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Half measures will not do

By Prem Shankar Jha

Last week's decision by the Central Government to impose IMF and World Bank-type conditionalities upon State governments when they approach it for permission to apply for structural adjustment loans from the World Bank is the final milepost on the long and contentious road that the Centre and States have travelled in their financial relations over the last three decades. In the late 1970s when fiscal constraints first emerged, they indulged in a spate of mutual recrimination with the Centre accusing the States of profligacy and the States accusing the Centre of monopolising all the elastic taxes and palming off all the inelastic ones on them.

In the 1980s and early 1990s, the Centre tightened the financial purse strings by enforcing the statutory ceiling upon overdrafts to the States. The States responded by ignoring the Constitution and raising sovereign loans on their own from the market. Only after they were forced to implement the salary increases for civil servants awarded by the Fifth Pay Commission in 1997, did the States finally come to the Centre asking it for short term financial assistance to pay their employees' wage bills and keep Government running.

Since then the Centre has tried a number of ways to tie this assistance to a reform of State finances, but not one of these has worked because the States have merrily broken the promises they made to it. Many of them have also diverted project assistance obtained from the World Bank and the Asian Development Bank to meet their current consumption expenditure. Thus, when six States approached New Delhi for permission to ask for structural adjustment loans from the World Bank and the ADB, it rang the alarm bells in the Ministry of Finance.

However, instead of simply saying no, the Ministry has decided to turn crisis into opportunity: It has made its endorsement of their request conditional upon their accepting severe conditions for financial reform. These are to lower their fiscal deficit to 3 per cent of the State GDP in at most five years; chalk out a programme to eliminate subsidies, especially in the power sector; reform the civil service, mainly by reducing its size, and sell off their public enterprises, nearly all of which are incurring a loss.

Where these agreements differ from their predecessors is that like the IMF and the World Bank, they will set up six-monthly performance targets for the States to meet. If a State falls more than six months behind, its loan will be suspended. This is the first time that the disbursement of a loan has been made conditional upon performance.

The Central Government has sugared the pill by promising the States a handsome carrot if they carry out the reforms. In the power sector where the State government losses exceed Rs. 25,000 crores a year, the Centre has promised a grant of half a rupee for every rupee by which they reduce their deficit.

The State governments know that the structural adjustment loans are their last opportunity to stave off bankruptcy and gain the time to carry out fiscal reform. But there is no guarantee that, even with the best will in the world, they will succeed. One needs to remember that more than half of the countries that took Structural Adjustment Loans from the World Bank and Extended Fund Facility Loans from the IMF in the 1980s failed to meet their commitments and had their loans suspended. Thus simply setting targets will not suffice.

The Centre will have to help the States to take their decisions by chalking out the reforms that States can make. This will require it to spell out jointly with them not only the goals of their fiscal reforms, but also the reforms themselves.

This is particularly necessary because a close look at the reforms that the Centre and the States have already discussed, for instance, at the Centre-State meet on the fiscal deficit that was held last October, shows that fiscal and administrative reforms at the Centre are a prerequisite for reform in the States.

A few examples will show how closely the two are interrelated. Today, every Central or State civil servant who retires takes with himself a package of separation benefits that includes not only his provident fund, but half his pension commuted at the very generous discount rate of 4.5 per cent per annum, and up to two years of encashed leave. The three add up to many years of gross salary. The Centre and the States have agreed in principle that these rules need to be revised specially in relation to the encashment of leave and the terms on which pensions should be commuted, but for obvious reasons, the States cannot change the rules without the Centre doing so at the same time.

A more important interdependence relates to the way in which the Centre exercises its taxation powers. In the petroleum sector, for example, the current subsidies on kerosene, diesel and cooking gas, are more or less offset by the customs and excise duties levied on petroleum products.

This is a great improvement on the situation that had existed till just a few years ago, when the entire sector was subsidised. But any sense of satisfaction on this account gets dissipated when one remembers that petroleum is one of the very few zero tax sectors in an economy where the rest of the products pay an average duty of 35 per cent or more, and that all in all the European economies, taxes on oil products are by far the most important source of government revenues. By not taxing the petroleum sector, the Central Government denies the States the 45 per cent of the revenue from such indirect taxes that is rightfully theirs.

The conclusion is inescapable: the States will not be able to meet their commitments under the adjustment programmes they take up, if the Centre does not reform its finances and related laws at the same time.

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