Fiscal and Procurement Processes 85
4 FISCAL AND PROCUREMENT
PROCESSES
4.1 IMPROVING SUB-NATIONAL FISCAL RESPONSIBILITY IN THE
FEDERAL CONTEXT OF INDIA
Second generation theories of federalism, such as those of
‘market-preserving’ federalism suggest that, given favourable
conditions, decentralization and federalism can provide better
incentives to governments to support market development
and economic prosperity than centralization. The main
preconditions are (i) a nationwide common market, (ii)
competition among sub-national units and (iii) no
expectation of central bailouts on the part of the sub-
national governments. The improvement occurs through
minimization of inefficient government interventions which
may drive away valuable factors of production, as well as
through strong links between revenues and expenditures. In
the absence of bailouts, these create better incentives for
economic prosperity that would yield greater revenues and
thus allow higher expenditures. The superior performance
of the system of decentralization and federalism in China
as compared to that in Russia, for example, is ascribed to
essentially these factors (Jin, Qian; and Weingast, 1999;
Zhuravskaya, 2000).1
Traditional theory of fiscal federalism, however,
emphasizes benefits of decentralized expenditure decisions
due to informational advantages indicated several
years ago by Hayek (1945) and popularized in the
‘decentralization theorem’ of Oates (1972), combined with
1 China, of course, has the advantage of a favourable history. Since
a greater share of aggregate revenues of all levels of government put
together has been traditionally collected at the sub-national levels,
the psychological dependence on central transfers and bailouts did
not develop in China.
Tapas K. Sen
relatively centralized revenue raising. But it also identifies
a number of possible allocative distortions and weakening
of central fiscal capability. Instances include large-scale
externalities, competition in taxation and macroeconomic
stability concerns. The traditional model also requires inter-
governmental transfers, which could sever the link between
own revenues and expenditures of sub-national units—a
combination required by the second-generation models.
Substantial intergovernmental transfers cannot be dispensed
with in India for many reasons. One principle reason being
the need to reduce the existing wide gap between the poorest
and the well-off states.
An inevitable question, the answer to which can help
resolve this dilemma, is: what kind of link do we require
at the sub-national level between revenues and expenditures?
Would one at the margin be enough? Or, do the sub-
national government expenditures have such large
spillovers—in terms of future revenues—to other
governments at the same or at a higher level that the link
simply does not operate thereby weakening the incentives?
Qian and Roland (1998) show that under certain conditions,
the existence of such transfers need not adversely affect
incentives, while Bird (2000) uses conventional reasoning
to argue that proper design and a combination of various
elements of the intergovernmental transfers can maintain
the right incentives without explicitly taking recourse to
technically suspect and not easily understood estimates of
tax effort. However, ‘it is important to take fiscal effort into
account in a more general sense in designing transfers’ (Bird,
2000).
86 India Infrastructure Report 2003
Based on the experience of a number of Latin American
federations, Dillinger and Webb (1999a, b) lay down eight
conditions for reducing unsustainable sub-national deficits
in a federal system. These are outlined below along with
their applicability in India.
Sub-national Governments Raise Much of Their Own
Revenues
This condition is not fulfilled in India for most of the states.
Both revenue sharing and central grants significantly
supplement the revenues of the states. In some states, own
revenues constitute a very small part of their total revenues.
Whether or not this is a deciding factor for the rising deficits
at the state level is, however, an open issue.
Transfers are Specified by Objective Formula and Not
Ad Hoc
This is largely true in India, as the bulk of the statutory
transfers, plan transfers and a significant part of the other
transfers are formula-determined, although in the case of
the last-mentioned category the applicable formula is not
always transparent. However, in the Indian context, it is
sometimes alleged that formula-driven transfers do not
guarantee objectivity; the formula itself can be open to
manipulation by various lobbies. For example, it was alleged
that the formulae adopted by the Tenth Finance
Commission were designed to benefit a particular state.
Similar allegations were voiced after the first report of the
Ninth Finance Commission was out. Further, in the case
of discretionary grants and when the benefits of the
individual schemes are geographically limited, the selection
of schemes supported by the central government itself can
be open to lobbying; no formula will then make the overall
system objective.
Sub-national Governments’ Expenditure Responsibilities
Match the Delegation of Revenue Sources
It is difficult to assess this condition objectively, since it is
not easy to translate functional responsibilities into
expenditure responsibilities in any obvious manner. One
way of looking at it in the Indian context would be to
examine the eventual revenue share (after tax devolution)
and the expenditure share of the sub-national governments,
since the condition essentially relates to the relative position
of central and sub-national governments with respect to
such matching. The condition, interpreted this way, appears
to be roughly fulfilled in India, as the states’ shares in
expenditures and post-devolution revenue receipts were 56
and 52 per cent in the respective totals for the centre and
the states.
Sub-national Governments have Authority to Cut Costs,
in Particular, in Big-ticket Items Like Salaries and
Wages (Number of Personnel and Wage Rates), and
Pensions
In a formal sense, this condition holds in India, but one
suspects that the view of state governments about the
discretion to lower wage-rates in practice would be different.
The likely argument would be that the states have no realistic
option but to conform to the Pay Commission awards as
implemented by the central government. However, it should
be noted that many states actually had lower pay-scales as
compared to those of the central government until the
Fourth Pay Commission awards were implemented. Pay
parity between state and central government employees is
relatively recent.2
The Central Government Strictly Controls Borrowings
Ex Ante
This condition is largely fulfilled in India—at least going
by the constitutional provisions—although it is not quite
clear why this is necessary for controlling unsustainable
deficits. A dependable mechanism to discipline possible
irresponsible borrowing by states is certainly needed, but
does it necessarily have to be the job of the central
government? There are other views (Shah, 1998) and this
prescription appears too centrist, as long as other mechanisms
to achieve the same objective can be credibly invoked. In
any case, the major problem in India is probably the ex post
failure of the central government to use the powers it already
has to control borrowing by states.
The Central Government Credibly Commits Not to
Undertake Bailouts, Prohibiting Explicit Bailouts and
Forcing Sub-national Governments to Service their Debts
This condition is arguably the most important supply-side
condition that is not fulfilled in India. Bailouts take many
forms in India and have a long history. Not only the central
government, but also other agencies have been responsible
for keeping alive this practice. In fact, there are only a few
states that can boast of never having been bailed out by the
central government. Often, it takes the less serious form of
advances against various kinds of transfers. As noted earlier,
rescheduling of loans is fairly common. The latest in the
history of bailouts is the discretionary central loans based
on Memorandum of Understanding (MoUs) to undertake
an agreed programme of reforms. The worst form of bailout
is, of course, writing off loans entirely. Market interventions
2 It may be of interest to note that in some states like Punjab,
the salary scales were (and continue to be) higher than those in the
central government.

by the central government through its agencies have also
been used to practise disguised bailouts. Instances of higher-
than-recommended support prices for foodgrains and other
agricultural products fall into this category. The problem
with bailouts is not only that it provides the wrong incentives
for fiscal discipline but it also allows politicization of an
essentially financial matter and leaves ample scope for
selective disbursal of favours.
Regulators Force Creditors to Accept the Losses Implied
by Any Failure to Service Debt (Provisioning for
Sub-national Debt)
This is another important condition that is not fulfilled in
India. The system of guarantees by state governments and
counter-guarantees by the central government—while
making it easier for the states to borrow—allows creditors
to avoid assessment of loans on purely commercial basis and
shift the risk of default. This is true not only for financial
institutions that lend to sub-national governments or public
enterprises under their control, but sometimes for commercial
enterprises supplying goods and services to the state
governments as well (agreements with independent power
producers like Enron are examples). Even centrally-owned
financial enterprises like Housing and Urban Development
Corporation (HUDCO) and National Cooperative
Development Corporation (NCDC) have routinely
demanded state government guarantees before a loan is
provided to the state-level public enterprises. This loophole
has in fact facilitated the growth of unproductive debt at
the state level. ‘The danger of irresistible pressure for federal
bailouts, and thus both types of moral hazard [relating to
the creditor and the borrower], is increased when the borrowers
are sub-national governments with service provision
responsibilities that are important to the national
government, such as primary schooling and police
protection.’ (Giugale, Korobow and Webb, 1999)
The Central Bank (and Bank Regulators) is Autonomous
and has a Strong Anti-inflation Mandate
The Reserve Bank of India (RBI) is reasonably autonomous
in terms of policy-making and is generally thought to be
conservative with respect to inflation. The central government
does have a say in matters of monetary policy, but this in
no way rules out RBI initiatives, particularly with respect
to state indebtedness, for most of whom it is also a banker.
RBI also performs the role of the regulator for all financial
institutions.
Bird (2000) provides some guidelines on the design of
intergovernmental transfers that would help to contain fiscal
imbalances at the sub-national level in cases where such
transfers are essential and significant. He believes that both
Fiscal and Procurement Processes 87
specific-purpose and general-purpose grants are required,
and within the first category, there may be need for some
matching grants also. He advocates a total pool of resources
for general-purpose transfer that is defined in a stable and
flexible manner. On this score, the present scheme of tax
sharing (which accounts for the larger part of general-purpose
transfers) should meet with his approval. He also prefers
taking into account both need and capacity in the distribution
of general-purpose transfers, but in a simple and transparent
fashion. This advice is not easy to implement, as there is
a trade-off between simplicity and transparency. Bodies like
the Finance Commission undoubtedly try their best to find
the golden mean, but it is an elusive goal. Even the plan
grants for state plans determined through the Gadgil
formula—the largest element of aggregate plan grants—aim
at providing general-purpose grants after taking into account
both need and capacity. But the difficulty in adequately and
accurately taking into account need and capacity also makes
it difficult to subscribe to his view that no specific incentive
is necessary to ensure revenue effort, since it is conditional
upon a proper design of the general-purpose transfers.
His advice, that no restrictions should be imposed on the
use of general-purpose grants, should normally be true by
definition. In some countries, the general-purpose transfers
or block grants are indeed misnomers (for example, in Sri
Lanka). But India is not one of these countries. On matching
grants for special purposes, variations in the matching rate
could depend on both the type of the expenditure and the
capacity of the recipient. While the former type of variations
are in vogue, the latter type is expected to be controversial
and, hence, is avoided in India, although there is an economic
case to encourage the adoption of such variations too (Rao
and Sen, 1996). Technical clearances which are also advocated
for some of the special-purpose grants (for example, for
infrastructure); are normally required in India. Bird’s final
guideline relates to adequate availability of information for
all interested parties from all levels of government. Public
scrutiny is an effective tool to ensure accountability, and
information is its precondition. While there are sporadic
attempts to ensure general availability of such information
(advances in information technology (IT) have helped
considerably), there is still a long way to go before the
governments are persuaded to become fully transparent
both in their decision-making and in the implementation
of policy decisions taken.3
Search for remedies to the problem of fiscal indiscipline
in India has tended to focus more and more on imposition
3 Confidentiality is often carried to ridiculous lengths in government
departments in India. This obsession actually signifies the difficulties
that confront any attempt to introduce transparency. The policy of
confidentiality is also convenient for the concerned parties as it
prevents exposure of corruption, bias and plain inefficiency.
88 India Infrastructure Report 2003
Box 4.1.1
Colombia: Ley de Semáforos or The Traffic Light Law
Criterion: Interest Payments/
Operational Savings
<40%
40%–60%
>60%
Note: Operational Savings = current receipts–personnel costs.
Source: Dillinger and Webb (1999b).
of controls over state budgets from the centre through the
mechanism of MoUs coupled with ‘incentives’ for good
fiscal conduct, that is, in essence, hierarchical controls.
While there can be no questioning the need for incentives
to induce good fiscal behaviour and disincentives to
discourage irresponsibility, the main issue relates to the
desirability of hierarchical controls vis-à-vis market and self-
enforcement in fostering discipline among sub-national
governments.
It is now well recognized that the problem of soft budget
among sub-national governments arises from the absence of
a credible commitment to a hard budget constraint on the
part of the higher-level governments. However, experience
shows that it is impractical to ignore the economic, political
and sociological spillovers of financial crises at the state level
on the centre and the national economy. At the same time,
similar reasoning leading to expectations of bailouts,
undermines incentives for fiscal discipline at the state level.
In this background, a more effective way of inducing fiscal
discipline among the states is, probably, to rely on the
market, whereby, they are obligated to go to the market for
borrowing and bear the cost as assessed by the market
through the process of rating. The efficiency of the markets,
however, depends on certain conditions which have to be
satisfied. Primary among such conditions are the availability
of information on the finances of the states and the existence
of independent (rating) agencies that can process these
information efficiently in an intelligible manner for the
market at large.
Acknowledging that fiscal-policy coordination poses a
challenge for federal systems and that Maastricht guidelines
provide a useful framework for the purpose, Shah (1998)
argues that they do not quite provide an answer to the
challenge of fiscal coordination in a federal system. In a
developing country like India where the economic strength
and level of development vary widely among sub-national
units, a fully market-oriented system can be potentially
Rating Result
Green No restriction on debt
Yellow Debt allowed by
Ministry of Finance only after
review of Debt-service projections
Red Debt allowed only under agreement
to enforce adjustment Plan
inequitable. Thus, at the present juncture, there may be no
option but to allow both central supervision and market test
of state finances. A recent World Bank study, examining the
issue of soft budget constraints at the sub-national level,
suggests a ‘middle road’ and concludes that, ‘countries need
not make a choice between dysfunctional markets and blunt
hierarchy. Hierarchical instruments can be honed and
made to supplement market mechanisms rather than to
obstruct their growing role’. Such a middle road, the study
argues, ‘belongs to the decentralization process’ and ‘market
discipline can grow only as a process of gradual central
government disengagement’ (Rodden and Eskeland,
forthcoming). One may add that in the particular context
of India, it may be necessary to build in adequate safeguards
for maintaining the federal fabric in the institutional
arrangements.
Having advocated a market-based system of state-level
borrowing, one must also consider the question of a possible
cap on their debt, particularly, market borrowing. One way
would be to have statutory fiscal responsibility, defined in
a way that automatically caps debt at some level. This has
the advantage that it would be voluntary on the part of the
states and would not be construed as an attack on the state
autonomy. But the flip side of the same consideration would
be that unless a state’s politicians (and bureaucrats) suddenly
become virtuous—or the state’s electorate becomes conscious
enough about such problems to engender such virtuosity—
voluntary fiscal responsibility may not ever come about in
some cases. Hence, it seems that some capping mechanism
is necessary.
A simple, rule-based system would be the best, as it
would be easily understood and the least controversial, as
long as the control was not exercised by the central
government in specific cases of infringement. However,
simple systems like the Colombian ‘Traffic Light Rule’ (Box
4.1.1) could end up providing some perverse incentives. In
that system, for example, unnecessarily widespread
 Fiscal and Procurement Processes 89

Box 4.1.2
M ar ket-B
arket-B ased R
ket-Based egulation of SSub-N
Regulation ub-N ational D
ub-National ebt in M
Debt exico
Mexico

The Mexican reforms of the sub-national debt system introduced in late 1999 and fully effective from April 2000 consists of the
following six components:
• Starting with the budget for the year 2000, the federal government gave up all executive powers for discretionary transfers.
• The system of mandatos (mandates) was abolished; this system allowed the federal government to accept states acting as trustees
for debt-servicing with the participaciones (revenue-sharing) serving as collaterals. The creditors and the states were left to make their
own arrangements, including collateralization of revenue-sharing, but without any federal commitment.
• The regimen de excepción that allowed waiver of normal single-customer exposure limits for banks in the cases of lending to
sub-national governments was removed.
• A link was established between capital risk weighting (between 20 and 115 per cent) of bank loans and the concerned state
government’s credit rating by two reputed agencies.
• Sub-national loans may be registered with the federal government, conditional upon full updated disclosure of its debt-related
statistics. Registration is not compulsory, but all unregistered loans are automatically risk-weighted at 150 per cent.
• High risk-weighted loans mean very high interest rates on loans from banks, and are effectively priced out. Federally-owned
development banks are not allowed to lend to states and municipalities when the loan is not registered or the capital risk weighting
is 100 per cent or above in the normal course. Such loans are allowed by federal development banks only when the loan package
contains a technical assistance component funded by an international development finance institution.
Source: Giugale, Korobow and Webb (1999).

government intervention with high levels of subsidies would
be encouraged, since the current receipts will rise with
governmental expansion, but as long as personnel costs did
not rise proportionately, it would qualify the state for higher
borrowings. Also, a rule-based system of controlling sub-
national debt is rarely sufficient by itself. After all, the
growth of contingent liabilities and some other forms of
debt not under central control probably represent a successful
strategy adopted by states to borrow and spend, while
avoiding the constitutional constraints on their debt. Even
in an industrialized country like Germany, where borrowings
are supposed to be restricted to the amount of capital
expenditures only, ‘all levels of government are quite
innovative in developing procedures to circumvent debt
restrictions. These practices include reclassifying current
expenditures as capital (investment) expenditures, setting
up entities whose operations are kept off-budget, and using
innovative debt instruments such as private–public
partnership in running and financing infrastructure projects’.
(Seitz, 2000).
The new Mexican system (Box 4.1.2) is, on the other
hand, too complicated and involves too many parties besides
the state government (credit rating agencies, the federal
government, international agencies and actual lenders),
although the manner of ensuring full disclosure is worth
emulating. Lessons from the evolution of the Australian
Loan Council system show that any complicated and non-
interactive system is not likely to work for a prolonged
length of time. An ideal system should not be based on
externally-given, inflexible limits, particularly when
macroeconomic parameters are given paramount
importance at the cost of sub-national budgetary needs
(Grewal, 2000).
What is suggested here for consideration is a system that
would have the following features:
• substitution of plan loans by market borrowing;
• scaling down of Gadgil formula assistance by 50 per
cent, consisting entirely of grants (for non-special category
states; the current system for special category states may
continue unchanged);
• market determination of interest rates through a
suitable mechanism operated by RBI, possibly through
auction of the state-government bonds. The state
governments will be free to get their bonds credit-rated by
recognized agencies that RBI approves;
• a disqualifying limit (say 25 per cent) set by the ratio
of interest payments to revenue expenditure of the concerned
state, beyond which RBI will not undertake to market the
bonds;
• negotiated loans of public enterprises, statutory boards,
etc. from financial institutions will not be provided with
any form of government guarantee. Any state not observing
this rule will not have the benefit of marketing of its bonds
by RBI;
• a discretionary limit of another 5 per cent of the same
ratio, provided RBI is given full information on the state’s
liabilities and a credible plan for better fiscal management; and
• additional special ad hoc loans from the central
government, the quantum and the terms specified only on
the recommendation of at least 75 per cent of the members
of the National Development Council (NDC). NDC would
decide special cases on the basis of an assessment by the
90 India Infrastructure Report 2003

Planning Commission and on a presentation of their case
by the representative of the concerned state. The central
government will have a veto power, but no loans can be
given to states on its own by the central government.
Some of the elements of the scheme have been proposed
elsewhere (Chelliah, 1998). Such a system will address the
basic concerns of macroeconomic imbalances, state autonomy
and special considerations, without unduly loosening the
market regulation of sub-national borrowing. Obviously,
this kind of supply-side measures need to be coupled with
measures on the demand side, but one feels that excepting
possible improvements in the estimation of normative
revenues and expenditures for the purpose of statutory
transfers and some marginal improvements in the system of
plan assistance, the incentives in the present system of
current transfers are considerably better than those obtained
in the past; further improvements must weigh the trade-off
with simplicity as also with political and administrative
feasibility. Further incentives for optimal fiscal behaviour
must also come from the electorate, but the system must
be amended to allow complete transparency for the electorate
to discipline errant governments.

Box 4.1.3
Fiscal Transpar ency and IIndia
ransparency ndia

Realizing the significance of information asymmetry on the working of markets, and on the behaviour of global capital markets
in particular, the International Monetory Fund (IMF) has evolved and adopted a ‘Code of Good Practices on Fiscal Transparency’
in 1998. India is a member of the interim committee of the board of governors, which adopted the code. Information asymmetry,
caused by lack of fiscal transparency, leads to financial crises. Fiscal transparency is a prerequisite for the evaluation of the fiscal
soundness or the fiscal efficiency of governments and their parastatals by the markets as well as by the public especially in societies
where financial markets are expected to play an allocative role. The code on fiscal transparency is just one of various codes and standards
suggested by IMF, viz., the International Financial Standards and Codes. The four principles from which the detailed guidelines
that constitute the code were derived are:
• Clarity of roles and responsibilities within the government and between the government and the rest of the economy
• Public availability of information on fiscal outcomes
• Open and transparent budget preparation, execution, and reporting
• Assurance of integrity, including those relating to the quality of fiscal data and the need for independent scrutiny of fiscal
information

ADVISORY GROUP ON FISCAL TRANSPARENCY

In order to review these codes and assess their relevance and implication for India, the Reserve Bank of India (RBI) established a
Standing Committee on International Financial Standards and Codes with Y. V. Reddy, the then Deputy Governor, RBI and E.A.S.
Sarma, the then Secretary, Economic Affairs, as the co-chairmen. The Standing Committee, in turn, appointed 10 Advisory Groups
to evaluate different sections of the codes, each covering specific areas. The Advisory Group headed by Montek Singh Ahluwalia
(Member, Planning Commission) examined the code on fiscal transparency and assessed the extent to which the Indian practice
complies with the code on fiscal transparency. According to the Group, ‘The overall assessment that emerges from our review is
that current fiscal practices at the central government level satisfy the minimum requirement of the Code of Good Practices on Fiscal
Transparency in many areas, though there are deficiencies in some important areas which need to be addressed. The position at the
state government level is much less satisfactory with most states being well behind the standards achieved by the central government’.
In the assessment of the Group, the areas where the Indian practices do not meet the minimum requirements are:
Central Government
Quasi-Fiscal Activities: Fiscal transparency requires that the quasi-fiscal activities performed by the government through extra-
budgetary funds or public sector entities be quantified and included in the overall fiscal reporting. Quasi-fiscal activities by such
agencies or funds are equivalent to government expenditure and should be accounted for as such. Currently, mechanisms such as
the Oil Pool Account, or the quasi-fiscal activities performed by the public sector financial institutions and enterprises are not
quantified and reported in the government budget. The Oil Pool Account, which was supposed to be a self-balancing account, has
either been in large deficits, or else in surplus, over long time periods. In the interim, these surpluses and deficits had a direct effect
on government finances as they were utilized to provide fiscal support when in surplus, and were propped up by issuing bonds when
in deficit. The quasi-fiscal activities by the public sector entities can also create contingent liabilities. This is another area of concern.
Contingent Liabilities: The code requires that the government should describe the nature and significance of the contingent liabilities,
tax expenditures and quasi-fiscal activities in the budget document. Contingent liabilities arise only in the case of specific events
on which they are based. They are equivalent to government borrowings if the contingent events were to materialize. Currently, only
the loan guarantees are reported in the central government budget. The Group points out that the letters of comfort, which are
quite similar to contingent liabilities, also go unreported. Similarly, the guarantee to meet the obligation to the Life Insurance
 Fiscal and Procurement Processes 91

Corporation of India (LIC) policyholders is not listed in the budget. The recapitalization or bailouts as witnessed in the rece nt past
were realizations of implicit contingent liabilities obfuscated by the legal separation of the entities but in reality not avoi dable. While
limited information on contingent liabilities is provided in the budget, little or no information is provided on tax expenditur e and
quasi-fiscal activities associated with the same. Tax expenditures refer to the exemptions from the taxes granted by the government,
for example, allowances deducted from gross income, etc., which are similar to expenditure by the government. Such exemptions
are very large and cover both direct and indirect taxes. The tendency to use ‘exceptions’ and also varying rates has been a lasting
feature of the fiscal system, which has been only reduced a bit, with the reforms of the 1990s. There is no estimate at all of the
revenue implications of all tax expenditures and exemptions.
Clear Criteria for Administrative Discretion in Tax Laws: The fiscal transparency code requires that the criteria for administrative
discretion in tax laws and regulations should be clear leaving minimal scope for discretion and consequent harassment and corruption.
As pointed out clearly by the Group, the scope for administrative discretion arises because of large number of rates of taxes, many
possible exemptions including complex multi-criteria exemptions, besides frequent changes, etc.
Budget Preparation and Reporting: The code on fiscal transparency requires that the budget document should specify fiscal policy
objectives, the macroeconomic framework, the policy basis, and identifiable fiscal risks. The information comparable to that in the
annual budget should be provided for the previous two years. Similarly projections for two years following the budget should also
be provided. The annual budget should be prepared and presented within a comprehensive and consistent quantitative macroeconomic
framework and main assumptions should be provided. There should be an active committee of the legislature that oversees the conduct
of fiscal policy and which facilitates civil society input into the budget. Further, a mid-year report on the budget developments should
be presented to the legislature. Currently, the Indian practice falls short on these criteria, as pointed out by the Advisory Group.
The assumptions on basic macroeconomic variables are not spelt out and are probably not based on any formal model. There are
no projections for the years following. Though the Public Accounts Committee (PAC) and various standing committees of the
parliament oversee the budget, there is no practice to seek inputs from the civil society. There is a ritual meeting of the finance
minister with economistsa. The supplementary demands by various ministries are presented to the Parliament for approval but the
overall budgetary developments and implications do not accompany them.
State Governments
According to the assessment of the Advisory Group, the practices at the state government level are substantially below the standards
specified in the code. The Group did not examine these in great details but made a few observations, which are revealing enough.
In the case of state governments, the quasi-fiscal activities of state government enterprises such as the State Electricity Boards (SEBs)
and the Road Transport Corporations (RTCs) result in substantial losses and consequent degradation of the true fiscal situation,
which goes unreported except to the extent of budgetary support. Similarly, even though the state governments are supposed to raise
the loans from the market only with the approval of the central government (as long as they have outstanding dues to the central
government), they do not require similar approval for guarantees. This is often utilized to soften budget constraints. According to
the estimates reported by the Advisory Group, the contingent liabilities are about one-fourth of the total liabilities.
The total outstanding guarantees by 17 major states, according to the Group, exceed Rs 1,00,000 crore. Another common practice
reported by the Group relates to the use of contingency funds by the state governments. Contingency funds, as the name suggests,
are provided for in the budget to meet unforeseen expenditures not appropriated and approved by the legislature. Some of the states
have used this provision to accommodate large expenditures not authorized by the legislature, when the legislature is not in session.
Through an ordinance, the size of the contingency funds is increased and then the ordinance is allowed to lapse. The expenditure
is later regularized without too much of discussion in the legislature!

FISCAL RESPONSIBILITY AND BUDGET MANAGEMENT BILL, 2000

In order to contain the fiscal deficit and to set up a strong institutional mechanism to promote fiscal prudenceb, a draft fiscal
responsibility and budget management bill has been proposed but is pending with the Parliament. The bill seeks to mandate on
the central government to provide for (i) Medium-term Fiscal Policy (MTFP) Statement, (ii) Fiscal Policy Strategy Statement and
(iii) Macroeconomic Framework Statement, while presenting the annual budgeting in the Parliament. It also seeks to bind the central
government into eliminating revenue deficit within a five years’ time-frame, prohibits borrowing from the Reserve Bank of India
(RBI) and limits overall borrowing to 50 per cent of Gross Domestic Product (GDP). Though the focus of the bill is on fiscal
management, some of these measures are likely to improve transparency as well. According to the bill, the government needs to
disclose significant changes in the accounting standards, policies and practices, which may affect computation of fiscal indicators.
Similarly, it also requires the government to disclose all outstanding contractual liabilities, unrealized revenues, committed liabilities
with regard to major works and projects, losses incurred in providing public goods and services, market value of assets and liabilities
and contingent liabilities created by guarantees. It also envisages an independent review by the Fiscal Management Review Committee,
a new body proposed to be created.
a See Section 6.3 of the report.
b The objectives of the draft bill, as referred to in its preamble.
92 India Infrastructure Report 2003
4.2 PUBLIC PROCUREMENT AND THE PRIVATE SECTOR
Any investment in the infrastructure sector by the private
sector has the aspects of some kind of procurement process
by the state, unless, of course, the sector has been completely
freed from the control of the state. In most of the
infrastructure sectors, private investment is usually in the
form of private provisioning of public services licensed or
procured by the government. For example, the telecom
sector in India required bidding for the licence fee when
it was opened to the private sector. In case of roads, the
private sector bids for the receipt of payments either through
annuity payments or actual or shadow tolls. The lowest or
the highest bidder, depending upon whether it is receipt or
payment, gets the right to provide the specific service, subject
to quality safeguards.
Inappropriate Procurement: a Constraint
It is now widely recognized that inappropriate procurement
and post-procurement processes of the government can deter
private investments in the infrastructure sector or can result
in inefficient provisioning, including waste, delays and poor
quality. Alternative procurement rules and processes4 have
implications on the incentives of the private sector, risk
allocation and how recontracting is done ex post. In this
section, we review the determinants of effective and efficient
procurement by the state. The motivation behind such an
exercise is that unless the procurement process itself is
‘appropriate’, attracting and using private capital or the
private sector for infrastructure projects per se may not lead
to the desired outcomes. This is especially true of
infrastructure services where the market failures are large,
and complete privatization, with only light regulation, is
not possible.
Right Procurement is Crucial
Besides private-sector participation in the infrastructure
sector—hitherto restricted to the public sector—a substantial
part of government expenditure is spent in procuring goods
and services from the private sector. While some of these
may not be critical from the point of view of consumers
of public services, they could still affect them directly or
indirectly. Poor quality5 of medicines procured by the
4See Laffont and Tirole (1993) for review of the literature in
which the problem of procurement is seen as a problem of ex ante
information asymmetry.
5 Poor quality and inefficient public procurement is not only an
issue in developing countries such as India. Rose-Ackerman (1978)
Ajay Pandey
government hospitals, poor laying of the roads by the
contractors for the government, are some obvious examples.
Historically, the procurement process of the government
seems to have been designed with a view to acquire goods
and services from the private sector with the least possible
cost to the exchequer. Competitive bidding (non-collusive
practices) and the quality were attempted to be ensured
through independent quality standards and audit, tight and
detailed specifications, and internal audits.
Incentive Incompatibilities
The bureaucracy appears to be aligned towards these goals
primarily through negative incentives or deterrents. Over the
years, the effectiveness of these safeguards has proved to be
questionable. The process is vitiated either by collusion within
the bureaucracy so that its acts of omission and commission
go unchallenged, or by subversion of independent agencies
like auditors. In the case of the former, the moves towards
transparency and public disclosures can be effective, particularly
in countries where public awareness is high and credible
enforcement of deterrent punishment is likely. In the absence
of these, in countries where independent agencies or institutions
have been emasculated and where public apathy prevails, the
information disclosure has very little, if at all any, effect.
Complexity Needs Recognition
Besides the question of inadequacy of safeguards, the
procurement process, which might have been appropriate
for relatively standard goods and services in the past, has,
today, become inadequate for the complex projects,
technologies, equipment and services. Large variants of the
standard as well as new procurement and post-procurement
processes have been used by governments the world-over.
In the infrastructure sector itself, different bases of bidding
(revenue-share, cost, user tariff, consolidated licence fee),
and structures (build, operate, and transfer (BOT), build,
own and operate (BOO), design, build, finance, and operate
(DBFO) etc.) used by the governments can be viewed as
attempts to improve the outcomes associated with private-
sector participation through procurement-process design.
In the next sub-section, the determinants of an effective
procurement process such as the type of the project, the
provides numerous references citing such problems in the US context.
Rose-Ackerman (1999) discusses the attempts made by Steven Kelman
as head of Office of Federal Procurement Policy (OFPP) to improve
the effectiveness and efficiency of public procurement.

characteristics of the output, the broader legal and contractual
framework and even the nature of public awareness in the
country are identified and discussed. This discussion focuses
on procurement for projects or services under long-term
contracts, a feature of infrastructure-sector projects. Using
the reports of the Comptroller and Auditor General (CAG)
of India, the observations made by the office of CAG on
procurement by the Government of India and its agencies
are documented and analysed later in this paper. Admittedly,
such an analysis suffers from ‘selection bias’ as only a small
number of problem cases are highlighted by the CAG report.
However, it is possible that the nature of problems
documented by the office of CAG may provide insights into
the weakness of procurement processes within the public
sector. CAG reports usually do not comment on the quality
of procured goods and services except when cases of poor
quality are obvious and entail easily verifiable immediate
financial costs or losses. To that extent, the reports themselves
suffer from a ‘selection bias’ in having ignored or not having
recognized cases of poor quality. Finally, we conclude with
suggestions for reforms in public procurement. We also
bring out the limitations of these measures.
Complexity of Public Procurement
Procurement of goods and services for the use of the public
sector or for the public services provided by the public
sector, entails the decision to ‘make or buy’ the good or
service under consideration. All economic agents, particularly
firms, routinely face make, or buy, decisions. Analytically
therefore, the considerations which play an important role
in such decisions, are also applicable to public procurement.
However, there are important differences between the private
sector and the public sector in the incentives, the internal
controls, the budget constraints, the ability to use the legal
and contractual framework, and the role of markets and
society. These differences can result in very different outcomes
for the two sectors even when following a given procurement
process. Henceforth, we first review the generic con-
siderations in procurement, viz., risk allocation, incentive
effects, information asymmetry, quality controls and all the
relevant costs such as project costs, operating costs,
transaction costs, recontracting costs and opportunity costs,
etc. Later, we bring out how the key differences between
the public sector and the private sector induce different
outcomes.
ISSUES IN PROCUREMENT
Risk Allocation and Incentives
Unlike relatively standard goods or services, execution of
any reasonably complex project entails considerable risks
Fiscal and Procurement Processes 93
related to time and costs of completion. The costs of a
project are not only the direct and indirect costs actually
incurred but also include opportunity costs arising out of
time overruns. Projects vary in their risk-profile based on
the interlinkages within and outside the domain of the
project besides the technological and the project-specific
uncertainties. Even the simplest of projects usually do not
have an engineering relationship between effort and time
or costs. More complex projects have uncertainties despite
detailed specification and project plans, developed to
overcome or minimize the effects of these risks. If a third
party, procured by the client, executes the project, the issue
of risk allocation arises. The general principle of risk allocation
is that the one who can bear it most efficiently and for
whom they are endogenous6 (that is, can be controlled by
him) should bear the risk. Effective allocation of risks leads
to appropriate incentives for an efficient project execution.
Typically, projects where there is relatively little uncertainty
about the quality, quantity and the interdependencies within
the project, tend to be offered or procured on fixed fee
‘turnkey’ basis. This process allocates the endogenous risks
of the project to the contractor. The interdependencies of
a large complex project is internalized and endogenized
through turnkey award. Fragmenting the contract would
lead to coordination risks being allocated to the client.
Project procurement through fixed-fee turnkey contract
creates incentives for the project-implementing contractor
to save on costs and time as any savings are retained by him.
It also creates incentives for him to innovate in order to save
costs. While some of these innovations could be desirable,
others could lead to poor quality of work if the specifications
are not tight enough or are not verifiable during or
immediately after the execution of work. To that extent, the
high powered incentives associated with fixed fee contracts7
may be perverse if the quality-attributes of the work or
project elements are not amenable to effective monitoring
or verification, ex post.
On the other hand, cost-plus contracts, in terms of risk
allocation and incentives, clearly retain project related risks
with the client and present no incentives to undertake
innovations both in a negative and positive sense. They are
used when the information asymmetry between the client
and the contractor is high, the requirements are difficult to
specify ex-ante, and when the quality is difficult to verify.
6 This simply means that he is the best placed to reduce the same.
7 While fixed fee turnkey contracts may resolve the problem of
the bidder having superior information ex ante, the high-powered
incentives that go along with such contract create difficulties for ex
post adaptations (Williamson, 1985). Need for ex post adaptations
arises when there are uncertainties about the project design and the
environmental conditions, such as in the case of construction contracts,
projects, etc.
94 India Infrastructure Report 2003
Accordingly, both cost-plus as well as turnkey contracts
are used extensively depending upon the attributes of the
project. In the case of most engineering-driven projects, like
setting up of production plants, fixed-fee contracts are used.
In cases like drilling8 of oil wells, since the entire project
is difficult to specify ex-ante (exact depth, geological features,
various tests and even completion criterion), the services are
hired on cost-plus (daily rates) basis. Similarly, most of the
software development projects, which cannot be specified
completely, are given out on cost-plus basis.
Information Asymmetry and Winner’s Curse
The procurement process has to take into account the chance
of severe information asymmetry between the client and the
contractor with regard to the tasks entailed by the project,
besides risk allocation and issues of incentive compatibility.
If the client knows more about the effort involved or the
likely cost of the project, the client ought to bear the risks
associated with the activity and the bidder when he knows
more. Otherwise, the winning bidder or contractor is likely
to face what is known as winner’s curse. Winner’s curse9
arises when a winning bidder or contractor underestimates
the effort required in completing the project and thereby
faces a loss-making situation despite winning the bid for the
project. In such cases, cost-plus contracts with close
monitoring by the client may be desirable despite being
non-incentive compatible. Even if there is no information
asymmetry between the client and the bidder or the
contractor, the problem of winner’s curse can arise in cases
where there is great uncertainty about project cost and effort
requirement. The winning bid is more likely to be the one
that underestimated the effort requirement and quoted low.
Facing winner’s curse ex post, either the bidder would
try and wriggle out of the contract or would try and
compromise on the quality. Bidders are likely to quote
higher ex ante if they are aware that ex post they cannot
do either. In such a situation, disclosing as much information
about the project as possible helps in mitigating consequences
of winner’s curse problem. Meetings called for clarifications
by the potential bidders and development of detailed
tendering documents as part of the standard procurement
process can be viewed as steps in the direction of disclosing
and sharing project-related information. These, of course,
also help in the enforcement of the contract and in reducing
8 Corts (2002) empirically analyses the role of adverse selection,
risk sharing, scale economies, incentives and transaction costs in
offshore drilling in the Gulf of Mexico, where both day-rate and
turnkey contracts have been used. Even the turnkey contracts are
converted to day rates if there is a storm or a particular geological
formation is encountered while drilling.
9 Winner’s Curse in auctions is a well-known result. See Milgrom
(1989) for an intuitive review of research in Auction Theory.
the possibility of costly renegotiations and recontracting.
Earnest money deposits, performance guarantees and
liquidated damages are similarly attempts to minimize the
possibility of non-performance by a bidder facing winner’s
curse.
Incomplete Contracts, Recontracting and Opportunity
Costs
Despite developing detailed plans and specifications before
project procurement, all procurement contracts are essentially
incomplete. Some changes in quantity or specifications based
on experiences during the course of project implementation
are always likely. In some cases, these may be minor and
in some others fairly major. The contracts, besides laying
down the obligations in specified situations, also provide a
framework for renegotiations through change-order clauses.
If major changes are expected, as would be the case when
the project details have not been worked out or are likely
to evolve, then the costs involved in recontracting10 are also
severe. In case of failed negotiations, these may involve cost
of retendering and consequent delay. If the project is ‘time-
critical’ and has substantial opportunity costs, other costs
involved in the procurement are likely to take a back seat.
Cost-plus contracts and non-competitive procurement, such
as emergency purchases from pre-identified vendors, tend
to be used to minimize such costs.
Item Specificity, Industry Structure and Reputation
Effects
If the product or project being procured by the client is
specific11 to the client, then the production technology and
the presence of substitutes become key determinants of the
procurement process. In the absence of substitutes, complete
mutual dependence leads to bilateral negotiations and long-
term contracts, as no party would like the other one to hold
it to ransom. In case the production technology for producing
the goods or services warrants investments by the supplier
or the contractor, which are likely to be sunk and
10 Bajari and Tadelis (2001) have developed a model incorporating
incentives and transaction costs and show that cost-plus contracts
would be preferred when a project is more complex and when time-
to-completion is critical. They also explain the prevalence of basic
cost-plus and turnkey contracts over other complex incentive contracts.
They show that internal production dominates market procurement
when the product is more complex.
11 This is known as ‘hold-up problem’ in the literature, (Grout,
(1984). When the product or project requires investments in assets
by a seller, which are specific to a buyer, the buyer can hold-up and
arm-twist the seller as contracts are incomplete. A reverse ‘hold-up’
problem can also arise if the buyer buys a product, which has to be
maintained and kept in operating condition only with the seller’s
support (in terms of consumables, spares, services, etc.).

irrecoverable, then the long-term contract specifying
minimum quantity and price is the only way out. On the
other hand, if the investments are not specific or are
recoverable, then the dependence of the supplier on the
client is less, and more competition on the supplier side is
likely and desirable. A related issue is the presence of
economies of either scale or scope or both in the production
technology. In the presence of these, long-term contracts
with a single or a few suppliers would be superior even if
the investment required by the suppliers is not sunk but is
recoverable. Long-term contracts with limited competition
in such cases create high-powered incentives for product or
project-specific innovations to reduce costs (to exploit
economies of scale) and to deliver quality (to build reputation
in order to exploit economies of scope). Promoting
competition in such cases, on the other hand, may be
counter-productive as it weakens the reputation effect12. In
case significant product- or project-specific investment is
required, such a strategy is infeasible, as the investments
would not be made in the absence of long-term contracts.
This is commonly cited as the rationale behind vendor
development and long-term relationship with the vendor.
Monitoring, Independent Inspections and Quality
In case of product procurement, the uncertainty about
quality is much lower as long as quality attributes are clearly
known13 and can be inspected. But, even in such cases,
there could be quality attributes which are difficult to verify
and test at the time of procurement. Usually, prior experience
and reputation supplement the inspections and tests to
ensure quality in procurement. This issue becomes more
prominent when the quality is not easily verifiable, as the
quality attributes are complex, multi-dimensional, many,
and interdependent. In the case where the user14 is different
from the procurement agent, complications arise, as the
12 Banerjee and Daflo (2000) document that older Indian IT
firms are more likely to be engaged on cost-plus basis for providing
customized software and for more complex projects. They interpret
age as a measure of reputation.
13 If the quality can be specified completely ex ante and ensured
ex post, then auctions can be an effective procurement mechanism.
Bos and Kolmar (2000) argue that poor specifiability of quality is
one of the reasons why public procurement does not have the structure
of an auction. Tiefer and Shook (1999) report that the government
in the US commonly carries out competitive negotiations for
procurement above US $100,000.
14 What we mean here is the end-user, and not the ostensible or
immediate user (buyer) of the product or service. If the immediate
user is different from the eventual end-user and is the one who
decides, the problem simply shifts from the procurement agent to this
immediate user. If, however, the immediate user and end-users’ interests
are aligned, then shifting the locus of decision-making might indeed
result in a superior outcome.
Fiscal and Procurement Processes 95
user’s assessment of the quality may be quite different from
that of the procurement agent. Worse still, the possibility
of collusion between the procurement agent and the supplier
becomes strong in case the incentives of the agent and the
user are not correctly aligned. In case of weak incentive
alignment between the end-user and his procurement agent,
the procurement process is likely to be driven by the
incentives of the procurement agent which may compromise
the quality. Monitoring and certification by the end-
consumer is usually the first-best solution and in the presence
of difficulties, such as existence of a free-rider problem, an
independent agent may be used in lieu of the end-consumer.
An independent agent may also be desirable when the
quality verification may call for complex and technical
analysis, which the end-consumer cannot do.
To sum up, procurement raises issues related to risk-
allocation, information asymmetry, transaction costs and
quality. As a result, design of procurement process and choice
of procurement policies for optimal outcomes are likely to
be influenced by the characteristics of product or services
being procured, the characteristics of the supplier industry,
the legal-contractual framework and how time-critical the
procurement is. Procurement can also be classified into four
stylized categories15: procurement requiring R&D or client-
specific investment, procurement of complex projects,
procurement of standard goods available in the market and
procurement of customized goods otherwise sold in the
market. In case of the first type, the main issue is the
effectiveness of the procurement and the issues therein are
extremely complex. In such cases, which are relatively few,
the risks have to be borne by the buyer. It is the second and
the last types, which are also most common, that require
careful procurement design. The third type is relatively trivial
for a bulk-buyer as the procurement can be off-the-shelf
possibly adjusting for any bulk-buying discount. In the context
of the private sector, the separation of the procurement agent
from the end-user is less of an issue as the corporate control
structure is likely to address this problem and, in any case,
the effect of sub-optimal procurement is internalized16 by
the entity particularly in a competitive product-market.
ISSUES IN PUBLIC PROCUREMENT
In case of public procurement, the issues related to
procurement are compounded by the distinct characteristics
15 This classification has been used by Rose-Ackerman (1999) to
analyse public procurement and the policy prescription for eliminating
corruption from public procurement. The conclusion discussed in
this paragraph are based on her analysis.
16 Unless the management uses procurement to further its own
interest at the expense of the shareholders—not an uncommon situation
but, possibly, not as rampant as it is in public procurement.
96 India Infrastructure Report 2003
of the procurement agent and the public services for which
procurement takes place. Unlike the case of more normal
products and services, where markets exist and can be
expected to perform, the absence of markets and, therefore,
lack of choice or substitutes for its consumers, characterize
public services. Even if they face competition, the public
entities providing them face relatively soft-budget constraints
compared to their private counterparts. The public entities
are more likely to be propped up by the government using
exchequers’ funds. Worse still, even if the budget constraints
are tightened due to resource constraints, the effect is not
on those who retain the locus of control on the relevant
decisions but on the other employees. This makes public
procurement one of the important focus areas in any debate
on governance.
Externalities and Weak Incentives
The lack of incentive compatibility between the procurement
agent and the end-user in the context of public procurement
is quite severe. The consequences of products and services
procured by the public servants have very limited, if at all
any, effect on them. As a result, negative externalities arise.
The costs of any sub-standard or costly product or service
procurement are borne by the users of the public service for
which it was procured, or by the taxpayers. Because of
difficulties in aligning the public servants’ interest with that
of their principal—the public—the public servants have
very little incentives to procure the best. They may instead
have incentives to procure what gives them maximum payoffs.
The only real incentive is the negative one of being caught
violating the guidelines and the ex ante controls
circumscribing the procurement process. Collectively, these
negative incentives can also be overcome easily through
collusion and by diffusing the responsibility. The
specifications can be chosen to suit some bidders or a
contractor, lax standards can be used or only certain type
of bidders could be allowed. Even independent agencies can
be co-opted to qualify poor quality or unproven bidders,
and poor quality, or even non-existent, work can be paid
for. In short, while the letter and the form of the procurement
guidelines and processes are maintained, the spirit may be
violated. Ex post reviews and prosecutions are difficult, if
not impossible, when the process and ex ante controls have
been complied with.
Red Tape
Red tape, or bureaucratic delays, can be effectively used to
increase the bargaining power17 of the public servants to
extract surplus from the supplier. It can also be used to
17 See Rose-Ackerman (1978).
extract payoffs by compromising on quality. Delays can be
used to extract payoffs, because often the cost of waiting
is higher for the supplier than the public servant. Such
extractions need not be limited to the surplus. They could
come out of normal profits of the supplier or, what is more
likely, through compromises in quantity and quality. This
can happen when the investment is sunk and waiting is
costly. Payments, even when due, may be released only
when the bribe is paid. The suppliers, knowing the delays
and the side-payments involved, would increase the amount
they bid for or lower the quality of product or services. In
case of reputation effects, when the product being supplied
is also sold in the market, this would result in self-selection.
Only suppliers with poor quality of products would be then
supplying to the government.
Corruption and Anti-Competitive Procurement
In the absence of corruption, the problems related to
procurement are similar in both the private and the public
sectors. Corruption, or the use of public office for private
gains, manifests itself in the form of poor quality or higher
costs of public procurement. In case the quality is easily
verifiable ex post, such as in the case of procurement of
standard goods and commodities, and when the corrupt
officials face reasonably high probability of detection and
associated penalty, then anti-competitive and costly
procurement process is a method to generate personal
payoffs. If the seller is able to earn surplus due to absence
of competition, it is easy to extract a part of this surplus
as bribe. Anti-competitive procurement can be organized
in multiple ways. Specifications could be chosen either to
favour some sellers or as entry barriers for others. Non-
standard items may be procured instead of relatively standard
items. Non-standard product or services, even if ostensibly
cheaper, may increase the possibility of ‘hold-up’ by the
seller later and thus increase their life-cycle costs. For
example, purchase of equipment having lower up-front
costs may, later, make the buyer dependent on the seller for
spares, if they are non-standard and use proprietary
technology. Red tape or delays and other bureaucratic devices
can be used to erect entry barriers selectively. If the quality
is also difficult to verify or selective response18 is given to
quality variations due to incompleteness of the contracts,
then anti-competitive procurement becomes even more
lucrative.
18 If the contract has deliberate gaps in specs, then acceptance of
quality delivered with respect to the gaps is open to selective review
by the public official. He can then accept the gaps or he can impose
costs on the seller if he decides to fill in the gaps. This discretion,
when used selectively, can erect an effective entry barrier for an
‘honest’ supplier.

Political Capital, Procurement and Fragmentation
As opposed to the public officials, the politicians have
usually preference for payoffs in both pecuniary and political
terms. In particular, they also need to generate political
capital from the decision taken by the public officials being
controlled by them. While centralization and aggregation
of procurement suits them for the former, fragmentation of
the public procurement suits their requirement to generate
political capital better. If favour is granted to a large number
of sellers or service providers, it helps them to generate
political capital. On the other hand, such a move dissipates
the bribes collected because of difficulties in collection and
bargaining through middlemen. In a political system in
which the politicians cannot generate political capital19,
there would be a tendency to a higher level of corruption
and centralized procurement. In case procurement cannot
be used to generate political capital, centralized and
aggregated procurement would be preferred. Both
aggregation and fragmentation have certain undesirable
characteristics and could be sub-optimal in a given case. In
case of aggregation, it might be easier to monitor and ensure
quality as well as prices, but aggregation results in increased
coordination and longer lead times and therefore, higher
likelihood of quantity errors. Aggregation may bring in
additional benefits if the orders are given to relatively larger
suppliers or bidders, as they might be more sensitive to
reputational effect and might be monitored more by the
public and the media. In case of services, particularly when
there are economies of scale and scope (outside the public
sector); large service providers are likely to be more sensitive
to quality. Fragmentation in such a case would clearly be
sub-optimal. Fragmentation of procurement also weakens
the incentives for making investments in innovations. On
the other hand, for relatively standard items, which can be
easily procured from a competitive market, it aligns the user
requirement better with the procurement.
Collusion, Anti-Competitive Behavior and Quality Issues
As argued earlier, anti-competitive procurement policies
can be used effectively by the public officials to line their
pockets. Similarly, anti-competitive behaviour by the
suppliers can generate rents for the suppliers. In collusion
with the public officials, the suppliers can form informal
cartels to create entry-barriers. Such cartels and monopolies
evolve over a period of time and rely on criminal activities
to prevent entry. In the Indian context, labour and public
works contracts and liquor-vending licences are prime
19 For example, if everyone votes for the party and not for the
individual in the elections. The effect would be the same in a case
where political capital generated is local in character but the effects
of procurement are outside this domain.
Fiscal and Procurement Processes 97
examples. Extraction of surplus from the consumers and the
exchequer using public procurement becomes the main
objective of many individuals. In fact, such individuals are
more likely to enter politics to protect the criminal empire
created on the back of public procurement. Poor qualification
standards set for the suppliers usually provide initial
motivation and incentives and over a period of time, some
of them either become less dependent on public procurement
or become politicians or both. The implications of such self-
reinforcing behaviour on the quality of public procurement
are obvious.
Difficulties in Recontracting
Unlike the private sector, the public sector finds
renegotiations and recontracting much more difficult. This
is mainly because of ex ante (procedural) controls and the
public gaze. If any major change is required in a contract,
and the contract had not provided for such a possibility or
had specified limits to such changes, public officials find it
difficult to renegotiate, and usually prefer to stick to the
contractual provisions for the fear of audit objections or
controversies. Examples of this kind are to be found in
software development projects20, where it is difficult to
specify all the requirements upfront. Later, once the
requirements are known and entail larger effort than planned,
the suppliers find it difficult to renegotiate with the public
sector. Even if the costlier supplier is engaged to retendering
and incurring transaction costs, after it is prefered to
renegotiations.
Limits of Disclosures, Public Awareness and Other
Deterrents
Given the severe incentive problems, aligning the interest of
public officials with that of the public is a difficult challenge.
Since divergence of the incentives of the public official is
at the core of most of the public procurement problems, any
change in the institutional framework or reforms per se are
not likely to be effective without addressing this problem.
For example, shifting the point of discretion simply results
in change in the locus of the problem. Centralization increases
high-level corruption while decentralization increases petty
ones. If discretion is vested with multiple agencies, it results
in turf fights, eventually leading to the dominance of one
or the collusion among many.
Unlike bureaucratic restructuring, reforms aimed at direct
control by the public, such as disclosures, users’ feedback,
etc., may be more effective but have their limitations too.
20 This is based on personal experience, gained while developing
cases on such projects for a large Indian IT firm. Not allowing
renegotiations when the monitoring is difficult and incentives are
perverse is, however, appropriate to prevent collusion.
98 India Infrastructure Report 2003
Information-processing capacity with the public is limited
and it has limited incentive to process the information due
to free-rider problems. Activism may help provided the
public supports such activism. If activism itself is driven by
private interests cynicism may take root instead. Activists,
on the other hand, face low incentives if their actions have
a low possibility of affecting any change. Legal and judicial
measures, such as public interest litigation or complaints,
are costly and rely upon enforcement by the state (controlled
by the executive) to be effective. Immunities available to the
public servants, coupled with secrecy, limit the effectiveness
of prosecution as a deterrent. Speedy and exemplary
punishments21 through judicial processes, along with increase
in disclosure, can however be effective at the high-level and
may also weaken collusion between various agencies of the
state.
SOME ILLUSTRATIONS FROM CAG REPORTS
The office of the Comptroller and Auditor General of India
(CAG) is an independent auditor of all the transactions and
expenditure of the union and state governments, including
public-sector enterprises. It compiles an annual review of
the expenditure and its audit observations in the form of
Union and State Audit Reports. In this section, some parts
of the CAG Union Audit Report 2000–1 are reviewed to
ascertain the kind of problems that have been highlighted
by the CAG with regard to public procurement. In particular,
focus is laid on sectors such as Railways, Ports, Roads and
Petroleum. These are some of the sectors which are important
to infrastructure and involve the private sector as suppliers.
This review has been motivated by the desire to identify and
characterize the nature of problems in public procurement
as highlighted by the CAG and is not meant to validate or
support the problems identified by the CAG. Accordingly, the
examples given in this section are not evidences of the
propositions advanced and are based on the limited information
given in these reports.
Unnecessary Investments and Procurements
As a class, unnecessary investments or procurement have
invited the maximum number of the CAG’s audit
observations. Some of the decisions, which lead to
unnecessary expenditure, are taken at the policy level and
are driven by political considerations and may not have any
economic justification. The decision of creation of new
zones by the Railways would fit this category. The creation
of new zones has been criticized not only by the CAG in
its 1999–2000 report, but also by other experts. Unnecessary
21
East Asian societies such as Korea in the past, China today,
Taiwan, etc. have used these very effectively.
procurement-related public expenditure is incurred due to
(a) lack of information and coordination across various
governmental agencies, (b) fragmenting the project execution,
(c) unnecessary procurement advised by the consultants,
and (d) the inability or the difficulty in taking the decision
to liquidate or discontinue.
In this section, only the issues and examples related to
lack of coordination among various agencies are discussed.
While the private sector always complains of lack of
coordination among various governmental agencies resulting
in delays in clearances and uncertainties, the problem affects
the government agencies as well. Whereas the private sector
may respond by delaying the investments, it seems
governmental agencies do not mind investing as long as
some promises and clearances are obtained. The expected
diligence exercise is either not undertaken or is ineffective.
Some examples of this kind are provided in the CAG
report. Non-acquisition of land from the Air Force has been
cited, as one of the major reasons why the Yashwantpur–
Salem gauge conversion project undertaken by the Railways
could not be made fully operational. Another reason cited
is the demand for a road over-bridge by the local population,
which required coordination with the state government.
Similarly, a metre gauge (MG) branch line between New
MalBazar–Damohoni in NEF Railway was restored (it had
been abandoned due to floods in 1968) at a cost of Rs 25.64
crore in 2000, which, thereafter, became gauge-locked! This
happened because, in 1999, the Railways decided that the
existing Siliguri–New Bongaigaon MG mainline would be
converted in broad gauge. In case of the public sector oil
companies, Bharat Petroleum Corporation Limited (BPCL)
and IBP decided sometime in 1989–90 to invest in the
construction of a product depot at Muzaffarpur in Bihar as
the crude from Assam for Barauni refinery was not adequate
for its operations. The construction for the depot was started
in 1995 and completed in 1997. Meanwhile in 1993, Indian
Oil Corporation (IOC) planned a crude pipeline from the
eastern coast to reduce the dependence of its Barauni refinery
on Assam crude. The project was completed later. As a
result, the product depot remained non-operational since
its construction. In a similar vein, the Durgapur unit of
Hindustan Fertilizers Limited procured capital good worth
Rs 11.08 crore in anticipation of clearance for revival of the
unit, which had not been received till the date of writing
of the CAG report (October 2001). As per the CAG report,
the Air Force developed a golf course in an area reserved
for storage of explosives! In another instance of a similar
kind, the CAG reports that Hindustan Petroleum Company
Limited (HPCL) constructed 3 ATF tanks at Vijaywada at
a cost of Rs 3.25 crore without ascertaining its linkage to
Hyderabad and Secunderabad. These are just a few
illustrations of the procurement agency within the

government either lacking information or not being able to
coordinate its procurement with other agencies, ultimately
leading to sub-optimal or wasteful procurement. The distance
between the decision-makers and the implementing agency,
lack of information or of selective information being made
available to the decision-makers, ‘accountability and reviews’
driven by the fund utilization accompanied by long approval
processes, perverse incentives in the absence of effective
monitoring by the public and absence of deterrents, all
contribute to this problem in their own ways.
Fragmented Projects and Procurement
Besides the problem of coordination among government
agencies, fragmentation of projects with independent
implementation is another reason which leads to idle or
unnecessary investments. For example22, the transmission
lines for a project like Nathpa–Jhakri have been laid even
though the hydel project itself has slipped far behind.
Similarly, in case of gauge conversion projects on the Miraj–
Latur section, the priorities were changed midway leaving
completed assets in some parts of the section, which would
go waste. While, in the case of the former, the implementation
was by two different agencies, in the latter case it was by
the Railways itself. Besides fragmentation of projects, which
is against the basics of project management, fragmentation
of procurement orders for services also reduces the incentive
of suppliers to build reputation. In the case of catering23
for the Railways, as many as 1111 private-sector contractors
operated, as on April 2000. This lessens their individual
incentive to improve quality and also that of the consumers
to monitor them. While fragmented procurement may have
the advantage that goods or services are procured depending
on the specific local requirements and are procured as and
when required, this cannot be the major factor in the context
of catering in the Railways. Similarly, there are too many
private contractors from whom vehicles are contracted by
the road transport corporations (RTCs). While it is possible
to argue that the ostensibly poor quality is economically
efficient given the income level of consumers, it is not
certain whether the poor quality is not accompanied by
rents earned by the contractors or by the RTC officials. It
is also evident that a large section of consumers are dissatisfied
with the quality.
Collusion with the Contractor
Collusion between the contractor or supplier and the
procurement agency to maximize their own payoffs is one
major problem with public procurement. By the very nature
of these arrangements, it is difficult to detect them. However,
22 This example is not from the CAG report.
23 See Raghuram (2002).
Fiscal and Procurement Processes 99
when the collusion is not complete and it results in the users
or inspectors rejecting the procured item, such cases do get
reported. The chances of such rejection are dependent on
how critical the procurement was and how the payoffs were
shared. A few instances of this kind have been reported in
the CAG report. Some of them might have been deliberate
and some inadvertent (due to incompetence). One such
example is the procurement of Balau sleepers from Malaysia
by the Railways, involving a sum of Rs 20 crore. The
Railway Board, against the recommendations of the Forest
Research Institute (FRI) cleared the imports. Later, the
officers charged with the task of inspection and assurance
cleared the sleepers imported by Indian firms, despite their
being of sub-standard quality. Similarly, Chennai Port Trust
paid an excess of Rs 8.72 crore for construction of
breakwaters, as it had forgotten to deduct the value of rock
supplied, before making payments. Some of the strategies
followed in collusion with the suppliers are (a) quantity
variations or changes in specification ex post to favour the
contractor in case of projects, (b) booking and paying for
fictitious work where measurements are difficult to verify,
such as earthwork, (c) accepting poor quality product or
work and (d) coming up with ingenious requirements and
arguments in favour of the contractor or the supplier. An
example of the last is provided in the CAG report, where
the leasing option for a crane was favoured by making
biased comparisons. According to the report, the NPV of
purchase option was calculated by applying cost of capital
at 12 per cent, which was not applied in the case of the lease
option by the Cochin Port. The ingenious argument put
forward in its defence was that a lease was a revenue
expenditure and, hence, interest need not be factored in
evaluating lease options. According to CAG, the concerned
ministry also endorsed the Cochin Port’s viewpoint.
Winner’s Curse and Ineffective Processes
As discussed earlier in this section, winner’s curse is likely
to be faced by the winning bidder when the degree of
incompleteness of the contract is high or when the competing
bidders have information advantage. The problem gets
compounded when the cause of the winner’s curse problem
is endogenous (that is, when the buyer can use the contract
to his advantage to increase the scope and is driven by
perverse incentives). Facing such a situation, the bid would
be pitched higher to account for the possibility of a winner’s
curse. Moreover, such a bid would take into account the
ability to control endogenous causes, the performance fee
put up upfront, etc. For example, if the earnest money and
bank guarantees are structured in such a manner that the
incremental gains from reneging on the contract is costlier
compared to continuation, then continuation would be
preferred. The other alternative would be to do shoddy
100 India Infrastructure Report 2003
work (incur minimum incremental costs) and somehow
complete contractual obligations. In the context of public
procurement, allowing ex post renegotiations can create
perverse incentives and, therefore, detailing the specifications
ex ante is to be preferred. In some cases, however, such
detailing may not be feasible and the problem remains.
Some manifestations of this problem are pointed out in the
CAG report. For the Arsikere–Hassan–Managalore gauge
conversion project of Southern Railways, 14 contractors
(with whom 17 contracts were entered into) failed on various
works between 1995–2000. Of these 17 contracts, 10 failed
after the work had been started and seven without the work
even having been commenced. The total cost recoverable
from the contractors, on account of their failure, was Rs
1.78 crore but only Rs 0.14 crore were collected. Since the
performance guarantees were not insisted upon, such
processes would have invariably led to aggressive bidding
and, hence, the failures and abandonment of the contracts.
In an earlier case of bidding by the telecom operators for
basic telephony, the government revised the condition of
how many circles each bidder could bid ex post, which had
the effect of bailing out those who had bid aggressively. A
bidder, who knows that conditions would be revised later,
would obviously bid differently. Another example in the
CAG report is that of the Mudkhed–Adilabad gauge
conversion project awarded to a firm in 1996 on Build,
Own, Lease and Transfer (BOLT) basis at a cost of Rs
159.96 crore. Initially in the tender, the bidder was expected
to provide bank guarantees to the tune of 5 per cent of bare
construction costs including interest, which, in this case,
was Rs 8.50 crore. After the issue of the tender, the Railway
Board revised the contractual provisions for the contracts
on BOLT basis by bringing in a cap of Rs 2 crore for bank
guarantees. The firm appealed for bringing down its bank
guarantee obligations, which was accepted and the lease
rentals were reduced after negotiation to reflect the savings
to the firm due to lower bank guarantee requirements.
Subsequently the firm failed to progress on the contract and
requested for it to be assigned to its sister concern. Even
this firm failed to perform and only 14 per cent earthwork
and 15 per cent ballast supply was done. Even though the
negotiations did bring down the rentals, the effect of lowering
the value of bank guarantee in removing any incentive to
complete the contract was clearly not understood or factored
in the negotiations.
Anti-Competitive Procurement Policies
Even when the open procurement is generally the norm,
many exceptions are allowed when they can be justified. At
least in two cases, exceptions are being made. These are: (a)
procurement required urgently and (b) when procurement
policies favour domestic or specific firms on grounds of
protecting or supporting domestic, or a class of firms. The
latter was particularly used in the past when the thrust of
economic policy itself was on import substitution and on
protection24 of small-scale enterprises. The consequences,
however, may not always be desirable as the quality of
procurement may suffer. On the other hand, procurements
on the basis of limited tender in emergency situations are
particularly prone to misuse, as the urgency of procurement
is partly endogenous to the procurement agency. Poor
planning or deliberate omission of some of the items can
force urgent procurement later. A couple of examples of this
kind from the CAG report illustrate these issues. In the case
of the Tehri Hydro Development Corporation, CAG reports
that 13 contracts valued at Rs 8.96 crore were awarded on
the basis of limited tenders for various on-going works
related to rehabilitation on grounds of urgency. Otherwise,
any work-order above the value of Rs 1 lakh required open
tendering. CAG’s comments have to be seen in the backdrop
of the slow progress of rehabilitation.
In the case of the Railways, the production of concrete
sleepers by the domestic firms began in 1972–3. By the year
1992–3, 73 such manufacturers existed and only 75 per
cent of their capacity was being utilized. Initially, these
sleepers were being procured on the basis of limited quotes
by different zones. Repeat orders were placed after examining
costs. Given the number of manufacturers and their capacity
utilization, way back in 1993, the finance directorate
suggested procurement through open tender. However, the
first open tender was floated only in 1997, in which the
prices were considerably lower than the repeat orders placed
in the interim. In case of asset specificity (procurement of
items not sold to anyone else) and economies of scale,
competition can be easily curbed in favour of the supplier
or suppliers of a substitute, who do not face the problem
of asset specificity. This simply requires the absence of
assured orders. No supplier of such a product would invest
unless he is assured of orders, even if the product is superior.
CAG points out that, in the absence of regular orders the
replacement of wooden sleeper turnouts with concrete ones
has been slow, despite a successful trial in 1989, as no
manufacturer would invest in manufacturing of concrete
sleeper turnouts without an assurance of regular orders.
Softening Budget Constraints through Costly Procurement
Unlike in the private sector, it is difficult to impose hard
budget constraints on public entities. Even when they face
resource crunch, in the absence of budgetary support, they
have the tendency to find ways to relax budget constraints.
For example, leasing might be preferred over purchase as
24 See Morris et al. (2001) for the implications of reservation for
small-scale enterprises in public procurement.

it entails revenue expenditure and phases out the obligations.
The lease obligations are not capitalized and hence not
accounted for as debt. Similarly, a firm may be created to
borrow from the capital market, which is then not accounted
for as public debt. In fact, the Railways have been using the
Indian Railways Finance Corporation (IRFC) for this
purpose. And the erstwhile department of telecommu-
nications used Mahanagar Telephone Nigam Limited
(MTNL) for its borrowing needs. When budget constraints
are softened using leasing options it can lead to costly
procurement. An illustration of this is the Own Your Wagon
(OYW) scheme25 of the Indian Railways. The scheme was
launched in 1992 to allow bulk users to own their wagons
and lease it to Railways. Pure financing or leasing companies
could also participate. There were three categories of owners,
in terms of benefits. Category A was pure lease in which
the owners would be paid at the rate of 14.5 per cent (later
revised to 16 per cent) of procurement price for the first
10 years (primary lease period) and at the rate of 1 per cent
for the next 10 years. Category B owners of general-purpose
wagons were entitled to the lease charges as above and were
guaranteed clearance of mutually acceptable pre-specified
quantum of load at normal tariff rates. Category C was for
special wagons, which moved on dedicated routes and
entailed empty running in one direction. In this case,
mutually agreed lump sum freight rates were to be negotiated
and lease rental was not payable. Initially, the wagons could
be procured directly (from Railways-approved wagon
builders) or indirectly through the Railways. Later, in 1999,
the policy was revised to allow procurement only through
the Railways. Meanwhile, 1725 wagons were allowed to be
procured directly at a higher cost between 1995 and 1997.
Clearly, the cost of procuring wagons through OYW scheme
was not kept in mind while allowing for procurement directly.
Role of Consultants
Theoretically, an independent consultant can improve the
outcomes when public procurement faces problems of
perverse incentives by recommending more efficient choices.
But this presumes that the independent consultant is truly
independent, his recommendations are agreed to and the
implementing agency also is willing to implement suggested
solutions. In other words, it assumes that there is an all-
round desire to obtain the best results. It is easy to see that
these conditions are unlikely to be met in reality. Consultants
may be used to pass on the responsibility of unnecessary
procurements, to cause delays, to change the specifications
midway in collusion. Their recommendations can also be
easily overruled in case they are inconvenient. In the case
of the Balau sleeper imports by the Railways mentioned
25 See Raghuram (2002).
Fiscal and Procurement Processes 101
earlier, it was pointed out that FRI did point out the
unsuitability of the sleepers but was overruled. In an example
of unnecessary procurement as pointed out by the CAG,
JawaharLal Nehru Port Trust (JNPT) procured 2-bag stacker
reclaimers worth Rs 8.93 crore in 1989 on the recommen-
dation of a consultant, which were never used later. The
system, meant for handling fertilizer and food grain bags,
had design deficiency and was not necessary.
Bias against Liquidation and Unnecessary Procurement
An agent working for a principal is likely to be biased
against liquidation if his own welfare depends on
continuation. This problem also creeps in the context of
public procurement as assets are not disposed off and
unnecessary expenditure is incurred even when it is clearly
wasteful. Absence of hard budget constraint aggravates the
situation further. This issue also acquires prominence in the
context of privatization programmes where the demand risk
is not borne by the private sector. In such cases, assets and
services may be continued even when their liquidation is
optimal. While sub-optimal assets are difficult to identify,
CAG provides an example of this problem in the form of
an extreme case. The narrow-gauge section between Latur
and Miraj had 195 wagons, which were being used for a
limited cement and Petroleum, Oil and Lubricants (POL)
traffic. Most of these were over-aged wagons and, in any
case, the traffic was non-existent. Despite that, expenditure
to the tune of Rs 1.33 crore has been incurred on their
periodic overhaul over the last 10 years. Later 91 of these
wagons were condemned after audit observations.
A Classic Case of Exploiting Quantity Variation
Despite open competition, detailed specifications and other
procedural controls, it is well known among the participants
in public procurement programmes that incompleteness of
the contract can be used to earn rents despite side payments
if ex post quantity variations can be influenced or foreseen
with the help of insiders. In a composite bid, if the quotes
are lower for those items whose tentative quantities are high
and the actual is likely to be low, and vice-versa, then the
winning bid can still be profitable ex post. Alternatively, if
the variations on profitable components can be arranged
with the help of the independent consultants later, then due
to the quotes, as well as due to the increase in bargaining
power, rents can be earned on an ostensibly less profitable
project. Usually this is done in a manner so subtle that it
does not raise any eyebrows, as there are no violations of
procedures. But a crude example of this has been pointed
out by the CAG. For gauge conversion work between the
Kulam and Vasco da Gama section of South-Central Railway,
tenders were invited for the execution of earthwork and
102 India Infrastructure Report 2003
minor reaches in 1995. Initially limited tenders were invited
for the work, but later open tenders were invited after the
Railway Board found the rates to be high. Agreements were
signed in September 1995 and completed. On audit scrutiny,
it was found that in seven of these agreements prices quoted
for different items of earthwork were quite suspicious. These
items constituted a substantial part of the value of work
awarded. Of the three types of earthwork, ‘cutting in all
soils’ required the least effort but was quoted at a high rate.
‘Cutting in rock not requiring blasting’ and ‘cutting in rock
requiring blasting’ should have been quoted at increasingly
higher rates but the quotes ran in an opposite direction.
While clearing the quotations based on initial estimated
quantities, the tender committee recommended safeguards
that there should not be any major upward variation in
items quoted at high rates, whereas the quantities for items
with low rates should be attained. But this observation was
not incorporated in the agreement. Later, the quantities
involved in the actual execution of different items were
highest for highest quoted item and lowest for lowest quoted
item. In case of one agreement, the quantity for ‘cutting in
all soils’, which was estimated to be 50 units turned out to
be 13818 units and the quantity for ‘cutting in rock requiring
blasting’ turned out to be 510 units as opposed to 3000
units envisaged in the tender. The standard safeguard in
such a condition is to limit quantity variation. In this case
also, a 25 per cent quantity variation limit clause was part
of the contract but it included all the three items of
earthwork. In other words, only the gross variation in the
total of the three items would have attracted that clause.
CONCLUSION
Public procurement has, of late, attracted some attention
in the policy discussions on improving the governance, as
a prerequisite of increasing economic growth and, in
particular, in improving the quality and efficiency of public
services. On purely theoretical and a priori grounds, in this
section, the public procurement situation has been analysed
by bringing in the special characteristics of the services or
items being procured and those of the public sector. Based
on notions of ‘incentive compatibility’ and the economics
of the same, we were led to certain expectations as regards
to types of failures and the reasons thereof. Even the small
numbers of instances in the CAG reports illustrate the
points made in the a priori discussions. Some suggestions
which have been advanced by the multilateral agencies and
others include: (a) procurement process based on project or
product characteristics and (b) increasing the accountability
of the procurement agency, in particular, and the bureaucracy,
in general. For the latter, transparency and disclosures are
a prerequisite. Also, monitoring by the end-users (public),
stronger deterrents, and increase in the independence of the
various arms within the bureaucracy are other possibilities.
In this section, is discussed the rationale for these suggestions
and their limits in improving the outcomes of public
procurement are pointed out.
Project/Product-specific Procurement Process Design or
Standardization
Based on her experience and work at the World Bank and
at Transparency International, Rose-Ackerman (1999),
suggests procurement policies26 to minimize the effect of
corruption in the procurement process. She suggests that
the standard product already being sold in the market can
be procured from the market and its prices can be
benchmarked with that of the market. Similarly, the
procurement of large complex projects such as dams, ports,
etc., which do not require advances in technology can be
procured through sealed bidding process under International
Competitive Bidding (ICB), as required by the World Bank.
She acknowledges the difficulties when the procurement is
that of customized products or solutions, otherwise traded
in the market and that of complex projects requiring
specialized research and development, such as new defence
equipment, aircraft, etc. In such cases, neither off-the-shelf
purchase nor sealed bidding may be appropriate. Even though
these solutions are appropriate under standard assumptions
of bureaucratic oversight and monitoring, it is obvious that
in the presence of weak or perverse incentives and ineffective
oversight even these standard prescriptions can fail through
collusion. The supplier may be able to dump poor quality
and be able to exploit incompleteness of contracts, if the
monitoring is weak, deterrents ineffective and collusion
possible. In the other problematic categories of customized
solutions and projects requiring research and development,
the problems are even bigger. However, one of the primary
imports of these recommendations is, standardization, which
can curb the extent of rents available for the public officials
and the supplier to extract. Standardization of purchases
and detailing of projects leave less scope for manipulations
later and increases effective competition. This should
improve, if not eliminate, the problems wherever it is feasible.
Monitoring and Consumers’ Feedback, Independent
Audit, and Inspection
One approach to solving the problems of poor public services
and procurement is improving the incentive alignment of
public officials’ interest with that of the public. The other
is to hire another agent, who is given the task of monitoring
the implementing agent. As long as the monitoring agent
26 These recommendations are for the four distinct stylized
categories of procurement.
 Fiscal and Procurement Processes 103

has the right incentives and has the power over the
implementing agent, outcomes are likely to be better. Another
variation of this argument is that as long as there is conflict
of interest between various agents, increasing their numbers
in decision-making makes collusion difficult. The
effectiveness of all of these arguments and proposals depends
upon whether collusion between the supposedly independent
auditors and inspectors can be prevented. In case of internal
hierarchies, collusion is inevitable over a period of time if
external pressures by the principals (the public, in this
context) are weak. Even in the case of independent external
agencies, payoffs and threats can be used to force them into
collusion. Recent examples of corporate frauds in the US,
wherein the ‘apparently’ independent auditors like Arthur
Andersen, with substantial reputation capital played ball in
connivance with insiders, point towards the limitations of
the effectiveness of such proposals.
Depending upon the extent, to which the pressures by
the public and the consumers can be brought to make both
the implementing agency and the independent auditors and
inspectors accountable, the problems can be minimized.
The effects would be stronger if both the deterrents and the
reputation payoffs are higher. Even though such a solution
is likely to suffer from free-rider problem (individuals have
little incentive to monitor), exemplary compensation in
case of damages can enhance incentives for monitoring and
whistle-blowing.
Public Awareness, Transparency, Disclosures and Stronger
Deterrents
The prerequisite for any kind of monitoring is complete
transparency and disclosure of all information related to
public procurement. With the cost of information
dissemination coming down dramatically, this would be a
necessary (but not sufficient) condition to improve the
outcomes of public procurement. There would remain a
tendency to reveal information in a manner in which it
hides more than it discloses. However once the right-to-
information has been accepted, the quality of information
can always be improved over a period of time if there are
incentives to monitor.
While transparency and disclosures are necessary for
monitoring, they are no substitute for public awareness and
consumer activism in curbing the perverse incentives of the
public officials. There would not be significant changes
unless there is active involvement of civil society in the
public procurement and aggressive whistle-blowing against
the poor quality of public services. There is a need for
stronger deterrents and punishments in case of erring public
officials and a need for basic changes in the legal framework.
As a first step, immunity to the public servants wherever
they are engaged in public service as opposed to enforcement,
needs to go. A separate judicial channel (courts) needs to
be established to try public officials as they can ride on the
clog created by the existing litigation. Class-action suits in
the context of public services should be admissible and
lawyers should be free to accept contingent fee contracts
(currently, Bar Council prohibits such contracts). While all
this sounds ambitious, the least that can be done by the
policy analysts is to factor in the poor outcomes of public
procurement processes in new initiatives such as privatization
and PFI.
Meanwhile, there is an immediate need to remove policy-
induced distortions in the public procurement, which
encourage inefficiencies. As discussed earlier, policies such
as price preferences to local manufacturers and suppliers,
reservations for the small-scale enterprises, buying from
within the public sector (any anti-competitive procurement
for that matter) need to be changed. Similarly, the tendency
to overcome budget constraints through costly procurements
can be curbed easily. Even though there has been a trend
of decentralization of purchases, it probably needs to be
taken further and agencies such as the Department of Supply
and the Directorate of Quality Assurance, etc. need to be
scaled down or wound up.

Box 4.2.1
E xpenditur
xpendituree R evie
Revie
evieww Commission on the D epar
Depar tment of SSupply
epartment upply and Affiliated O ffices
Offices

The Government of India recently reviewed the functions and activities of the Department of Supply in the Ministry of Commerce
and decided to abolish the department. It also disbanded the office of the Chief Controller of Accounts (CCA), wound up the Institute
of Supply and Quality Management and the shipping clearance work related to the office of the Directorate General of Supplies
and Disposals (DGS&D) and transferred the National Test House (NTH) to the Bureau of Indian Standards (BIS). All these offices
functioned under the Department of Supply in the Ministry of Commerce. Around the same time, the Expenditure Review
Commission reviewed the function of the Department of Supply and came up with its recommendations.

DEPARTMENT OF SUPPLY
The Department of Supply was expected to purchase and inspect the stores required for central government ministries and departments
and also for those state governments, autonomous bodies, public undertakings, etc., who wished to avail of its services. It was also
responsible for arranging payment to suppliers on behalf of the buying entities. Besides purchase and inspection, it was also entrusted
104 India Infrastructure Report 2003

with the responsibility of disposal and import of stores. It also ‘managed’ the cadres of the Indian Supply Service and the Ind ian
Inspection Service. The department performed these functions with the help of the offices of DGS&D and CCA and the facilities
of NTH.
Office of DGS&D
The office of DGS&D was established in 1951 for rendering procurement services to the central and state governments. The DGS&D
places rate contracts for common user items and through contracts against their ad hoc requirements. Even though ad hoc
procurements were decentralized in 1991, departments and agencies, which did not have procurement infrastructure, were allowed
to use DGS&D’s services for ad hoc procurements. In 1974, the Ministries of Defence, Railways, and Post and Telegraph were allowed
to procure items, exclusive to them, on their own. In 1984, the scientific departments were similarly exempted from the purview
of DGS&D for procurement. Besides procurement, the office of DGS&D was also entrusted by the departments with the disposal
of stores. This activity was wound up in 1999. (It had already been decentralized in 1985 for all civil departments).
Office of CCA
The main function of the office of CCA was to make payments to the suppliers for the procurement orders placed under rate contracts
of DGS&D. It also made payments to clearing agents for imports and raised bills for the consignees placing the order. The need
for the office of CCA was mainly due to the system of centralized payments to the suppliers.
NTH Facilities
NTH has facilities spread geographically for testing and evaluation of materials, products, equipment, etc. It was started in 1912
as a modest facility for evaluation of certain indigenous products for the Railways but had expanded to seven separate testing facilities
at six locations.

RECOMMENDATIONS OF THE EXPENDITURE REVIEW COMMISSION

The Expenditure Review Commission recommended drastic reduction in the overall strength of the Department of Supply and its
affiliate offices. Its recommendations, however, were preceded by the government decision to disband the department and the office
of CCA and also to transfer the NTH facility to BIS. The rationale behind some of the recommendations were:
Duplication of Testing Facilities
A study conducted by the Indian Institute of Managemetn (IIM), Kolkata, and completed in 1999, was cited by the commission.
The study pointed out that four central government-funded testing institutions, viz., BIS, Regional Testing Centers (RTCs), Pilot
Testing House (PTH) and NTH had similar capacities, equipment and facilities. This had led to excess capacities, wasteful duplication,
under-utilization, etc. The study recommended the integration of such facilities in order to avoid waste. The commission agreed
with the government decision to transfer the facilities to BIS and further recommended the examination of excess manning and
under-utilization once the facilities were integrated with that of BIS. It was pointed out that NTH facilities were able to generate
only 20 per cent of their non-plan expenditure as revenues and needed to market the facilities aggressively.
Decentralized Ad hoc Procurements and Payments
As the ad hoc procurements were decentralized in 1991 and even purchases for procurement through DGS&D’s rate contracts by
the state governments were decentralized in 1996, the payments made by the office of CCA during 1999–2000 had dropped to
about less than half of that made during 1995–6. With the recommendation that the payments be made by consignee departments,
the role of CCA itself was marginal and the commission recommended its abolition. Some of its residual functions were recommended
for absorption in the respective ministries at about 10 per cent of its original staff strength. With the decentralization of payments,
the commission noted that state governments and public-sector undertakings were directly placing orders (but using rate contract
prices) with the suppliers. Similarly, with decentralization and the winding up of disposal activities, DGS&D’s activities were confined
mainly to rate contract procurement. The ad hoc procurements, after decentralization in 1991, had collapsed, and during 1999–
2000 were barely about a tenth of that of 1991–2. Besides procurement, DGS&D carried out inspections through its Quality
Assurance wing. Some of the inspections carried out by this wing were being paid for by the suppliers. These inspections were for
orders directly placed on suppliers post-decentralization. The commission noted that this could create incentives for malpractice and
recommended stoppage of such inspections. Accordingly, the commission recommended downsizing of DGS&D by about one-third
and recommended the withering away of the cadres of Indian Supply Service and Indian Inspection Service. It noted that the activity
of DGS&D, since the abolition of centralized payment and ad hoc procurements, might be confined mostly to rate contracts for
common-user items.

SOME INTERESTING ISSUES

The report of the Expenditure Review Commission highlights a few interesting issues on the procurement system under the
Department of Supply and the way the government departments work. These are: (a) the basis for decentralizing or centralizing
procurement and inspections and (b) the presence of inertia and the self-serving character of cadres and departments.
 Fiscal and Procurement Processes 105

Decentralization vs. Centralization of Procurement

The arguments for centralization of procurement, particularly that of standardized common-user items demanded repetitively, is that
it can enable the procurement agency to get quantity discounts as a bulk buyer. Even the commission notes the claim of savings
to the tune of Rs 145 crore in a year on just 12 items procured by DGS&D under rate contracts. However, getting the quantity
discounts when the payments are decentralized may not be as effective. On the other hand, if the quality of the procurement is
an issue in a centralized setting (possibly due to lack of incentive on the part of the procurement agency), then decentralizat ion
might improve the outcomes. No rationale has been given (or possibly even been considered) while recommending or taking decisio ns
affecting the procurement process on this dimension.
Self-serving Character of the Departments and Cadres
From the level of activities of DGS&D, CCA and NTH during the 1990s, it is evident that they are indeed coming down dramaticall y
with decentralization of procurement and inspection. In the case of NTH, it probably did not require IIM, Kolkata to figure out
that similar facilities were available with multiple agencies within the government and they were being under-utilized. However, just
three years before the study, DGS&D started work on a full-fledged institute known as the Institute of Supply and Quality
Management. The institute was supposed to be utilized for induction training of its cadres and other training programmes. Such
institutes can be found within any reasonably large cadre of the Government of India and, by that criterion, why not the cadres
of the Indian Supply Service and the Indian Inspection Service? Eventually, the government decided to close the institute just one
year after it became operational! Similarly, despite poor facility utilization and eventual transfer to BIS, the NTH, at the time of
writing of the report (2000), was constructing a new facility at Salt Lake in Kolkata at a cost of Rs 34.24 crores! Unless the information
was revealed to the government and the commission overnight, it is difficult to think how and on what ground such investments
were approved in the first place.

4.3 BUDGETARY PROCESSES AT THE STATE LEVEL

Shantanu Mitra • Vijay Pillai

The links between budgetary processes, public expenditure
outcomes, and infrastructure development within Indian
states are discussed herewith. While reference is made to
Orissa and Andhra Pradesh, the aim is to comment on the
situation of states in India in general. States differ on their
fiscal details and also on the steps they have taken to institute
budgetary reforms. Nevertheless, the similarities, in terms
of basic budgetary processes, fiscal positions and
administrative systems, are large enough to warrant general
applicability of this assessment.
States possess three broad types of policy instruments for
dealing with the supply of services for productive or supportive
functions: direct government provision (financing and/or
delivery27), the use of taxes and subsidies to influence private
behaviour and regulation of private service providers. Drawing
on the principles of welfare economics, the case for state
intervention is generally determined by the need to correct
various forms of ‘market failure’ and to compensate for the
The authors are Economic Advisers at the UK Department For
International Development, India. This chapter does not necessarily
represent the views of DFID.
27 This is an important distinction. The question of who should
finance what relates largely to the public/private characteristics of the
good or service, and the degree and nature of any externalities. The
question of who should deliver what (and how) is a separate issue
to be informed by criteria of cost-effectiveness and efficiency.
results of unconstrained market forces on the distribution of
income, wealth and other resources that might be considered
socially unacceptable. On the other hand, political-economy
approaches, stress the role of political and institutional factors
in analysing and determining the role of the government.
Focus is laid on the implications of budgetary processes—
by which is meant, broadly speaking, systems and procedures
for budget formulation, budget execution, accounting,
monitoring and audit. These greatly influence both the
quantity and quality of public expenditure in key infrastructure-
related areas. Three aspects need to be considered: (1)
allocative efficiency: is the government making the ‘right’
investments? (2) technical efficiency and equity: is it making
them well and who benefits from such expenditure? and (3)
effectiveness: what are the impact and outcomes of such
provision? As public policy-making and the budgeting
processes in states in India become stronger, they should
start asking these questions. While a rigorous analysis of all
these issues is not possible at this juncture, an attempt has
been made to address them, wherever feasible.
INFRASTRUCTURE STATUS OF ORISSA AND ANDHRA
PRADESH
The Eleventh Finance Commission (EFC) had
commissioned a study of infrastructure resources across
106 India Infrastructure Report 2003

states. Setting its all-India average to 100, Orissa scored 81
overall, the fourth lowest among states, based on a score
of 77.2 for social and 81.7 for economic infrastructure.
Andhra Pradesh was higher than the all-India average overall,
at 103.3. This was the result of a substantially above-
average score for economic infrastructure (107.8) being
offset by a relatively poor index value for social infrastructure
(79.3). (These scores are for 1995.) Similarly, the Centre
for Monitoring of the Indian Economy (CMIE) too has a
Composite Development Index (CDI) for infrastructure
for states in India. The index is based on the availability
of seven major infrastructural facilities, that is, energy,
transport, irrigation, finance, communication, education
and health. With India’s CDI being taken as 100, Andhra
Pradesh has a CDI of 104 and Orissa of 101, placing them
at the 10th and 12th place respectively among the 15 major
states in India.
Both indices indicate the poor relative position of both
Andhra Pradesh and Orissa when compared to the major
states of India in terms of overall infrastructure
development28. They are cited here as contextual
background; no causal link is claimed between the analyses
that follow and these index scores since a comparative
assessment of budgetary systems in different states is not
offered. It must be recognized, moreover, that, irrespective
of the relative position of states according to these indices,
the level of public infrastructure provision across India is
deficient on almost all counts. The need, therefore, for
increased infrastructural investment is obvious. How fiscal
and budgetary reform can help to direct more resources,
with greater efficacy, into priority infrastructural needs, is
also discussed in this section.
FISCAL STATUS AND PUBLIC EXPENDITURE
PATTERNS OF ORISSA AND ANDHRA PRADESH
Orissa29
Orissa is among the most fiscally distressed of all the major
states. As a poor and predominantly agrarian economy its own
tax take is low as a percentage of gross state domestic product
(GSDP). But this is offset by high transfers from the
Government of India which assure the state a higher than
average total revenue to GSDP ratio. At the same time, however,
Orissa’s total expenditure ratio is the highest of all states,
leading to high fiscal deficits and a spiralling debt burden.
Table 4.3.1 summarizes the fiscal position of the state from
1995–6 onwards. The large spike in the fiscal deficits in 1998–
9 and 1999–2000 was due primarily to the delayed and
backdated implementation of the recommendations of the
Fifth Pay Commission. Since Orissa’s bureaucracy is by far the
largest in relation to its population, the fiscal impact of this
pay award was greater on this state than on any other state.
Since then the state government has had some success
in reducing the deficit both due to higher revenues (both
own revenue and central resources) and due to a degree of
expenditure restraint. However, the fact that the state
continues to run a significant primary deficit (deficit
excluding interest payments) indicates that further restraint
of non-interest expenditure is required to bring down debt
levels and move the state towards fiscal sustainability.
Meanwhile, the high revenue deficit indicates that the state
is continuing to borrow for recurrent expenditures that are
less likely to boost its debt-servicing capacity.
Table 4.3.2 confirms that the primary sources of
expenditure growth in recent years have been salaries,

Table 4.3.1
Orissa: A Fiscal Summary (as % of GSDP)

1995–6 1996–7 1997–8 1998–9 1999–2000 2000–1 2001–2

Actuals R.E.
Revenue 14.3 15.8 14.2 12.8 15.0 15.9 16.9
State’s own revenue 6.4 6.7 6.0 5.7 6.2 6.6 6.9
Central resources 7.8 9.1 8.2 7.0 8.8 9.3 10.0
Expenditure 19.3 22.4 19.7 22.3 24.5 23.6 24.3
of which interest payments 3.4 4.0 4.0 4.2 3.2 5.3 6.3
Gross fiscal surplus (+)/Deficit (–) –5.1 –6.6 –5.5 –9.6 –9.5 –7.7 –7.4
Primary deficit –1.6 –2.6 –1.5 –5.4 –6.4 –2.4 –1.1
Revenue deficit –2.9 –3.0 –2.7 –6.3 –6.5 –4.4 –4.4
Note: R.E. = Revised Estimate

28 Despite their poor relative position, both states have a higher 29 The section on Orissa draws heavily on data compiled by the
CMIE index than the national average due to the significantly lower World Bank. The authors are particularly grateful to V.J. Ravishankar,
scores of the bottom three states. U. Varma and M. Nagarajan of the New Delhi office of the World Bank.
 Fiscal and Procurement Processes 107

Table 4.3.2
Orissa: Economic Composition of Expenditure i.e. by Economic/Object Head Classification (as % of GSDP)

1995–6 1996–7 1997–8 1998–9 1999–2000 2000–1 2001–2

Actuals R.E.
Interest 3.4 4.0 4.0 4.2 3.2 5.3 6.3
Salary 6.0 7.9 7.3 8.8 9.5 8.3 7.5
Grants-in-aid of salary 1.0 0.6 0.7 0.7 0.4 0.5 0.6
Pension 0.7 0.9 1.0 1.3 1.8 1.9 2.6
Major subsidy NA NA 0.4 0.3 0.4 0.3 0.2
Other revenue expenditure 6.0 5.5 3.6 3.8 6.3 4.1 4.2
Total non-interest revenue expenditure 17.2 18.9 16.9 19.1 21.5 20.4 21.3
Capital outlay 1.6 3.2 2.6 2.6 2.0 1.9 2.2
Net lending 0.5 0.3 0.1 0.7 1.0 1.3 0.9
Total expenditure + net lending 19.3 22.4 19.7 22.3 24.5 23.6 24.3
Note: R.E. = Revised Estimate

Table 4.3.3
Orissa: Sectoral Composition of Capital Outlays (as % of GSDP)

Capital Outlay 1995/6– 1998–9 1999–2000 2000-1 2001–2

1997/8 R.E. B.E.
Irrigation and flood control 56.1 66.8 66.8 52.0 58.4
Transport 21.3 14.4 16.5 14.5 20.6
Water supply, sanitation, housing, urban development 7.1 5.3 3.8 13.5 6.8
Power 6.6 7.0 1.4 1.3 1.0
Agriculture and allied activities 4.0 2.8 7.2 5.8 1.1
General services 1.6 1.9 1.9 4.6 3.4
Health and Family Welfare 1.5 0.6 0.7 3.4 5.4
Education, sports, art & culture 0.9 0.4 1.1 3.0 2.2
Welfare of SC, ST, OBC 0.4 0.3 0.3 1.2 0.8
Tourism, Investment in general, finance and trading 0.5 1.1 0.4 0.5 0.2
Industry and Minerals 0.1 –0.6 –0.1 0.2 0.1
Total 100.0 100.0 100.0 100.0 100.0
Note: B.E. = Budget Estimate; R.E. = Revised Estimate

pensions and a growing interest burden. The capital outlay
has been relatively stagnant over the period, whilst the
‘other revenue expenditure’ category, which includes all
non-salary Operational and Maintenance (O&M)
expenditure, has declined. Furthermore, it is apparent from
Table 4.3.2 that Orissa’s budgeted revenue and expenditure
estimates have been a poor guide to actual out-turns, both
in absolute terms and relative terms, to other states. A
reasonable interpretation is that systematic overestimation
of revenue receipts has led to expenditures having to be
curtailed within the year. Both revenue and capital
accounted for by discretionary items, particularly non-salary
O&M.
It would seem reasonable to draw a causal link between
fiscal distress and unrealistic revenue estimation, on the one
hand, and stagnation and unpredictability of allocations for
capital expenditure and non-salary O&M on the other30.
Such a process would, in turn, have negative consequences
for infrastructure provision and utilization, both through
less asset creation and through faster deterioration of existing
30 In seeking to explain this suggested causality, political economy

expenditures, except in 1999–2000, have fallen short of
budget estimates. In general, and on average, however, capital
expenditures have tended to undershoot by the greater
proportion. Given that salaries, pensions and interest are
largely fixed and non-discretionary, it may be assumed that
the shortfalls against budgeted revenue expenditure are
approaches may be of most value. It is difficult, without recourse to
such theories, to answer questions such as why there are incentives
to overspend on salaries, why historically there has been little concern
about over-estimation of revenues, or why capital investment and
O&M have been treated as residuals. A full discussion of these issues
is beyond the scope of this section. (Norton and Elson, 2002, for
a discussion of theory and applications.)
108 India Infrastructure Report 2003

Table 4.3.4
Andhra Pradesh: A Fiscal Summary (as % of GSDP)

1995–6 1996–7 1997–8 1998–9 1999–2000 2000–1 2001–2

Actuals B.E.
Revenue 11.5 11.6 13.6 12.0 13.0.0 13.3 13.8
State’s own revenue 6.3 6.4 8.5 8.1 8.6 8.8 8.7
Central resources 5.2 5.2 5.1 3.9 4.4 4.5 5.1
Expenditure 14.5 14.7 17.1 17.1 17.1 18.6 19.6
Revenue 12.5 12.6 14.4 14.4 14.0 16.0 16.3
Capital 2.1 2.1 2.7 2.7 3.1 2.6 3.3
Fiscal Surplus (+)/Deficit (–) –3.1 –3.1 –2.5 –5.0 –4.1 –5.3 –5.8
Primary deficit –1.2 –1.0 –0.3 –2.7 –1.5 –2.5 –2.5
Revenue deficit –0.9 –1.0 –0.7 –2.4 –1.0 –2.7 –2.5
Note: B.E. = Budget Estimate
Source: GoAP: Strategy Paper on Fiscal Reforms, 2001

Table 4.3.5
Andhra Pradesh: Economic Composition of Expenditure i.e. by Economic/Object Head Classification (as % of GSDP)

1995–6 1996–7 1997–8 1998–9 1999–2000 2000–1

Actuals B.E.
Interest 2.0 2.2 2.4 2.5 2.8 3.1
Salary 5.2 5.3 5.6 5.2 6.0 6.3
Pension 1.2 1.2 1.3 1.3 1.6 1.7
Non-salary O&M 1.1 1.1 1.4 1.5 1.9 1.8
Transfers and Subsidies 3.7 3.5 3.5 4.2 3.6 5.1
Other Revenue Expenditure 0.1 0.2 0.4 0.8 0.8 0.5
Total Revenue Expenditure 13.4 13.5 14.6 15.5 16.7 18.4
Total Capital Expenditure 2.2 2.2 2.9 2.9 2.9 3.6
Net lending 0.8 1.0 1.7 1.6 0.7 0.9
Total expenditure 15.6 15.7 17.6 18.4 19.6 22.0

assets. Additionally, less spending on complementary inputs
for service delivery (such as medicines and schoolbooks)
would have reduced their utilization. These trends need to
be set in the context of historically high capital expenditure
(in relation to GSDP, the highest of all major states from
1991–2 to 1996–7). The squeezing of non-salary O&M is
undoubtedly a concern; there is ample anecdotal evidence
of inadequate allocations for maintenance of existing
infrastructure.
The sectoral composition of capital expenditure (Table
4.3.3) appears to be broadly appropriate. The lion’s share
of capital spending goes on irrigation (including flood
control) and transport, both examples of investments having
significant public-good characteristics31 and crucial for
31 This is not to deny that substantial scope exists for increased
cost recovery, particularly in irrigation which has both public and
private-good characteristics depending on the type of irrigation system
and the ease with which private or community property rights can
be effectively enforced at different stages of the delivery system.
economic growth—in other words, where there is a strong
case for the state to play a leading role.
Attention needs to be paid to the effectiveness and
efficiency of public spending, as much as to levels of
expenditure. In Orissa, inefficiencies and leakages in the
prioritization, design and management of capital projects
appear to be large32.
Andhra Pradesh
The average annual growth rate of Andhra Pradesh during
the 1990s was 5.3 per cent, almost a full percentage point
lower than the national average of 6.2 per cent. During the
five-year period ending 1999–2000 there have been large
32 World Bank research suggests, for example, that the efficiency
of expenditure on irrigation has been low. Analysis of a major Bank-
financed irrigation project indicates that delays and other deficiencies
in implementation have resulted in an economic rate of return (ERR)
of only 6 per cent, compared with 14 per cent at appraisal.
 Fiscal and Procurement Processes 109

Table 4.3.6
Andhra Pradesh: Sectoral Composition of Capital Outlays (as % of GSDP)

Capital Outlay 1996–7 1997–8 1998–9 1999–2000 2000–1

R.E. B.E.
General Services 0.02 0.02 0.02 0.03 0.04
Education 0.01 0.01 0.01 0.01 0.00
Health 0.0 0.0 0.0 0.22 0.37
Welfare Programmes 0.06 0.05 0.1 0.2 0.05
Agriculture 0.01 0.02 0.03 0.01 0.01
Irrigation 0.75 0.83 0.76 0.92 0.93
Power 0.0 0.04 0.02 0.03 0.02
Transport 0.23 0.11 0.25 0.33 0.59

variations in the agricultural and industrial growth rates,
while a much more consistent performance was seen in the
services sector. Thus, growth rates in agriculture ranged
between (–)15.3 per cent and (+) 24.3 per cent; while that
of the industrial sector was between (+) 1.8 per cent and
(+) 7.8 per cent. Andhra Pradesh had a per capita income
of Rs 10,886 in 2000–1 (in 1993–4 prices), a little lower
than the national figure of Rs 11,799.
Relative to many other states, Andhra Pradesh had a better
record in fiscal management until about 1998–9. The fiscal
deficit was about 2.5 per cent of GSDP in 1997–8 and
almost doubled to 5 per cent the following year—as in Orissa
the civil service pay award contributed much to this sharp
deterioration. Table 4.3.4 summarizes the fiscal situation in
Andhra Pradesh. The state’s own revenue performance has
improved during the last five years and its share in total
revenues rose from 62 per cent in 1997–8 to 66 per cent in
2000–1. At the same time, there has been a decline in the
share of central transfers to Andhra Pradesh—declining from
5.2 per cent of GSDP in 1995–6 to 3.9 per cent in 1998–
9 and then improving to 4.5 per cent in 2000–1.
The revenue expenditure33, which was stable for the
three-year period ending 1999–2000 at 14.3 per cent of
GSDP increased to 16 per cent in 2000–1, mainly due to
the reflection of explicit power subsidy in the budget. Capital
expenditure has shown a steady increase in recent years—
from 2.1 per cent in 1995–6 to 3.1 per cent in 1999–2000.
Salaries, pensions and interest payments make up about 64
per cent of the total revenue expenditure of the state.
Subsidies (for example, in the power sector) make a significant
share of public expenditure—and much of it is untargeted.
That subsidies continue to be a huge drain on public resources
leading to distortion of spending priorities is exemplified
33 In India government expenditure is clubbed into capital and
revenue expenditure. Capital expenditure typically consists of capital
outlays for building new assets and loans given by the state for various
purposes. Revenue expenditures are the running costs of the government
and includes recurrent expenditures on various programmes or schemes,
and expenditure on interest, salariess and any subsidies.
by the fact that power subsidies are almost twice as large
as government expenditure in primary health.
Rising debt burdens and consequent interest repayments
squeeze out the resources deployed for infrastructure and
other development priorities. What is the state borrowing
for? While in recent years Andhra Pradesh has succeeded
in reducing its revenue deficit (borrowing for recurrent
expenditures), it still continues to be high (see Table 4.3.5)—
indicating that much of this borrowing does not go towards
generating future income streams for the state.
Andhra Pradesh has shown a relatively good performance
compared to some other states, in terms of increasing trends
in both capital allocations and those for non-salary O&M.
While this is a positive development, given the historical
under-funding in the infrastructure sector there is a need
to continue this positive trend in budget allocations for
infrastructure, and equally importantly, the efficiency and
efficacy with which assets are created and utilized.
As in Orissa, irrigation and transport take up a large
proportion of public expenditure where the state rightly
plays a leading role. But there is also a critical need to step
up capital expenditures in the health and education sectors
(see Table 4.3.6).
BUDGETARY PROCESSES34
The objectives of the budget process (or public expenditure
management (PEM) system) may be summarized as:
1. to maintain fiscal discipline by ensuring that aggregate
expenditure is kept within limits dictated by revenue capacity
and sustainable levels of borrowing;
34 This sub-section draws upon various unpublished reports
prepared by Bannock Consulting and JPS Associates for the
Government of Orissa, and on the Government of Orissa’s own
internal policy paper on Budget Reforms and Public Expenditure
Management. The section also uses findings of a series of unpublished
Impact and Expenditure Reviews conducted by Government of Andhra
Pradesh for eight departments in 2001, with assistance from DFID.
110 India Infrastructure Report 2003

Table 4.3.7
Orissa and Andhra Pradesh: Deviation of Final Accounts from Budget Estimates (percentage variation, Accounts/Budget Estimate)

1995–6 1996–7 1997–8 1998–9 1999–2000

Revenue Orissa –5.7 –9.8 –10.6 –19.7 –5.0
Receipts Andhra Pradesh –2.9 –2.3 10.3 –8.8 –9.6
All states 0.3 0.5 –3.3 –13.1 –5.9
Revenue Orissa –8.2 –7.7 –9.6 –6.0 4.9
Expenditure Andhra Pradesh –2.5 19.4 5.9 4.4 –10.5
All states –1.0 3.1 –2.6 –4.1 0.1
Capital Orissa –17.3 –11.6 –7.7 –4.5 –25.8
Expenditure Andhra Pradesh 31.2 –27.2 24.1 51.5 31.1
All states –0.1 –3.3 4.8 2.0 4.9
Source: RBI

2. to promote prioritization by ensuring that available
resources are allocated in line with the government’s strategic
objectives and/or ‘rational’ social and economic criteria;
3. to deliver value for money by ensuring that
resources are used efficiently and effectively in the pursuit
of priorities.
Additionally, the processes have to be such as to ensure
accountability and transparancy at each stage. Whilst these
are important in helping to deliver the three objectives set
out above, they are also important in their own right to
safeguard the integrity and legitimacy of the system.
It is essential to consider any PEM system within its
institutional context, that is, as a system of formal laws,
rules and processes, as well as informal customs and incentives
that help determine how the system actually operates and
how effectively it meets the objectives outlined earlier. To
facilitate the description and the appraisal of the key features
of the system in the Indian states, the analysis35 has been
broken down among the three component parts of the
budgetary cycle: (i) strategic planning and budget
formulation; (ii) budget execution; (iii) audit and evaluation.
STRATEGIC PLANNING AND BUDGET FORMULATION
Unrealistic Revenue Forecasts
Unrealistic revenue forecasting would appear to have been
a major contributor to the lack of fiscal discipline, which,
as mentioned before, has led to capital and maintenance
expenditures being squeezed. Unpredictability also arises
35 What follows is not intended to be a detailed and exhaustive
description of all aspects of the system. It is rather an attempt to
identify some of the key features contributing to particular observed
outcomes in Orissa and Andhra Pradesh, especially those most relevant
to public infrastructure development. It highlights only areas where
improvement is required; this is not to say that the current system
does not also have its strengths.
with regard to certain transfers from the centre, which form
a significant proportion of the revenues of the states. Arguably
the real systemic problem lies deeper, in the perceived need
to show a rising Plan budget (which is equated politically
with ‘desirable’ investment to enhance productive capacity).
Similarly, the practice of incremental budgeting for major
non-Plan expenditures, particularly salaries (reasons for which
have also been, at root, political) contributes to the problem.
The resultant upward pressures on expenditure bids have
led to budgeted revenue receipts being fixed at levels inflated
by the need to justify excessive expenditure levels rather
than by actual revenue realization potential.
In these circumstances it is hardly surprising that the
result has been ad hoc cash rationing within the year in
response to revenue shortfalls. And since non-discretionary
items such as salaries and debt service effectively have first
call on resources, such rationing has been reflected
particularly in the delayed implementation of investment
projects and postponement of non-wage O&M (including
maintenance of infrastructure assets).
Dual Budgeting Dysfunctionality
The effects of the dual budgeting system (separation between
Plan and non-Plan budgets) in the Indian context have been
well documented. Although the separate focus on Plan
expenditure in theory ensures that development activities
are given due weight, as already noted, this produces
incentives to budget for an inexorably rising Plan even when
this is clearly not feasible. Greater emphasis is given to the
budgeted Plan allocation than to its realization36. More
fundamentally, because the two budgets are prepared
36 Moreover, as is widely understood, the rule-of-thumb that Plan
expenditures comprise of 70 per cent capital and 30 per cent recurrent
spending no longer holds: as reported by the Reserve Bank of India
(RBI) report on State Finances (2001–2) recurrent items account for
more than 50 per cent of Plan expenditures aggregated across all states.

separately with little coordination between these processes
or between the Finance and Planning Departments, there
is really no means of focusing on total sector costs and little
or no incentive for spending departments to trade off between
Plan and non-Plan expenditures. States have a tendency to
maximize the amount of Plan funds available from the
centre by overestimating their balance on current revenues.
Since all Plan programmes become part of revenue
expenditure after completion of the Plan period, the pressures
that work towards increase in Plan spending also contribute
to the increase in expenditure on the non-Plan account.
Clearly the sanctity attached to maximizing the Plan size
has led to some detrimental outcomes.
Supplementary Budgets
The legality that permits the processing of supplementary
budgets three times a year has led to governments viewing
the initial budget as a soft constraint. As shown in Table
4.3.7, a result of this soft initial constraint has been in terms
of poor ‘fiscal marksmanship’—deviation between actual
figures and BE figures for the year.
Incomplete Budgets
These deleterious effects are exacerbated by the fact that the
budget is not comprehensive. The existence of various extra-
budgetary flows (for example, in-kind flows to districts,
funding from externally-aided projects to state/district
societies) further vitiates attempts to focus on sector costs
or allocations in a comprehensive manner. In addition,
contingent liabilities (for example, in respect of guarantees
to public enterprises, power purchase agreements and investor
letters of comfort) are not subject to adequate scrutiny of
the Finance Department, or to prudent overall ceilings, and
are not fully reflected in the budget.
Lack of Medium-term Perspective
There are also important flaws in the planning process itself.
Perhaps the most pernicious of these is the lack of any effective
medium-term perspective for programming Plan expenditure.
Whilst a Five Year Plan exists on paper, the lack of realism
in macro-budgeting renders this increasingly less related to
annual plans. There seems to be a disconnect between priorities
set out in the Plans and actual public expenditure allocations
in the annual budgets. No formal mechanisms exist for regularly
reviewing or rolling over the Five Year Plan. The lack of
effective medium-term expenditure programming is
exacerbated by the fact that at the time of Plan preparation
there is no assessment of the eventual non-Plan liability
resulting from the forward O&M cost implications of plan
projects. Such tendencies can lead to the creation of assets
without the means to utilize and maintain them.
Fiscal and Procurement Processes 111
The prioritization process for Plan expenditure tends to
be subjective rather than being carefully derived from policy
objectives. In practice, the process is highly centralized and
‘top-down’, with the budgets for most expenditures relating
to local functions, such as education and health, being
decided at the state level. Although District Plans provide
indications of the Districts’ views on priorities and phasing,
these are typically only advisory to spending departments
when preparing their detailed budgets37. At the level of
individual projects, whilst cost-benefit analysis is theoretically
mandatory, in practice it is not always prepared, or is sketchy,
and seldom reviewed.
Formulation of non-Plan budgets is similarly devoid of
any effective medium-term perspective. Limited discretion
is given to spending departments, with the Finance
Department issuing prescriptions on budgeting of specific
line items according to extremely detailed classifications.
Combined with limited virement (‘re-appropriation’)
authority, this leads to over-centralization because there is
always informational asymmetry between the Finance
Department and the spending departments with regard to
the appropriate allocation and management of sector budgets.
The approach taken is one of incrementalism, as noted
earlier, with little discrimination between the needs of
different departments and programmes.
No Outcome Measures
Strategic prioritization has suffered further from the lack of
any linkage between expenditure allocations and ‘outcome’
measures (such as higher agricultural incomes, improved
health status of the population, etc.). This prohibits any
meaningful attempt to prioritize between competing
demands in terms of policy objectives or to measure the
performance of spending departments in achieving the same.
Deficiencies in Process
Both Plan and non-Plan budget formulation are largely
manual processes. Only in the final stages prior to publication
is there any attempt to use computational and planning
tools. This process involves huge effort and makes it
practically impossible to manipulate data and to test the
impact of different scenarios and options. Lack of
computerization of the budget process, therefore, represents
an important technological constraint to improving
budgeting practice.
Last, but not least, very little public consultation takes
place at state level as part of this process. Recognizing that
37 Whilst this is the case for most states, Kerala, for example, has
moved substantially towards devolving untied allocations to districts,
to be allocated according to local needs based upon participatory
planning techniques.
112 India Infrastructure Report 2003
the allocation of public resources is essentially a political
rather than a purely technocratic exercise, formal consultation
with citizens or representative civil society groups can be an
important conduit for promoting transparency and ensuring
that the voices of the intended beneficiaries of public
expenditure are heard38.
BUDGET EXECUTION, ACCOUNTING, AND
MONITORING
Given the problems and weaknesses in the budget
formulation process outlined above, the extent to which it
is meaningful to talk of effective execution of such budgets
is debatable. It is virtually predetermined, for example, that
there will be substantial variations from budgeted receipts
and expenditures, which is reflected in the widespread and
regular use of Supplementary Budgets within the year.
Equally important, there are serious problems with the
budget execution process itself, which contribute separately
to sub-optimal budgetary outcomes.
Accounting System Weaknesses
Many of the problems arise from the fact that accounting
systems are largely manual. As a result the flow of data is
fragmented, untimely and inflexible in terms of the depth
of analysis available. Accountability in budget imple-
mentation is seriously undermined.
After processing of transactions by local treasuries,
accounting information is prepared and passed to the
Accountant General, where it is summarized and the returns
forwarded to the Finance Department for budgetary control
purposes. The time-consuming nature of these manual
processes means that this data is usually two months old by
the time it reaches the Finance Department, by which time
the problems have often got worse. Where sub-treasuries
exist, they can further add to the delay. In addition, accounts
are not reconciled on a regular basis, with the result that
in-year financial information is hardly reliable.
Budgetary discipline is further weakened by the fact that
the treasuries are unable to check availability of budget
provision at the point of payment, and by the level of
aggregation of accounting data supplied to the Finance
Department. Since these data are at the overall budget-head
level, in the event of an overspend it is not always possible
to see which department has caused it. An additional problem
is the lack of correspondence between alternative sources of
data. Local departmental records and central records often
38 See Norton and Elson (2002) for examples and a summary of
international experience with participatory budgeting initiatives. The
pending ‘Freedom of Information’ bills in many states could usefully
incorporate clauses providing for such consultation.
do not agree, so there is no common basis for dialogue in
the event of problems.
‘Public Accounts’
A lack of timely fund release by the Finance Department,
and the fact that unspent appropriations may not be carried
over, have led to the common practice among departments
of establishing ‘Civil Deposit Accounts’/‘Public Accounts’
to which expenditures can be booked even though no
expenditure has actually been incurred39. By decentralizing
cash balances and removing expenditure from effective
scrutiny, this practice weakens accountability and financial
control, further inflating the reported fiscal deficit, and the
Government’s already-high borrowings.
The weaknesses outlined above amount to a sure recipe
for ineffective expenditure control and poor implementation
of agreed budgets. The present budget controls have not
been wholly effective in ensuring that voted expenditure is
spent on agreed activities as allocated, or in preventing
departments from exceeding their cash limits, contributing
significantly to high budget deficits and chronic cash flow
difficulties. Liquidity problems, along with the lack of any
cash planning system, result in cash rationing by departments,
leading to expenditure being re-prioritized within the year
in an ad hoc manner.
Weak Project Management
For infrastructure development, the effectiveness of capital
expenditure management is crucial. As already mentioned,
weak project appraisal practices at the outset, lead to
inefficiencies in the allocation of capital expenditure. Once
approved and included in the Plan, weak project management
procedures mean that many individual projects are not
effectively managed to ensure timely achievement of clear
and measurable outputs. It appears that too many projects
are allowed to continue well beyond the point at which they
should have been completed, or when it is clear that they
are no longer cost-effective. Combined with political
incentives to announce new schemes and continually raise
the overall Plan size, the result is an excessive number of
projects, many of them starved of resources with little
prospect of timely completion. Simultaneously, weak
financial controls allow for overspending on individual
projects, and the possibility of misappropriation of funds
‘earmarked’ for specific purposes.
Weak and opaque procurement procedures, and unclear
client and contractor roles and relationships, are also major
factors leading to inefficiency, corruption and poor value
39See Section 6.4 for more details on this and other accounting
anomalies.

for money in infrastructure spending. In summary, it is
apparent that poor capital expenditure controls undermine
both fiscal discipline and value-for-money objectives of
public expenditure management.
AUDIT AND EVALUATION
External Audit
The external audit function, which belongs to the
Comptroller and Auditor General (CAG) of India, appears
to be effective in identifying many of the most serious
weaknesses and inefficiencies at the state level. Reports from
CAG are regularly tabled in the state legislature. The impact
of this external audit, however, depends crucially on the
effectiveness and timeliness with which the Public Accounts
Committee reviews CAG reports and the effectiveness of
mechanisms for follow-up and enforcement, including the
use of disciplinary powers40.
Internal Audit
In Orissa the internal audit function consists of common
cadre audit (which audits the accounts of the central
administrative departments of the government), local fund
audit (which focuses on institutions such as block
development offices, gram panchayats, municipal
corporations and grant-aided educational institutions) and
efficiency audit (which is concerned with the efficiency with
which resources are deployed by administrative departments).
Internal audit is not generally effective at present. It is
highly transaction-based. It does not focus on the underlying
system weaknesses, correction of which could have helped
management in developing more cost-effective controls. Its
scope is mainly to restricted voucher audit, which involves
checking whether expenditure is as per sanction, properly
authorized and supported by sufficient proof of payment
as per rules and law. It does not include checking whether
the expenditure has been utilized for the intended purposes;
there is no physical verification of civil works or assets.
Audit planning, techniques and reporting are weak and
outdated, and exacerbated by weak staff capacity. There are
serious staff shortages in all areas of internal audit and audits
of institutions are typically in arrears by five to ten years,
although this problem is also due to poor planning and
outdated methods for selecting and carrying out audits.
There are more fundamental reasons for the ineffectiveness
of internal audit. Independence and accountability are weak.
A significant number of the administrative departments,
40 For a brief review of the CAG audit, see Chapter 5.4 ‘Office
of the CAG of India as Accountability in Government,’ by Ajay
Pandey in this report.
Fiscal and Procurement Processes 113
including some with major infrastructure budgets such as
Public Works, Water Resources and Rural Development, do
not have internal auditors appointed by the Finance
Department. Instead they have total control over their own
internal audit. More generally, internal audit staff report
only to the head of the department concerned and not to
the Finance Department or any other organization. Because
the auditors have no power to enforce compliance to audit
objections, compliance to internal audit reports is very low
and action is rarely taken on the basis of audit reports,
except when procedural deviations are pointed out.
As noted above, targets are rarely set for development
‘outcomes’ to be achieved, so there is little means of checking
the effectiveness of expenditure in delivering policy objectives.
Although physical targets are set in respect of Plan schemes,
these are in the nature of intermediate outputs rather than
social outcomes. Moreover, resource shortfalls that arise
almost as soon as the Plan is produced make it practically
impossible to hold spending departments accountable for
planned physical achievements. Although the efficiency audit
department carries out some reviews of project performance,
very little attention is paid to the effectiveness of non-plan
expenditure. (And efficiency audit is subject to the same
problems of weak capacity and low compliance as the rest
of internal audit.) In general, there appears to be a lack of
systematic and comprehensive review of the extent to which
expenditure represents value-for-money and contributes to
higher-level policy objectives.
REFORM DIRECTIONS
It is evident that the budget process at state level suffers
from multiple weaknesses. There is lack of clarity,
predictability, transparency, accountability and comprehen-
siveness at various stages of the budget cycle. The result is
poor outcomes with regard to fiscal discipline, strategic
prioritization and value-for-money. What, then, should be
the priorities for reform of PEM at state level? A number
of broad strands are suggested by the above analysis.
Need for MTEFs
In terms of planning and budget formulation, the overall
imperative is to move towards instituting a comprehensive
medium-term approach to expenditure programming. Such
approaches, being operationalized in an increasing number
of countries in the form of Medium-Term Expenditure
Frameworks (MTEFs), involve programming expenditure
(i) on a multi-year (usually 3–5 years) basis allowing for
forward planning; (ii) in the context of a realistic and
sustainable macro-fiscal framework; (iii) with reference to
a coherent set of policy objectives and sector strategies,
114 India Infrastructure Report 2003
strengthening the link between inputs and outputs; and (iv)
taking an integrated approach to capital, current and
externally-aided resources, so that the appropriate capital-
current mix can be achieved and the recurrent cost
implications of capital expenditure taken into account. The
role of the Finance Department in such a process would be
limited to specifying and monitoring strategic expenditure
aggregates and agreeing to the strategic outcomes to be
achieved, leaving spending departments with flexibility to
determine the details. However, the formulation and
institutionalization of a fully-fledged MTEF takes time to
achieve, and in the context of the Indian states an incremental
approach, putting in place the most fundamental elements
first, is likely to be the more sustainable and realistic way
forward41.
Importance of Computerization
Moreover, it must be recognized that introduction of
medium-term expenditure planning without attention to
budget execution and expenditure control will not lead to
the desired objectives. Addressing these problems will require
computerization of accounting processes to provide high
quality and more timely information, along with improved
and streamlined systems to enable the Finance Department
to utilize this data to better control expenditure and manage
the cash flow. It is important to open up access to
computerized data to departments other than Finance and
the Accountant General in order to promote more integrated
data use and ensure a common basis for dialogue between
the Finance and other departments in the event of
disagreements or problems. Although computerization of
accounting is the first priority, computerization of transaction
processing—such as payroll transactions—will also be
important in improving expenditure control.
Capital Expenditure Management
Strengthening of capital expenditure controls, including
procurement procedures, is of particular importance to
infrastructure development. This should cover all key stages
of the project cycle, including feasibility, design, tendering,
monitoring and evaluation, with appropriate approval
procedures, wherever relevant. At the same time, improved
project and programme management procedures, with clear
reporting and monitoring arrangements, are required to
improve the performance of individual projects and the
capital programme as a whole.
41 It is noteworthy that some states are looking at the national
debate on Fiscal Responsibility Act (FRA), which is intended to give
legal backing to medium-term fiscal forecasting.
Audit Reform Priorities
Major improvements are required to enable internal audit
to play its proper role in the accountability process. These
include organizational and management changes,
strengthening of audit planning and skills, focus on
underlying systems rather than merely transactions, and
more effective reporting and compliance mechanisms.
Ultimately, there must be the willingness and the procedures
to hold controlling officers accountable for mismanagement
and malfeasance.
Political and Administrative Commitments
It would be a major mistake to treat PEM reforms as a
technocratic exercise. Constructive political engagement is
critical in bringing about the positive changes desired. Since
the budget is, in essence, a tool for translating political
intention into public policy, involvement of the Cabinet
and the Legislature in the budget process is essential,
particularly in budget formulation and in ensuring
compliance with external audit. More generally, as noted,
serious efforts to promote wider stakeholder-participation
and citizen-focus in the budget process can be a powerful
tool for increasing transparency, holding governments to
account and improving the impact of budgets.
DEVELOPMENT OF REFORMS IN ORISSA AND
ANDHRA PRADESH
The need to institute a wide-ranging programme of reforms
to address the weaknesses in the existing budgetary process has
been acknowledged by the Governments of both Orissa and
Andhra Pradesh. A number of important steps have already
been taken and others are ongoing. Following is a snapshot
of progress as of August 2002. It should be stressed that this
is very much a work in progress. Whilst much remains to be
done in terms of implementation, the following initiatives
indicate the seriousness of intent of both governments.
MTFP Agreed with the Government of India
As a critical underpinning of any future move to medium-
term expenditure programming, both governments have
articulated a clear medium-term fiscal framework designed
to restore overall fiscal sustainability and setting out its
overall fiscal targets over a five-year period. This is enshrined
in a Medium-Term Fiscal Plan (MTFP) agreed with the
Government of India, and in a highly candid Cabinet-
approved White Paper/Strategy Paper, which sets out the
rationale for, and elements of, fiscal reform. The latter
represents an important mechanism for political engagement
in respect of a politically difficult set of reforms.

Careful Reviews of Expenditure Priorities
A zero-based public investment review has been initiated by
the Government of Orissa, led by a high-level review
committee, chaired by the Chief Secretary. The Government
of Andhra Pradesh conducted a similar ‘Zero-Based Budget
Review’ in 2001. The aim of these exercises was not to cut
investment spending, but to improve its efficiency and
effectiveness by reallocating Plan resources from low-priority
to high-priority projects or schemes and ensuring adequate
fund availability for the prioritized schemes. The zero-based
review is a one-time exercise, to be followed by improvements
in procedures and capacity for programming, evaluation
and funding of the investment budget.
In Orissa, the main item of non-Plan expenditure, namely
staff costs, is similarly being subjected to fundamental review
through a process of organizational reviews of all major
departments. The objective of this exercise, initiated in July
2002, is to review the appropriate role and functions of
departments, the organizational structure and staff strength
required to fulfil these functions, as well as to advise on
procedures, management systems and mechanisms for
enhancing client focus. Thus, whilst these reviews are seen
as a critical step towards the government’s stated aim of
reducing the size of the civil service, they have a considerably
broader focus on effectiveness and performance. As with
the zero-based investment review, they are a one-time exercise.
In Andhra Pradesh, the effort is currently on preparing
MTEFs for a few sectors on a pilot basis, which will help
take forward medium-term expenditure planning to the
level of spending departments. In addition, the Government
of Andhra Pradesh has taken the initiative of holding public
consultations to feed into the budget-making process.
More Flexibility for Spending Departments
In Andhra Pradesh, the sectoral budget ceilings are now
being set at the start of the budget process and departments
are being given enhanced planning and financial powers.
The spending departments would be held responsible for
payments, accounting and accountability. The system of
control exercised by the Finance Department is moving
away from micro-management, to the selection of an ‘anchor’
for each department, for example, limits on running costs,
and such an ‘anchor’ would then provide the basis for
improved dialogue between the Finance and other
departments.
It has also taken some initial steps to bundle heads of
account and give greater flexibility to departments. The
present system of seven-digit classification remains too
detailed and inconsistent with the principle for permitting
greater flexibility in budget management. While the formal
revision of the budgetary classification requires the
Fiscal and Procurement Processes 115
concurrence of the CAG, and will require modification
across all states of India, the Government of Andhra Pradesh
is planning to simplify the classification as a supplementary
to the existing classification.
Computerization on Pilot Basis
Computerization of the treasuries is underway on a pilot
basis, with financial assistance from the Government of
India. As noted, this will be essential to improve the timeliness
and the reliability of accounting information for budgetary
control purposes.
The Government of Andhra Pradesh has plans of moving
from a system of cash accounting to modified accrual
accounting initially on a proforma basis.
Cash Management Plan
Another extremely important initiative of both the
Governments of Orissa and of Andhra Pradesh, particularly
in view of the liquidity crisis facing the states, is the
preparation of a detailed cash-management plan. The overall
objective is to enable the governments to more proactively
manage their cash flows, in order to provide more
predictability in budget execution and avoid the ad hoc cash
rationing which has prevailed thus far.
Audit, Evaluation, and Transparency
Both states have undertaken a review of their internal audit
function, and plan to initiate a programme to strengthen
the same in due course. Meanwhile, they are implementing,
or designing a range of measures to increase transparency
and accountability to the client or end-user of public services.
These include: (i) passage of a Freedom of Information Act;
(ii) consideration of ‘citizen’s charter’-type mechanisms to
inform service users of their entitlements and provide
grievance redressal procedures; and (iii) plans to carry out
expenditure-tracking studies of some key public services, in
order to ascertain the extent to which expenditure reaches
the intended end-user and the extent of leakage/inefficiency
at each level in the system.
The Government of Andhra Pradesh is moving towards
greater performance orientation, under which each
department has prepared a set of performance indicators,
which can be monitored with current or prospective data
availability. These indicators would provide the basis for
making quarterly budgetary releases, and also for feeding
into budget discussions for the subsequent year.
Work is being planned or is under consideration in both
states, with cooperation from the World Bank and the
Department for International Development (DFID), to use
diagnostic tools like State Financial Accountability Assessment
(SFAA) and Procurement Assessment Review to identify the
116 India Infrastructure Report 2003
problems in the financial accountability and procurement
systems and prepare action plans to tackle them.
CONCLUSION
PEM reform is not an agenda for developing countries
alone. Many developed countries also have some way to go
in this regard. But given the urgency in meeting the growth,
infrastructural development and poverty-reduction objectives
for developing countries, the criticality of these reforms
becomes that much greater.
International experience offers some important lessons
that may be of value to Indian states pursuing PEM reforms,
or to those attempting to understand or support the process
from the outside. In general, there are no blueprint solutions,
and it is important to bear in mind five sets of issues: (i)
the pace of reforms is likely to be more rapid when
governments are forced to take action by a macroeconomic
or fiscal crisis. In the absence of crises, pressures for
improvements may still build up in under-performing
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