It is by now clear that fiscal consolidation in India requires concerted action by both the Centre and the states. Fiscal reforms in the early 1990s were largely restricted to the Centre and although they achieved moderate success until 1996-97; the pay revision in 1997-98 and the consequent bourgeoning deficits, debt and ballooning interest payments set back the situation.

The malady of large and persisting deficits continued until 2003-04, though, since then there has some containment largely due to buoyant revenues from Central direct taxes.

Concerned at the adverse impact of fiscal imbalances on the macroeconomic management of the economy, the Twelfth Finance Commission recommended a fiscal restructuring plan in which states were required to pass fiscal responsibility legislation, phase out their revenue deficits and bring down fiscal deficits to 3 per cent of GDP by 2008-09.

However, questions have been raised on the uniform deficit targets, which constrain the ability of the states to use fiscal policy as an effective policy instrument for development. International experience has shown that fiscal rules are neither necessary nor sufficient to bring about fiscal discipline, but they can be useful in the short and medium terms.

Recent trends, however, show a significant improvement in the state finances not only in reducing revenue and fiscal deficits but also in releasing more resources for investment in infrastructure.

States' aggregate revenue deficits relative to GDP declined sharply from 2.6 per cent in 2001-02 to 0.5 per cent in 2005-06 and this has helped to reduce fiscal deficit by one percentage point (from 4.3 per cent to 3.2 per cent) and increase capital expenditure by an equal magnitude (from 1.5 per cent of 2.4 per cent). In fact, these adjustments are close to the targets set by the TFC for 2008-09.

A detailed analysis of the sources of improvement shows that, of the 2.1 percentage point improvement, increase in revenue contributed to 1.5 points or 72 per cent, and the remaining 28 per cent was due to expenditure compression.

Within revenue, over one percentage point was due to higher TFC transfers, higher buoyancy of central direct taxes since 2002-03, and increased grants for various Central schemes. On the expenditure side, reduction in interest payments following the debt-swap scheme and restructuring of debt contributed to 0.24 point improvement.

In contrast, the cumulative improvement in revenue deficit in 2005-06 over 2001-02 due to states' own effort contributed to the correction by 43 per cent. Of this, improvement in own revenue was about 0.6 percentage point and the compression of non-interest expenditures was about 0.3 percentage point. This is still important and will help to improve the situation further.

Furthermore, even the improvements attributed to exogenous factors are likely to be sustained. Thus, in the medium term, it is eminently feasible to achieve the fiscal restructuring targets.

There are some serious risks to fiscal consolidation, however. The first is the outcome of the Pay Commission. The recommendations of the Sixth Pay Commission could cause ripple effects. In fact, revision in pay and pensions contributed to almost two percentage point increase in revenue expenditures of states between 1997-98 and 2000-01.

An increase of similar magnitude may nullify all the gains. Second, the era of low interest rates seems to be over. Although the average rate of interest was brought down by the TFC's debt-restructuring plan, the new loans will carry higher interest rates. Third, some of the states have not shown any inclination to adopt the path of fiscal correction. In fact, the recent Assembly election in Tamil Nadu has shown the inclination of the political parties to resort to populist stance.

Finally, the pressure to have large-sized plan has led to the thinking that deficits do not matter. The tirade against revenue deficit correction in the draft approach plan document could spell danger to fiscal austerity.

Indeed, the introduction of VAT has helped to shore up the finances and the gains could last if measures are taken to strengthen the information system. By April 2006, all the states except Uttar Pradesh and Tamil Nadu switched to the VAT regime and the collections during the first five months show an increase of 28 per cent over the same period last year.

All the states except Arunachal Pradesh have registered significant increases in revenue and in Andhra Pradesh, Chhattisgarh, Gujarat and Jharkhand, the growth rate has exceeded 30 per cent.

While the states' aggregate fiscal picture shows significant improvement, there are dark spots. The states continuing with a worrisome fiscal imbalance are West Bengal, Kerala, Jharkhand and, to some extent, Punjab.

In Kerala and West Bengal, revenue deficits in 2005-06 were close to 4 per cent of NSDP. In Kerala, there was hardly any improvement in the revenue deficit situation. In West Bengal, even after the reduction by 1.2 percentage points in 2005-06 over 2003-04, revenue deficit remained high at 3.7 per cent of NSDP.

The fiscal deficits in Kerala and West Bengal in 2005-06 relative to their GSDP were 5.2 per cent and 4.6 per cent, respectively. In fact, these two states have not shown the inclination to follow the restructuring path recommended by the TFC.

Interestingly, fiscal stress as measured by revenue and fiscal deficits is not related to the level of development of the states. In 2003-04, for example, the correlation of per capita GSDP with revenue deficit was -0.07 and with fiscal deficit, it was 0.236.

In 2005-06, Bihar and Rajasthan showed revenue surpluses and revenue deficits in Orissa and Madhya Pradesh were small. This should not be taken to mean that these states do not have serious fiscal stress, nor does it mean that their fiscal discipline is any better.

The simple fact is that the volume of their spending on social and economic services is extremely low. In fact, in 2003-04, per capita spending on developmental heads in Bihar

(Rs 1,075) was one half of the all-state average (Rs 2,035) and in Uttar Pradesh, it was 60 per cent (Rs 1,187). Indeed, their deficit containment has come about by abdicating the responsibility of providing public services.

On the whole, the states' fiscal situation looks much better now, but the risks are formidable. Hopefully, this will not be the case of shining before the shock.

The author is director, NIPFP. Comments at mgr@nipfp.org.in