Both the print media and some commentators on the Indian economy are convinced that the finances of states are not that well managed and, indeed, that the states are drowning in debt. By and large, this is not true. Since the recommendations of the XIIth Finance Commission came into force, which provided for consolidation and write off of certain amounts of state debt, subject to rigorous conditionalities, the outstanding debt of most states has improved. Today, many are nearer the XIIth FC target of 25 per cent of Gross Domestic Product. The 17 major states of India, which had a combined revenue deficit of 1.62 per cent of their Gross State Domestic Product in 2004/05, had a revenue surplus of 1.02 per cent of GSDP by the end of 2007/2008. Consequently, there was a reduction in overall fiscal deficit. This was possible due to improvements in states’ own tax revenues, increased devolution from the Centre, debt relief and also some marginal reduction in their revenue expenditure.

The XIIIth FC has carried forward this fiscal consolidation by states into a new realm of discipline. Encouraged by the revenue surpluses of most states, it recommended that all states should achieve a fiscal deficit target of 3 per cent of GDP and continue to maintain their revenue surplus status. They also recommended that the combined debt of the Centre and states should be brought down to 60 per cent of GDP by 2014/15 with the outstanding debt of states coming down to 25 per cent of GDP.

The performance of the states with respect to their own tax revenues has been satisfactory insofar as their tax revenue to GSDP ratio improved from 7.35 in 2004/05to 7.89 in 2007/2008, with some states like Andhra Pradesh, Maharashtra, Madhya Pradesh and Karnataka showing substantial improvements. If anything, with a Goods and Services Tax the situation will improve further. There are wide variations in per capita tax collections, with Tamil Nadu leading, with per capita tax revenue of Rs 5,894 crore, followed by Punjab with Rs 5,065 crores, and Andhra Pradesh with Rs 4,605 crore. In stark contrast is Madhya Pradesh with only Rs 2,879 crore. This glaring disparity reflects the level of industrialisation in the states, as by and large they have similar VAT rates, except Tamil Nadu, where they may be a shade higher

The states have a long way to go in respect of the efficiency and effectiveness of expenditure. The 1,160 state undertakings in the states together accounted for an investment of Rs 3.69 lakh crore, of which Rs 1.41 lakh crore was in equity (XIIth FC Page 103) with an accumulated loss of Rs 65,924 crore. They are reported to be employing around 1.8 million people.

This is a serious issue, and conscious efforts have to be made to privatise those that need not be with the state, and make the rest more efficient. This consolidation and improvement in their working would only lead to increase in secondary and tertiary employment, if not primary.

The worst are the state electricity undertakings and road transport corporations. The XIIIth FC has projected an estimated loss of Rs 1.16 lakh crore even after assuming an improvement in the Transmission & Distribution losses. The return on investment in the thousands of irrigation projects is even worse. This leads to incomplete and defective maintenance that costs the country dearly in terms lost food grain output.

The XIIth FC therefore recommended some grants for maintenance expenditure linked to recoveries in the irrigation sector. A Ministry of Road Transport survey has placed the losses of the state road transport corporations at Rs 5,492.28 crore in 2010-11. Only five of the 35 SRTCs posted a profit, with Karnataka leading with a profit of Rs 62.05 crore and Maharashtra with Rs 50.2 crores. Even Odisha SRTC posted a modest profit. Andhra Pradesh, Karnataka, Maharashtra and Tamil Nadu accounted for 70.5 per cent of the total fleet strength of 1,22,355 buses. Improvement in these two sectors alone would improve the finances of the states to a large extent.

It is interesting to note some of the observations of the Comptroller & Auditor-General on the finances of some sample states. The Audit Report for the year 2009/10 states that Andhra Pradesh had revenue surpluses consecutively for five years. The fiscal liability of Rs 1.35 lakh crore was only 24.52 per cent of the GSDP, which was in full compliance with the XIIIth FC prescribed limit. However the state had a large number of incomplete projects with a liability of Rs 63,890 crore. The revenue expenditure of the state is also on the rise.

The state has increased its expenditure on the social services sector to a significant extent. It is now 35.41 per cent as against the all-India average of 32.64 per cent of the total. The growth in GSDP was also higher than the all India average of 12.54 per cent from 2001/09. In contrast Tamil Nadu had a GSDP growth at 11.04 per cent lower than the average for the same period. The population below poverty line was 22.5 per cent in Tamil Nadu as against 15.8 per cent in Andhra Pradesh.

Tamil Nadu is also violating Article 293(3) of the Constitution by standing guarantee to the borrowings of its undertakings and then repaying their loans in default. The report states that the Tamil Nadu Fiscal Debt increased from one per cent in 2005/06 to 3.1 per cent in 2009/10. Its debt is increasing and it may not be able to meet the XIIth FC target.

It is clear that the freebie regime of TN is affecting it in more than one way. Its deficit has deteriorated, and it has not been able to take on development schemes for the long-term benefit of the state. The continuance of the freebie regime, which has become a competitive game between the two major political parties, is going to tell severely on the state’s socioeconomic profile.

Among the north Indian states, Madhya Pradesh seems to have increased its own tax revenues by 20 per cent per annum since 2005/06, which has given it an enormous revenue surplus of over Rs 5,000 crores in 2009/10. Its fiscal liability is also around 35 per cent of GSDP, within the limits prescribed for 2009/10 by the XIIIth FC.

However considering the size of the state and its high percentage of Scheduled Castes and Scheduled Tribes, and general investor apathy, the tax base is low. Unless Madhya Pradesh industrialises quickly, it may not be able to provide adequately for the social sectors of education and health where it is lagging behind many states.

In contrast, West Bengal which steadfastly refused to frame a Fiscal Responsibility Legislation till recently, despite having very erudite economists as its finance ministers, shows exceedingly poor fiscal management. Its tax revenue in 2009/10 was 38 per cent less than what was projected by the XIIIth FC. As it did not enact the legislation, it lost Rs 3157 crore by way of debt relief. It surpasses reason that a government which boasted of such highly qualified ministers should have managed its finances so poorly that the state was deprived of a huge amount.

West Bengal does spend a lot on social service sectors—almost five per cent more than the national average—but its poor economic performance has resulted in a very low economic base, keeping its own revenues at a low level.

West Bengal does spend a lot on social service sectors—almost five per cent more than the national average—but its poor economic performance has resulted in a very low economic base, keeping its own revenues at a low level.

These analyses of the finances of some sample states clearly bring out the glaring contrast in fiscal management. Some states have adhered to fiscal discipline to take advantage of the debt relief and other incentives given by the various financial commissions but others, for reasons best known to themselves, have ignored these only to suffer. States have only the VAT, state excise, registration and stamp duties, motor vehicle taxes, electricity duty and passenger fare taxes as their source of tax revenue. Land taxes have almost ceased to exist in most states. The non-tax revenue receipts have never been exploited.

The Central government has only income tax, corporation tax, service tax, customs and Central excise duties as its source of revenue. The states have a 31 per cent share in these tax revenues of the Central government.

Cost of supply of merit goods like irrigation water, drinking water and electricity have been severely under priced and consequently very inefficiently managed due to lack of resources.

The losses of the state electricity boards are estimated at Rs 1 lakh crore. The T&D losses are still at around 27 per cent. They may not all be T&D losses but theft of power. The 35 road transport undertakings together incurred a loss of Rs 5,492.8 crore.

Only the Karnataka and Maharashtra road transport undertakings were in profit. This clearly shows that road transport undertakings can clearly be made to run in profit. There is no reason why SEBs cannot also run in profit. The states seem to lack the will to run them efficiently for unknown political fears.

The states go in for massive borrowings year after year from the market, small savings fund and through negotiated borrowing from Financial Institutions like the LIC, NABARD and so on. They together exceeded Rs 1 lakh crore for 2007/08 alone (Planning Commission data tables). Almost all this borrowing, even though called market determined, is subscribed to by banks that hold them against their statutory liquidity ratio.

There is hardly any trading in state government securities. As per information available in the RBI bulletins the secondary market for state government securities was hardly around Rs 500 crore. Given the choice the banks may not subscribe to many state government bonds. In any case these bonds are rolled over from maturity to maturity, owing to a higher level of borrowing every year.

While there may have been objections to the Ricardian equivalence theory of public debt, one fact is established, that governments, whether in India or elsewhere, rarely have any intention of repaying the debt. It is the people who bear the burden through increased taxes to repay the debt or through inflation. The US has to roll over around $7 trillion debt in 2012 and so have the European countries.

This inability to meet debt obligations is what is worrying the whole world. Governments may repay by issuing new bonds but if there are no takers how would they repay? The problem becomes acute when a bulk of the government bonds is held by foreigners. The cross holding of debt by European countries and the bunching of maturities is a time bomb waiting to explode. In the case of India, there is mercifully a limit on foreigners holding government bonds.

The states in India have ample space to strengthen their finances in many ways. To start with, they could make all their public utilities cover their costs fully, if not make a profit. This alone will have a major positive impact on state finances. They could also systematically plan to eliminate the losses in their PSUs.

States should also aim to recover, if not fully, the cost of investment and maintenance, at least the maintenance cost, of irrigation works. There could also be differential pricing for drinking water supply to recover the cost of expensive projects in the urban areas. With such improvements in non-tax revenue, states could easily reduce debt burden and also provide more for the social sector.

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It is the danger of governments at the Centre and the states falling into a debt trap that made the XIIIth FC recommend that total debt liabilities be reduced to 70 per cent of GDP, with the Centre’s liability at 45 per cent and that of the states at 25 per cent. This figure is much less than that of many European countries and the US.

Our country is, of course, delicately poised in respect of the external liabilities of the banking system which far exceeds its external assets. The RBI has been warning the banks on this issue but  no definitive action plan has been put in place. Our external reserves are not to be taken for granted as they are not built on trade surpluses like China, but on Foreign Direct Investment, invisibles, Foreign Institutional Investors, NRI deposits and invisibles. They could vanish if there is pressure on exchange rates or in the event of political uncertainty.

While there is great room for the states to improve their finances it is the Central government that has to exercise caution on external liabilities front and on the growing of subsidies centred only on politics and less on economics. The huge burden that will result from the National Food Security Bill has not even been correctly estimated. Further, its impact on food grain prices within and outside the country has been ignored.

The fiscal imbalance at the Central government level could affect the exchange rate, with its consequences on rising import bill. It may also result in foreign investors becoming cautious about India’s ability to ensure fiscal stability, given the desperate measures of politicians to please the electorate with huge subsidies even where they are not deserved.