MEDIUM TERM FISCAL PLAN FOR KARNATAKA, to

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2 MEDIUM TERM FISCAL PLAN FOR KARNATAKA, to I. Introduction: 1. Government of Karnataka released its first Medium Term Fiscal Plan (MTFP) for the period to during the budget session in This was a sequel to the release of a White Paper on Karnataka State Finances in While the White Paper identified the sources and causes of stagnancy in revenue and reasons for proliferation of public expenditure and had indicated directions and guidelines for undertaking corrective measures, the MTFP provided a framework for designing implementable reforms in the fiscal area over a medium term. This was done in the context of the commitment of Government of Karnataka to its overarching goal of reduction of poverty. It was realised that without fiscal sustainability, reduction of poverty would be extremely difficult. Once the fiscal situation comes under control, the State Government can afford to prioritise expenditure in favour of critical areas like social and infrastructure sectors. Higher allocation in these priority sectors in turn would result in higher economic growth, which would improve the revenue buoyancy. This will lead to a virtuous circle of fiscal balance and higher economic growth ultimately leading to substantial reduction in poverty. Though the head count ratio of poverty of Karnataka is 20% as against the all India average of 26%, there is no room for complacency in this regard and there is much to be done to improve the living conditions of the poor. 2. Keeping the above in mind, the Chief Minister of Karnataka has announced in the 2002 budget speech that the Medium Term Fiscal Plan will become a rolling annual document which will also provide an outlook of the fiscal situation in the medium term and would also indicate the actual performance of the previous year 2

3 against the stated fiscal targets. The present document covering the period from to is Karnataka s second MTFP. Though it updates and expands on the 2001 document, it is also a self-contained document reporting on the performance in 2001 against the targets of that year and updating the targets and policies of the Government for the coming years. This MTFP also includes a new section on Karnataka s macro economic context and outlook. 3. As stated in the 2001 MTFP, economic reforms, under way in India since 1991, have posed important challenges as well as opportunities to state governments. Accelerating economic growth and reducing poverty call for releasing resources for strengthening infrastructure facilities in the states and making available substantial resources for education, health and rural development. State governments have a predominant role in the task of strengthening physical infrastructure and, more particularly, in human development. Besides, the greater role assigned to the private sector has presented the states with the challenge of creating an accommodating environment in the wake of fierce inter-state competition. Karnataka has to participate in this competitive environment. However, to be a favourable destination for private investment that can enhance growth, the State government should not only follow investment-friendly policies but also create high quality infrastructure. This will be possible only if the fiscal position of the State is sound. 4. The fiscal deterioration in the State is not the result of fiscal operations in one or two years but is a culmination of problems accumulated over several years. Given the magnitude of the problem, fiscal correction cannot be achieved within one or two years. Besides, fiscal decisions of one year have multi-year consequences. Thus, a road map for corrective measures will have to be drawn up carefully in the medium term. The medium term framework allows designing implementable reforms, and applying remedies depending on changing situations and imperatives. 3

4 5. The Medium Term Fiscal Plan sets the key fiscal targets for the State and details the policy package necessary to achieve them. It is updated every year, and dovetailed to the annual budgetary exercises. A draft MTFP is prepared prior to the budget to guide budget preparation, and then it is updated and published once the budget is released. The Government has announced that it plans to table a Fiscal Responsibility Bill in the Assembly. This will provide legislative backing to the Medium Term Fiscal Plan. 6. The preparation of Medium Term Fiscal Plan (MTFP) is part of the State Government s commitment to greater fiscal transparency. Other important steps already taken in this direction include publication of an Overview of the Budget which provides basic fiscal data and information on guarantees. To further improve transparency, the Government has included in this publication information on off-budget borrowings (i.e., borrowings by PSUs or SPVs which are committed to be fully repaid from out of the State budget), tax arrears and tax expenditure (cost of tax incentives). The Government has also started publishing monthly financial accounts on the Internet ( These have been well received. In , the Government will publish more detailed monthly accounts, including collection of major taxes, and on-budget and offbudget borrowing figures by their sources. 7. As the 2001 MTFP stressed, bringing about fiscal rectitude entails hard decisions. This has to be a rational community choice to achieve the common good on a sustainable basis. Difficult but unavoidable measures will have to be taken to raise revenues, to weed out unproductive expenditures, rationalise and target subsidies, enhance efficiency and accountability in public spending, and to stabilise debt. Postponing these measures will only compound the problems, necessitating much harsher remedial measures in the future. 4

5 II. The Problem: 8. The White Paper on the State's finances has brought out the significant deterioration in the fiscal position in Karnataka over the last decade particularly since The fiscal position was transformed from a revenue surplus of Rs.159 crores in to a revenue deficit of Rs.2325 crores in Similarly, during the period from to , the fiscal deficit increased from Rs.513 crores to Rs.4276 crores. This has created an unstable fiscal situation characterised by a vicious cycle of increasing interest payments feeding into deficits and debt stock. If the past trends were to continue, Karnataka would surely face a crisis within the next few years. 9. An important cause of the deteriorating fiscal situation in the State is declining share of revenues to Gross State Domestic Product (GSDP). The ratio of tax revenue to GSDP fell from 9.3% in to 8.1% in The ratio of non-tax revenue to GSDP has shown a decline from 2.2% in to 1.2% in , mainly due to low and declining cost recoveries from non-merit public services and poor performance of the public enterprises. Implicit subsidies due to uneconomic pricing of irrigation and drinking water supply, higher and technical education and urban health services amount to about 1.2 per cent of GSDP. Cost recovery in irrigation in the State is only a fraction of the corresponding figures prevailing in the neighbouring states. The Government has started to take steps to correct the declining revenue/gdp ratio. The tax/gsdp ratio, after falling to 8.1% in rose to 8.6% of GSDP in and 8.9% in However, there is still a lot of scope to increase non-tax revenues, which are only about 1% of GSDP. 10. An equally worrisome issue of the State finances in Karnataka is the dismal financial performance of public utilities and enterprises. In , the State Government paid Rs.914 crores to Karnataka Electricity Board by way of explicit 5

6 subsidy alone. The subsidy required by the Karnataka Road Transport Corporations amounted to more than Rs 100 crores. Besides these, there are a number of public enterprises, many of which are of commercial nature, which have been making significant losses. Out of 78 Government companies, 33 made losses in amounting to Rs.197 crores. In case of 22 companies, the accumulated loss exceeded the share capital, reserves and surpluses put together. For these reasons, Government has decided to embark on public sector restructuring, an area in which it has now made considerable progress. During , 3 loss-making enterprises have been closed, and VRS has been given to 2,200 employees. Since 1999 till now, 8 PSUs have been closed and more than 3,600 employees have availed of VRS. 11. Another important reason for the fiscal problem is the fast expansion of public expenditure within the revenue account during the last few years. The significant increase in salary and pensions, interest payments, subsidies and transfers has pre-empted a high and increasing proportion of borrowed funds for meeting current expenditures. Interest payments as a proportion to GSDP increased from 1 per cent in to 2.09% per cent in During this period, the subsidies and transfers as a ratio of GSDP also increased by about one percentage point. The Government is giving special priority to containing subsidies, and is continuing to apply strict controls to recruitment and the wagebill. 12. The problem is accentuated by the declining productivity of public expenditure, which in turn has come about due to a sharp increase in administrative expenditures, poor maintenance of public assets, declining proportion of capital expenditures and long gestation periods in completing infrastructure projects. Moreover, increase in indebtedness has resulted in higher amount being set apart for debt servicing, leaving a relatively less amount for 6

7 productive expenditure. Government has given special attention to limiting borrowing and to improving the productivity of public expenditure. III. Objectives and Strategies (a) Objectives 13. The medium-term fiscal restructuring plan will have to reverse the historical trend of the deteriorating fiscal situation in order to phase out public dissavings in the medium term so that borrowed funds are invested to create productive assets. The strategy in the medium term should also enhance productivity in public spending to ensure efficient and equitable delivery of public services. Finally, increasing requirements of public expenditure should be financed through an efficient and equitable tax system and proper cost recovery. Thus, the medium-term fiscal plan, while ensuring satisfactory levels of infrastructure should also pave the way for increased private sector investments, which will result in accelerating economic growth and reducing poverty in the State. 14. With this in view, the Government s main targets under the medium-term fiscal plan are as follows: (i) (ii) (iii) Phasing out revenue deficit (which was 2.4 per cent of GSDP in ), so that borrowing is not used to finance current expenditures. Reducing fiscal deficit (from the level of 4.4 per cent of GSDP in ) to 3 per cent of GSDP to stabilise debt stock, and prevent an ever-increasing burden of interest payments. Safeguarding adequate allocation to social sectors like primary and secondary education, basic health care and rural development and for physical infrastructure requirements, both for investment and for maintenance. 7

8 Originally, the Government planned to achieve its deficit targets by However, with the severe economic slow-down of , this will not be possible, and the Government now aims to achieve these targets one year later, by Since it is the responsibility of the State Government to repay the loans contracted by two specialised irrigation finance corporations, i.e., KBJNL and KNNL, as well as a number of other public sector units which have borrowed funds from agencies like HUDCO, a set of consolidated fiscal indicators have been worked out by adding the off-budget borrowings and repayments to the traditional budgetary figures. The consolidated figures capture the borrowings by State undertakings, e.g., from HUDCO or through raising bonds, where the liability for repayment is on the State Government. These are not merely contingent liabilities but are actual repayment liabilities of the Government. MTFP assumes that such exceptional borrowings by KBJNL and KNNL to complete the Krishna river projects will cease by It is also the intention of the State Government to reduce off-budget borrowings and to move all such borrowings back on to the budget by end of No additional recourse to off-budget borrowing will be made beyond the current beneficiaries. At present, these consolidated figures have greater relevance in the assessment of the true fiscal situation of the State. An important objective of the MTFP is to stabilise consolidated debt as a ratio of GSDP, besides reducing consolidated fiscal deficit to 3% of GSDP by A very important component of the fiscal stress facing the Government is the financial losses of the power sector that have given rise to a subsidy obligation on the part of the Government in excess of Rs 2,300 crore. A Financial Restructuring Plan (FRP) has been developed to map out a path for restoring the viability of the power sector. The FRP is consistent with MTFP. The MTFP also consolidates the fiscal deficit with the power sector subsidy gap (i.e., the 8

9 subsidy obligation to the sector that is not paid) to give a comprehensive view of the state s finances. 17. The fiscal planning also needs to include all contingent liabilities including guarantees issued by the Government. The State government has already passed the Ceiling on Government Guarantees Act, and is adhering to this ceiling to control the growth of debt guarantees. (b) Strategies 18. The basic reason for the fiscal imbalance in the State is that the growth rate of revenue receipts was significantly lower than that of revenue expenditures. During the last decade, the average annual growth rate of revenue receipts in Karnataka was 14.9 per cent whereas revenue expenditures grew at 15.9 per cent per annum. Any plan of phasing out fiscal imbalance in the State has to combine the strategies of increasing the growth of revenues and compressing expenditures, keeping in view the efficiency in raising revenues and productivity of public expenditures. As stated in the 2001 MTFP, achieving the above objectives will require the following key strategies: improving the revenue productivity of the taxes by bringing about systemic changes in the base, rate structure and administration and enforcement mechanisms. The simplification of the sales tax system leading to the introduction of value added tax (VAT) would be one of the major reform initiatives. This would not only rationalise the consumption tax system, but would also improve revenue productivity; enhancing productivity of non-tax revenues. In case of user charges, this is to be brought about by greater community participation in maintenance of assets and by ensuring quality and reliability of services. Public enterprise reforms would help to achieve productivity gains for generating better receipts; reducing budgetary support to public enterprises. This has to be achieved by disinvesting and restructuring public enterprises. While in some cases it may be necessary to introduce voluntary retirement 9

10 schemes (VRS) to reduce over-employment, government may have to close down or privatise some of the enterprises; drastic reduction of implicit and explicit subsidies to electricity and transport sectors through economic pricing, improving productivity in generation, transmission and distribution and metering the consumption of electricity by the agricultural sector and privatisation of distribution; achieving significant improvement in cost recoveries and reducing implicit subsidies in respect of services, such as drinking water supply, irrigation, higher and technical education, and secondary and tertiary health care, particularly those not directed to the poor; reducing the quantum of food and other subsidies by eventually targeting these subsidies strictly to persons below the poverty line; improving the efficiency of government expenditures by increasing allocation to the creation and maintenance of infrastructure facilities and augmenting outlay on human development; compressing unproductive government expenditures by reducing government employment and re-deployment to social sectors such as primary and secondary education and health; assessing expenditures in irrigation, and public works departments by closely scrutinising the schedule of unit rates. Sequencing expenditures on major projects to minimise time and cost overruns and improving public expenditure management and control systems by increasing the level of public participation and investment (e.g. through creating water user associations); ensuring a careful debt management plan to reduce the composition of high cost borrowing and to limit contingent liabilities. In particular, a close scrutiny of contingent liabilities; moving away from borrowing at high cost, for example from specialised financial institutions like HUDCO, LIC and NCDC; and borrowing on the basis of repayment capacity rather than availability as had happened in the past; improving governance, putting in place a sound public expenditure management programme to improve the efficiency of expenditure and targeting. 10

11 IV. Macroeconomic Performance and Outlook 19. While the focus of the MTFP is on fiscal variables, the overall macroeconomic performance of the state namely, growth and inflation has a bearing on its success. Growth affects tax revenue collection and the level of inflation impacts salary and pension bill, administrative expenses, and the cost of new borrowings, to name a few. The sustainability of any fiscal program depends crucially on the level of economic growth. At the same time, the success of the MTFP affects the overall macro sentiment of the state and, thus, affects the future growth prospects: Karnataka s growth will surely be affected if the state enters into a fiscal crisis. Therefore, since fiscal reforms and the macroeconomic performance and prospects of Karnataka are closely linked, this MTFP includes a new section on Karnataka s macroeconomic performance and prospects. (a) Growth performance 20. Karnataka is one of India s fastest growing States. Between and , the Karnataka economy grew at an average rate of 7.9% per year, 1.6 percentage points higher than the growth rate achieved by the Indian economy. In per capita terms, the growth difference was even higher, as Karnataka experienced a slower growth rate of population than the all India average. All the sectors of the State economy grew at a rate higher than the national average. The annual average growth rate of agriculture, industry and service sectors in Karnataka between and were 4.5%, 8.3% and 10.4% respectively, compared to 2.8%, 6.4% and 8.5% respectively for the Indian economy. 21. There are four factors that helped Karnataka to achieve and maintain high economic growth rate in recent years. First, the State, with its excellent educational facilities, is home to one of the largest pool of skilled and low-cost human capital available anywhere in the world. Second, the State s investment climate, which includes its institutions, regulatory mechanism and infrastructure is one of the best in the country. Third, the macro fundamentals of the State, i.e., its 11

12 inflation rate, fiscal deficit, and other fiscal indicators, are relatively better than most other Indian States. Finally, Karnataka is politically stable and reformoriented. (b) Growth in The year was one of the toughest years for Karnataka in terms of economic growth. The State economy, for the first time in the last six years, grew at a rate lower than the national average. As per the Central Statistical Organization (CSO), the likely growth of the Indian economy in is 5.4% at constant prices. According to Karnataka s Directorate of Economics and Statistics (DES), the State economy achieved a modest 5% growth rate in the same year (at constant prices). While the service sector maintained its past growth momentum and grew at 10.2% and the industrial sector grew at 4.6%, a rate marginally higher than the corresponding all India growth rate, it is the sharp decline in the agricultural performance, triggered by the once-in-a-decade drought that resulted in a significant decline in the overall growth rate during (Figure-1). 12% 10% 8% 6% 4% 2% 0% -2% -4% Fig 1: Karnataka Sectoral and Aggregate Growth Rate /02 (Advance Estimate) -2.7% 4.6% 10.2% 5.0% Agriculture Industry Services GSDP 23. During the 2001 kharif season, nearly 31 percent of the Talukas in the State received deficient rainfall and almost 43 percent received deficient rainfall with respect to agriculture. 18% of kharif area was not sown at all. In 2001 rabi season, 46% of the Talukas received deficient rainfall and 40% received deficient rainfall with respect to agriculture. Only twice in the last three decades, i.e. in 1972 and in the period, did such a large number of districts receive deficient rainfall in a year. The drought of affected kharif harvest in three ways: (i) some cultivable areas could not be sown due to poor or deficient rainfall; (ii) other 6 12

13 cultivable areas experienced low yields; and (iii) in certain cases, farmers shifted from high-value to low-value crops. Initial estimates show that nearly 30 percent of the total crops during the kharif season were affected due to drought. Some of the output lost during the kharif season is likely to be made up during the rabi season due to a better than expected rainfall during September 2001 and January 2002 period. Nevertheless, the advance estimate for foodgrains production for is lakh tonnes, down from lakh tonnes the previous year. Growth of the primary sector at constant prices is estimated by DES to be negative at 2.6% for (c) Growth Forecasts 24. The factors determining the long-term growth rate of the Karnataka economy remains favourable and the State is poised to perform as well as, or surpass, its past growth performance. The availability of skilled labour at competitive wage rate, positive investment climate, strong macro fundamentals, and political stability the factors that have propelled the State on to a high growth path still remain in place. Furthermore, the State, in order to deepen the reform process and improve its future growth prospects, has undertaken significant fiscal, governance, and structural reforms in recent years and has invested large amounts of funds to improve its physical infrastructure. 25. The investor community has taken note of the reforms being initiated in Karnataka. The State is now one of the favourite destinations of foreign (as well as Fig 2: Karnataka: FDI Approval (in million US$) domestic) investment. As Figure 2 shows, Karnataka has been receiving FDI approval in the range of US$ 600- US$1200 million each year in the last five years, one of the highest in the country. With increasing flow of FDI and domestic investment to the State, if the 13

14 environment favourable to high and sustained long-term growth is maintained, the State economy is likely to achieve annual average growth rate in the range of 7 8% during the coming 5 years. 26. Therefore, the MTFP forecasts the Karnataka economy to recover from its current 5% real GSDP growth rate in to 6.5% in (down from 7.5% assumed in the 2001 MTFP), followed by growth of 7.5% in and the years following (as in the 2001 MTFP). (d) Inflation 27. Karnataka s inflation has been below that of all India average for the last few years. The average annual inflation rate during the second half of last decade was between %, which was 0.5 to 2.5 percentage points lower than the average inflation rate that prevailed in the 14 major Indian states. The three sectors -- agriculture, industry and services are found to have experienced average annual inflation rates of 6.5%, 5.3%, and 7.8% respectively during this period. However, in recent years, inflation has fallen sharply in Karnataka: to 1.9% in and 2.4% in In , with inflation falling to a record low across India, Karnataka s inflation rate, as per the DES s advance estimate, was 2.3 percent in , with sectoral inflation for agriculture, industry and services at 1.1%, 3.8% and 2.9% respectively. 28. The underlying reasons for low inflation in Karnataka compared to other Indian states require further investigation. For , the 2002 MTFP assumes an inflation rate of 4%, down from 6% assumed in the 2001 MTFP. This is in line with national forecasts. In and future years, inflation is forecast to go up to 5% (down from 6% in the 2001 MTFP). 14

15 29. In the coming year, the Government plans to encourage researchers to develop economic forecasts for Karnataka so that better analysis and forecasts of inflation and growth can be developed for the State. (e) General Outlook and Fiscal Implications 30. While preparing the new MTFP, some important developments need to be taken into account. There are three favourable factors : (a) currently prevailing lower interest rate regime is expected to continue. This would keep the future interest burden low. Efforts can also be made to retire outstanding high cost debt by taking equivalent fresh loan at a substantially lower rate; (b) the economy has a low inflation rate and consequently, the increase in expenditure in nominal terms would be lower though revenue receipts in nominal terms would also be lower; and (c) the reforms undertaken in previous years have started showing results in terms of increased revenue buoyancy and reduced expenditure on unproductive items. On the flip side, (a) the economic environment is still slack, though there are some signs of recovery; (b) GSDP growth rate has been slower than anticipated : containing deficit as a ratio of GSDP therefore requires much larger compression of expenditure than what was envisaged; (c) the buoyancy in Central transfers has been low; (d) although the State Government has taken several initiatives, financial losses in the power sector are still increasing; (e) the severe drought of in Karnataka depressed agricultural growth and pushed up the power sector expenditures through (i) higher demand for power by the agricultural sector which is already highly subsidized and (ii) higher requirement of costly thermal power due to depletion of reservoirs. Unfortunately, the monsoon of 2002 has also been deficient to date in large parts of Karnataka. The consequent risks need to be managed very carefully, keeping in view the fiscal targets and the importance of meeting these targets so as to ensure fiscal recovery and the ability 15

16 of the State Government to support the State s all round development and to protect the needy and the poor. V. Fiscal Performance in and Since the publication of 2001 MTFP, actual figures for have become available, and revised estimates for are also available. These can be used to review performance in the past two years against targets. This is part of the State Government s efforts to improve accountability and transparency. 32. Tables 1 and 2 show the results for and , in absolute terms and as a percentage of GSDP. In , fiscal performance showed the first signs of improvement. After years of increase, the budget fiscal deficit fell from 4.45% of GSDP in to 4.00% in Including off-budget borrowing, the actual consolidated deficit for was almost on-target at 5.47% of GSDP compared to the budget estimates at 5.44%. This was again the first time in several years that the consolidated deficit had not increased: it was 5.50% in The fiscal improvement seen in was made possible by good revenue growth. Revenues increased from 12.90% of GSDP in to 13.53% in : a growth of 15% during the year. The state s own tax revenue grew by 17%. On account of this strong revenue growth, and tight expenditure control, the budget revenue deficit fell from 2.42% of GSDP in to 1.77% of GSDP in was a very difficult year with the combined impact of the drought and the national economic slowdown. Nevertheless, the Government stuck to its fiscal targets. The revised estimate for the fiscal deficit for is Rs 5,151 crore as against the budget target of Rs.5,127 crore. Including off-budget borrowing, the consolidated deficit is estimated to be Rs 6,800 crore, actually 16

17 below the budget target of Rs 6,926 crore. Despite nominal GSDP growth being so much lower than expected: only 7.4% compared to the targeted 14%, it was still possible to meet the MTFP targets as a percentage of GSDP. Compared to a target for the consolidated deficit of 5.87% of GSDP, the revised estimate is 6.01% of GSDP. In spite of the slow-down, thanks to the revenue reform measures adopted by the State Government, it was able to further increase the revenue/gsdp ratio in : which is now estimated at 14.07% compared to 13.53% in Nevertheless, because of the slow-down, revenue fell well short of target, in fact by an estimated Rs 1,400 crore. Out of this, the shortfall in receipt from the Centre amounted to Rs.575 crores. Although tight expenditure controls were imposed to prevent a deficit blowout, revenue expenditure is largely inflexible, and the budget revenue deficit rose to 2.66% of GSDP against a target of 2.23% of GSDP. 35. Though the consolidated deficit rose from 5.47% of GSDP in to 6.01% in , in fact the underlying fiscal position improved. To see this, one may note that in , the Government was able to pay only Rs 868 crore to the power sector, only a small part of its subsidy obligation to the sector, whereas in the Government met its full subsidy commitment of Rs 2,300 crore. Thus in , a large part of the financing requirement of the Karnataka Power Transmission Corporation Limited, i.e., Rs.1,112 crores was met outside of the budget, whereas in , this figure was reduced to Rs 212 crore on account of power sector reforms and the higher amount of power sector subsidy payment. If this amount is added to the consolidated deficit (including off-budget borrowing), then the consolidated deficit (including power and off-budget borrowing) falls from 6.53% of GSDP in to 6.19% of GSDP in (see Table-2). Since the power sector has such an important fiscal impact, it is pertinent to include it in the analysis. Doing so confirms the improvement in Karnataka s fiscal position in the first such major improvement since the 17

18 mid-nineties. Such a performance, despite the revised GSDP of ending up lower due to economic slow-down at Rs.1,13,200 crores as against originally projected Rs.1,17,908 crores, clearly points to the fact that the reforms are yielding results. 36. The various steps and reforms taken by the Government to date have prevented a fiscal crisis of the type seen in many other states from developing in Karnataka. Its fiscal performance is much stronger than that of many other states. For example, Karnataka was the only major Indian state in and not to use RBI s overdraft facility. That said, a review of and certainly shows that there is no scope for complacency. The debt stock of the Government including off-budget borrowing rose sharply, from Rs 26,178 crore in to Rs 31,967 crore in and Rs 38,700 in (revised estimates). As a percentage of GSDP, the debt stock rose from 27.22% in to 30.33% in and 34.19% in Thus, although the state has started to reduce its deficit, further decreases in the deficit will be required to stabilize the debt stock. 18

19 TABLE 1 KARNATAKA: FISCAL PERFORMANCE IN AND (Rs. crores) Item A/c BE RE A/c BE RE 1. Revenue Receipts of which 1(a) State' Own Tax Revenues (b) Non Tax Revenues (c) Resources from the Centre Revenue Expenditure of which 2(a) Interest (b) Salaries (c) Pensions (d)(i) Subsidies (Food, Transport Housing & Industry) 2(d)(ii) Power Subsidy (e) Major O&M (Roads,Buildings & Irrigation) (f) Other O & M (Edn, Health,RD,WS,Agr, Forest) (g) Devolution to ULBs (h) Administrative Expenditure (i) Other Revenue Expenditure Revenue Deficit Capital Receipt ( Non Debt) Expenditure on Capital Formation Fiscal Deficit Total Debt Stock Debt Services Salary+Pension+Interest Off-Budget Borrowings Consolidated Interest Consolidated Revenue Deficit Consolidated Capital expenditure Consolidated Fiscal Deficit Consolidated Debt Stock Power Sector Subsidy requirement Budgetary Support to Power Sector Power Sector Subsidy gap Consolidated Fiscal Def. (incl of Power) Interest/Revenue 16.21% 15.88% 16.76% 16.74% 16.44% 17.82% 21. Consolidated Interest/Revenue 19.40% 19.43% 19.58% 20.15% 20.10% 21.35% 22. Debt Services/Revenue 20.17% 19.28% 20.34% 20.39% 20.52% 22.26% 23. (Salary+Pension+Interest)/Revenue 65.49% 59.26% 60.68% 60.30% 57.42% 59.97% 24. Consolidated Rev Deficit/ Revenue 21.92% 13.79% 17.95% 16.46% 19.02% 22.21% 19

20 TABLE - 2 KARNATAKA: FISCAL PERFORMANCE IN AND (as percentage of GSDP) Item A/c BE RE A/c BE RE GSDP at Current Prices * * * Inflation 1.90% 2.05%* 2.05%* 2.40% 6.50%* 2.27% GSDP Annual Real Growth 7.31% 6.25%* 6.25%* 7.02% 7.50%* 5.02% 1. Revenue Receipts 12.90% 14.63% 14.00% 13.53% 14.70% 14.07% of which 1(a) State' Own Tax Revenues 8.05% 9.13% 8.95% 8.60% 9.20% 8.94% 1(b) Non Tax Revenues 1.16% 1.20% 0.83% 1.04% 1.11% 1.07% 1(c) Resources from the Centre 3.69% 4.30% 4.23% 3.89% 4.39% 4.06% 2. Revenue Expenditure 15.32% 16.13% 16.12% 15.30% 16.92% 16.72% Of Which 2(a) Interest 2.09% 2.32% 2.35% 2.27% 2.42% 2.51% 2(b) Salaries 4.76% 4.86% 4.63% 4.39% 4.49% 4.38% 2(c) Pensions 1.60% 1.49% 1.52% 1.50% 1.54% 1.55% 2(d)(i) Subsidies (Food, Transport 0.62% 0.61% 0.64% 0.66% 0.64% 0.61% Housing & Industry) 2(d)(ii) Power Subsidy 0.80% 0.85% 0.85% 0.82% 1.95% 2.03% 2(e) Major O&M (Roads,Buildings & Irrigation) 0.36% 0.39% 0.45% 0.39% 0.38% 0.29% 2(f) Other O & M (Edn, Health,RD,WS,Agr, Forest) 1.56% 1.77% 1.70% 1.47% 1.56% 1.38% 2(g) Devolution to ULBs 0.43% 0.52% 0.50% 0.50% 0.57% 0.51% 2(h) Administrative Expenditure 0.49% 0.43% 0.43% 0.43% 0.39% 0.40% 2(i) Other Revenue Expenditure 2.61% 2.89% 3.05% 2.86% 2.99% 3.07% 3. Revenue Deficit 2.42% 1.50% 2.12% 1.77% 2.23% 2.66% 4. Capital Receipt (Non Debt) 0.15% 0.16% 0.16% 0.10% 0.17% 0.16% 5. Expenditure on Capital Formation 1.77% 1.65% 1.56% 1.78% 1.65% 1.54% 6. Fiscal Deficit 4.45% 3.66% 4.03% 4.00% 4.35% 4.55% 7. Total Debt Stock 23.96% 25.77% 26.29% 25.87% 26.88% 28.58% 8. Debt Services 2.60% 2.82% 2.85% 2.76% 3.02% 3.13% 9. Salary+Pension+Interest 8.45% 8.67% 8.50% 8.16% 8.44% 8.44% 10. Off-Budget Borrowings 1.05% 1.93% 1.93% 1.56% 1.60% 1.51% 11. Consolidated Interest 2.50% 2.84% 2.74% 2.73% 2.95% 3.00% 12. Consolidated Revenue Deficit 2.83% 2.02% 2.51% 2.23% 2.80% 3.13% 13. Consolidated Capital Expenditure 2.82% 3.58% 3.49% 3.34% 3.25% 3.05% 14. Consolidated Fiscal Deficit 5.50% 5.44% 5.84% 5.47% 5.87% 6.01% 15. Consolidated Debt Stock 27.22% 30.61% 31.16% 30.33% 32.43% 34.19% 16. Power Sector Subsidy requirement 1.88% 1.92% 1.92% 1.88% 1.89% 2.22% 17. Budgetary Support to Power Sector 0.80% 0.84% 0.84% 0.82% 1.95% 2.03% 18. Power Sector Subsidy Gap 1.08% 1.08% 1.08% 1.06% -0.06% 0.19% 19. Consolidated Fiscal Def. (Incl. of Power) 6.58% 6.52% 6.92% 6.53% 5.82% 6.19% *Forecasts of GSDP, inflation and annual growth rate at the time of preparation of MTFP

21 VI. Revenue Projections and Reforms: 37. Improvement in the fiscal situation in the State requires concerted action to reform the tax system. The second and final report of the Tax Reforms Commission was submitted in October 2001 and many of its recommendations have already been implemented. The crucial issues, as highlighted by the Commission, are to expand the tax base, i.e., improve coverage and reduce exemptions, rationalise the tax structure, improve tax compliance and strengthen tax administration and enforcement. 38. In the area of commercial taxes, a number of steps have already been taken to improve the buoyancy of commercial taxes. The imposition of floor rates in all the States and Union Territories has controlled the race to the bottom to some extent and reduced revenue loss due to trade diversion. The abolition of tax incentives for industries too will improve the revenues and reduce distortions. This is important since tax incentives have become a major drain on revenue in Karnataka. It is calculated that the revenue foregone from commercial tax incentives was Rs 619 crore in up from Rs 312 crore in Although it has been decided by the Empowered Committee of State Finance Ministers to delay the introduction of Value Added Tax (VAT) to April 2003, Karnataka has already taken many important policy measures and administrative steps towards introduction of VAT, including the following: abolition of the turnover tax; abolition of entry tax on inputs and packaging material; abolition of the infrastructure cess on sales tax; rationalization of rates towards four main rates, 4%, 8%, 12% and 15%; introduction of self-assessment for dealers; and retrospective use of self-assessment to clear the backlog of pending assessments. 40. The Government is also advanced in its preparation for VAT introduction, and has drafted a VAT law. The Government will shortly be tabling its VAT 21

22 policy for consideration, as well as the draft VAT legislation. Since services enter into goods during manufacture, and goods also enter into services, the State Government is also urging the Central Government to allow states to include services in the VAT base to raise buoyancy and reduce evasion. The Commercial Tax Department has engaged consultants to assist it with VAT introduction, and is embarking on a major programme on restructuring and computerization. The Government has decided to re-organize the Commercial Tax Department along functional lines, and is strengthening its enforcement capacity. The Department will be coming out with a Citizens Charter shortly. 41. In the area of motor vehicles tax, the bulk of the recommendations of the Commission has already been implemented, with the introduction of ad valorem rates and rationalization of rates and slabs. Service delivery is being over-hauled and computerization is being introduced in the Regional Transport Offices. A citizens charter has been introduced to improve customer service. With respect to bus transport, the Tax Reforms Commission has recommended that, in the interests of transparency and to enhance customer service and increase state revenue, the Road Transport Corporation and private buses be placed under the same tax regime (as is the case in neighbouring states). The Government is now reviewing these recommendations, and will announce its policies shortly. 42. In excise, Government is strengthening enforcement, and making evasion of excise dues more difficult. To streamline the system, sales tax on alcohol has been eliminated, and replaced by a special excise duty. The Tax Reforms Commission has made extensive recommendations on e-governance, which the Department is now implementing 43. In stamps and registration, a number of reforms have been undertaken to plug loopholes. Guidance values are being updated. A citizens charter has been issued. Office infrastructure has been improved and more will be done in this area 22

23 to improve the facilities for tax-payers. Stamp papers are being phased out to prevent misuse. Government is considering the recommendation for a Central Guidance Valuation Committee to lay down the general methodology for valuation and determining guidance values for Bangalore city, and oversee other regional committees. 44. These reform measures are already showing results. As mentioned, the own-tax-gsdp ratio has already improved from 8.05% in to 8.60% in and is estimated at 8.94% for Implementation of tax reforms in the coming years and better administration and enforcement of the taxes are expected to further improve revenue productivity, and the tax-gsdp ratio is predicted to rise to 9.52% in In regard to non-tax revenues, the Government s objective is to improve cost recovery in general and to ensure full recovery of operating costs for nonmeritorious economic services. However, it will take time to achieve this goal, which will be attempted in a progressive manner. In order to inculcate a sense of ownership of assets and services, beneficiaries should contribute towards the capital costs, either at the initial stage of the project, or later during the operation of the services. Appropriate policy measures will have to be taken to increase user charges from higher and technical education, health, irrigation and drinking water supply. This will be easier to achieve if simultaneous steps are taken to enhance the quality of service provided to the users. Higher cost recoveries in respect of these services are necessary not merely to improve the fiscal situation but also to reflect their economic values with appropriate adjustment made for social obligations. Thus, in the case of the health sector, proper pricing of secondary and tertiary health care services and various clinical and other medical tests conducted in the hospitals and dispensaries should help in achieving higher cost recovery. Similarly, cost recovery in secondary education is estimated to increase from 3.55% ( RE) to 4.09% in , in technical education from 14.7% to 23

24 20.9%, in major and medium irrigation from 34% to 83%, in minor irrigation from 4.57% to 20%, and in rural drinking water supply from 2.24% to 3%. Other nontax revenues are assumed to grow at their historical rates. The detailed cost recovery rates in each of the four years from to for these sectors are presented in the Annex. In case of rural water supply and health, the improved recovery will be used at the field level to meet part of the O&M expenditure and will not come back to the Government. This envisages progressively greater participation of the community in maintaining the assets. 46. While it is necessary to increase user charges to contain subsidies, more attention needs to be given to the recovery aspect. Thus, although irrigation rates were hiked by 2.5 times in , recovery from irrigation charges is estimated to have increased from Rs 18 crore in to only Rs 25 crore in , an increase of about 40%. Departments will be held accountable for recovering charges owed to them, and will also be given incentives to do so. Increasingly, departments will be allowed to retain their own revenues so that they have an incentive to collect them. In the case of irrigation charges, where collections are currently the responsibility of the Revenue Department, major changes will be needed to improve recovery. The process of setting up user groups, which is currently on, is expected to help in this regard, and further reforms will also be introduced. 47. Another area that needs concerted effort is to enhance recoveries from the beneficiaries of housing provided by the government. While the expenditure on housing has increased substantially over the years, cost recovery from beneficiaries is negligible. Only when loans are recovered from beneficiaries will it be possible for the Government to repay the loan to the Housing Finance Agencies and obtain more loans for new beneficiaries. The Budget Speech has announced that measures will be taken to improve the recovery of housing loans to reduce the repayment burden. Gram Panchayats will be more involved in the 24

25 scheme, and they will organize savings schemes. It is therefore proposed that on housing loans, the recovery will be stepped up from 10% in to 34.83% in To improve the collection of non-tax revenue, the Tax Reforms Commission has been reconstituted as the Revenue Reforms Commission, and has been asked to report to the Government on appropriate reforms for non-tax revenues. The Commission s report is expected by December 2002, and will be carefully considered by the Government. 49. Karnataka state has been a pioneer in democratic decentralisation. Rural and Urban Local Bodies receive funds from the State Government as per the recommendations of the State Finance Commission. However, these bodies are short of funds and are unable to provide satisfactory standards of services. Government will explore possibilities of augmentation of revenue of these local bodies. A system of self-assessment of property tax has shown considerable promise in Bangalore city. This is now being extended to other cities using the capital-value based system of property taxation. The Government is also planning a revamp of property taxation in rural areas, and to give Panchayati Raj institutions incentives to collect additional revenue. The urban water sector is also one where cost recovery is poor. The Bangalore Water Supply and Sanitation Board increased water rates during the last year by 30%. Water charges outside of Bangalore is also poor, and there are massive funding requirements to meet critical investment needs. The Budget Speech has stressed the importance of the levy and collection of urban water charges. In this regard, the Government plans shortly to come out with a comprehensive urban water policy. 50. Revenue from central transfers accruing to the State depends on the recommendations of the Finance Commission, policies of the Planning Commission and programmes of the central ministries implemented through the 25

26 States. The Eleventh Finance Commission has already made its recommendations regarding tax devolution, non-plan grants, and calamity relief. The State s entitlement for the coming years has been worked out on the basis of these estimates. The second report of the Finance Commission deals with an incentivelinked additional transfer based on the fiscal reforms undertaken by the States. Since the present MTFP is fully consistent with such fiscal reforms, the allocation made for Karnataka on this account has been assumed in the MTFP. 51. The State Government recognises the importance of an accurate model for arriving at revenue projections for each year during the budgetary exercise. To improve revenue forecasting, a system of monthly monitoring of tax revenues has been started. From , this will be placed on the Internet in the interest of transparency. This monthly monitoring is being extended to cover non-tax revenues as well. VII. Expenditure Reforms 52. Restoring fiscal health in Karnataka critically depends upon compressing unproductive expenditures and improving public expenditure prioritisation to enhance efficiency and effectiveness. It is also necessary to provide adequately for maintenance of existing assets and for high priority expenditures in the social sector and on basic infrastructure. The expenditure policy, thus, will have to be calibrated to conform closely to the fiscal targets, commitments and priorities. 53. One of the most important components of expenditure expansion in recent years has been wages and salaries. Recruitment controls remain in place. However, exemptions have been allowed in case of primary and secondary education, health, police, forest and wildlife protection as indicated in the Annex. The benefits of this can be seen in the recent decline in the share of salaries as a percentage of GSDP. Salaries were at 4.4% of GSDP in , but had risen to 26

27 4.76% in as a result of the pay revision of However, by , salaries had fallen again to 4.38% of GSDP. 54. Unfortunately, there is not much flexibility in the short-term in regard to expenditure on pensions. Government has undertaken a massive data collection effort to enable it to improve its pension forecasting capability. The results are currently being reviewed, and will be released shortly for public consideration. 55. An important area of fiscal correction is the compression of subsidies. This is an area where significant effort is necessary. As outlined in the White Paper, the State government commissioned a detailed study to quantify the volume and composition of implicit and explicit subsidies and to formulate appropriate strategies to reduce them in a phased manner, inter alia, through better targeting. As detailed below, measures are now underway to contain and reduce spending on subsidies. 56. As mentioned in the 2001 MTFP, the power sector represents a huge drain on the Government s resources and poses the biggest fiscal risk in the near future. It will be impossible to eliminate revenue deficit without comprehensive structural reforms in this sector. Recognising this, the State Government has set up a regulatory commission, which has already issued its first two tariff orders. The electricity board has been corporatised and generation, transmission and distribution have been separated. Four new distribution companies for the Bangalore, Mangalore, Hubli and Gulbarga regions have been established. Key to eliminating power sector subsidy is loss reduction, which is being done through universal metering and privatisation of distribution. The Electricity (Supply) Act has been amended to strengthen the anti-theft provisions. The one-time regularization scheme implemented in March and April 2002 resulted in some 8.8 lakh illegal customers being regularized fetching a one-time revenue of Rs.93 crores. Subsequently, inspection drives are being conducted to clamp down on 27