deficit, it was shown that while the debt financing was unsustainable, resorting to monetary financing would lead to a vicious circle of large deficit, higher monetary financing and more inflation leading again to a higher deficit (Rangarajan, Basu and Jadhav, 1989). Many other studies in the 1990s, and thereafter, also show the unsustainability of Indian public debt (Buiter and Patel, 1992; Jha, 2001).

The sustainability of the public debt in terms of both the approaches viz., accounting approach or Domar’s stability condition and the ‘present value constraint approach’ is assessed in this section. In the accounting approach, a comparison of weighted average interest rate on the Government borrowings and the GDP growth rate indicates that the differential between the two rates has narrowed down considerably. During 1990s, at least on three occasions, the weighted average interest rate on Central Government securities exceeded the output growth rate (Chart IV.16). Although these results point towards pressure on the sustainability of the public debt during the second half of the 1990s, the concomitant fall in primary deficit as a proportion to GDP has enhanced the zone of comfort.

In the second approach, the hypothesis in the tradition of Buiter and Patel (1992) was tested. The method involves discounting the nominal stock of Government debt with an appropriate interest rate and assessing the stationarity of the resultant discounted series. Since the interest rate on pubic account liabilities are not market determined, total internal liabilities excluding public account liabilities were discounted with the weighted average interest rate on Government dated securities (Chart IV.17). The discounted series was tested for stationarity by alternative tests, viz., Augmented Dicky-Fuller and Phillips-Perron Unit root tests. Both the unit root tests show non-stationarity of the discounted series.

Since the above results could be biased, as they do not account for any possible structural break following reforms, unit root tests with structural break were also conducted. Three alternative models were tested: (i) change in intercept (model 1); (ii) change in intercept and in the slope (model 2); and (iii) change in slope but both segments of the trend function are joined at the point of break (model 3) (Perron, 1997). In none of the models, the discounted debt series was stationary. These results indicate that the continuation of current fiscal stance could make public debt of both the Central and State Governments unsustainable unless corrective measures are undertaken to rein in the fiscal deterioration .