"Radical restructuring of state finances is not only necessary for faster development but a concerted effort in expenditure control, revenue augmentation and debt relief is needed," World Bank country director Michael Carter said in New Delhi.
Releasing a report on 'State Fiscal Reforms in India -Progress and Prospects' at NIPFP, he said "the poorer and lagging states are particularly at risk." He said the Centre and the states have to make a concerted effort to eliminate the revenue deficits of states by 2007-08.
According to World Bank projections, revenue deficits of all states can be wiped off by 2007-08 following sweeping fiscal reforms. The average revenue deficit of poorer states is now at 3.5 per cent of gross state domestic product while it is 2.5 per cent for richer states.
The fiscal deficit of poorer states can come down from 6 to 3 per cent after reforms while it can be cut down from 4.5 to 2.5 per cent for richer states.
"State governments have significant, if not the main responsibility, for many of the developmental areas - roads, irrigation, health and education, which the bank is financing. If state finances are not put on a stronger footing, the sustainability of investments cannot be assured and government effectiveness will continue to suffer," Carter said.
Carter said the proposed VAT from April 2005 would significantly improve the financial health of states. Pitching for early introduction of VAT, World Bank lead economist Stephen Howes said it should be "voluntary" and based on the basis of a floor rate.
Otherwise, he said there was undue delay in implementing the new tax regime due to apprehensions of a handful of states. According to the bank's estimates, VAT introduction would raise revenues of states by 0.2 per cent of GSDP each in the fiscal years of 2006-07 and 2007-08.
Other tax reforms like reduction of stamp duties and strengthening professions tax and reforming motor vehicles tax would raise revenues by another 0.2 per cent in 2004-05 and 0.1 per cent in 2005-06.
Taxation of services from 2006 would hike revenues by another 0.2 per cent in 2007-08, it said.
Moreover, World Bank suggested widening of states' tax base by allowing them to tax services and enhancing the professions tax limits. The bank also pitched for better tax administration, which has received less attention.
On debt relief of states, Carter said there was a scope for debt restructuring by increasing the grant component and reducing loans given by the Centre to states, apart from swapping of high cost debt with low cost ones.
The World Bank also favoured greater flexibility to states to borrow from the market. The improvement of the overall Tax:GDP ratio of the country was essential for enhancing transfer of funds to states especially poorer states.
Proposing stringent expenditure control measures, World Bank said states should restraint on hiring and pay scale, which would lead to a fall in wage bill by 0.2 per cent of GSDP annually.
Pension bill as a ratio of GDP should also be kept contant in the next five years inspite of increased retirement, the bank said. World Bank also called for better management of subsidies as there was no sure path of reducing it.
While suggesting sweeping reforms, World Bank admitted that there could be political obstacles coming in the way of reforms and further erode state finances.
"Perhaps the most important risk across states is that the comprehensive reforms needed could be delayed due to political concerns, including elections, and the resultant unwillingness by the states to take tough measures," it said.
World Bank also warned that rise in interest rates could threaten the development prospects of states, which have build up huge debt burden.
"Even 1 per cent increase in interest rate would lead to a significant diversion of resources away from productive spending and to debt-service purposes," it said. Moreover, slower growth in economy would have a detrimental impact on state finances, it said.
"If the average real growth rate during 2004-08 drops to 5 per cent from the current 6.5 per cent, committed spending as a share of GDP would increase significantly. There would be no fiscal space to protect other recurrent spending including operations and maintenance," it added.
