This year's Union Budget is turning out to be a washout; the misplaced turnover tax on equities and debt and the hugely over-optimistic revenue targets have dented the Budget seriously.

One important element that can be still salvaged is the Rs 10,000-crore (Rs 100 billion) hike in the gross budgetary support to the Plan. At the moment, this money has been just provided without making any allocations.

How this additional money is to be used will be determined by the Planning Commission, which will begin its exercise of finalising the state plans shortly. The simplest but the scariest scenario is the Planning Commission agreeing to the states' demand for more money to finance much bigger plans.

Their demand for an increase in the size of the state plans is only to be expected in view of the steep increase of 21 per cent in the gross budgetary support to the Plan given in the Budget.

While Montek Singh Ahluwalia and his team need not look a gift horse in the mouth, they would do well to resist the temptation of acting in the same benevolent manner as the finance minister, and not increase the central assistance to the state plans proportionately.

Instead, the starting point for the Commission should be to look at the flashpoints in the state finances and also the sequential emergence of deficits in the state budgets.

Two trends are indisputable: first, that the debt of the states (to the Centre and to institutions) is crippling the state finances. And second, the original source of deficit is the plan revenue account.

In 2003-2004, interest payments of Rs 83,000 crore (Rs 830 billion) accounted for 71 of the fiscal deficit and were 1.75 times the revenue deficit of the states. The reduction in the interest rate will help, but only marginally. The real problem is the stock of debt and the interest thereon.

Seen from the perspective of debt, for every additional rupee of central assistance to the states, the debt burden goes up by 70 paise. By passing on an additional Rs 4,000 crore (Rs 40 billion) to the states (out of the Rs 10,000 crore, Rs 6,000 crore will be kept for the central Plan), about Rs 2,000 crore (Rs 20 billion) more will be added to the debt burden of all states this year. At a rate of 10 per cent, this amount of additional outgo this year will be Rs 200 crore (Rs 2 billion) as interest payment.

As far as deficits are concerned, the aggregate balance from current revenue (which is a plan financing item) is - Rs 30,000 crore (Rs 300 billion), getting worsened by ever-increasing plan revenue deficits.

Given the current way of financing where the resources on the revenue account are not separately matched with the revenue component of the Plan, any increase in the Plan automatically increases the Plan revenue deficit and diversion of the borrowed funds from capital to revenue, making fiscal balance impossible.

Given this understanding of the state finances, it may be better to restrict the states to keep their plan size constant in real terms. Having provided for a nominal increase, the additional Rs 10,000 crore can be split this way: a) paying back some part of the debt of the states to the Centre, and b) changing the composition of the plan assistance to a 50 loan:50 grant ratio from the existing 70:30 scheme, which is a legacy of the 1960s.

It had been estimated then that the revenue component of capital expenditure was about 30 per cent. Hence, the 30 per cent grant element in the assistance. Now all this has changed. With more being spent on health and education, the revenue component of a unit of investment is more likely to be 50 per cent. Indeed, in the plan expenditure of states, the revenue component now is higher than the capital expenditure; revenue accounts for 55 per cent and capex for 45 per cent.

In this scheme, the revenue expenditure of the Centre (more grants, less loans) will increase, and revenue receipts (interest payment from the states to the Centre) will decline.

Essentially, the revenue deficit of the Centre will go up, while the fiscal deficit will come down. The Rs 10,000 crore can be used to compensate the revenue losses of the Centre and make the impact on the revenue deficit neutral while maintaining the positive impact on the fiscal deficit.

On their part, the states will be better-off. Their revenue balance will look better because of the reduced interest burden as well as more revenue receipts (higher grants), and accordingly their balance from current revenues will also show an improvement.

Given the plan size, an improvement in the negative balance from current revenue will reduce their dependence on institutional and market borrowings. In other words, the loan financing of the plan will be reduced. This will set in motion a virtuous cycle of fiscal balance.

The other reason for being conservative and not increasing the size of the state plans at this stage is that the Fiscal Responsibility and Budgetary Management Act stipulates if at the end of the second quarter the total non-debt creating receipts of the Centre are less than 40 per cent of the Budget estimates, or the fiscal deficit and/or the revenue deficit is 45 per cent higher than the budgeted estimates for the year, expenditure (which includes non-statutory transfers to the states) will have to be reduced to bring these variables in line with the budgeted estimates.

If the revenue receipts fall short, as is most likely to happen, the Centre will have to reduce its expenditure and the first item that is likely to be cut will be the Plan, and that means the Plan assistance to the states. This will be a double whammy for the states.

One, their plans are financed with the budgeted tax devolution, and when this falls short, their plans will have a financing gap that will be met through loans. Second, the plan assistance itself will be reduced. This will cripple the state finances.

The broader issue is that the process of planning has to undergo a complete change. The problem with the present system is that in the post-fiscal reform period, the approach to financing the state plans hasn't undergone any change.

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