New Delhi: The Union Budget could have a negative impact on smaller states that rely more heavily on monetary transfers from the Centre than bigger counterparts, according to a report by credit rating agency Fitch Ratings.
The finance ministry revised downward the estimates for gross tax revenue for 2008-09 by 8% to Rs6.27 trillion when it announced the Budget on 6 July. It also estimates anaemic growth of 2% in tax revenues in 2009-10. Lower revenues mean a slowdown in transfers to the states, which could derail their plans for economic expansion.
States that rely on a large share of Central transfers in their total revenue include Bihar, Orissa, Uttar Pradesh, Madhya Pradesh and Chhattisgarh. Central transfers made up at least half of these states’ revenue receipts in 2007-08, according to the Reserve Bank of India’s review of state finances.
But the Fitch report singles out small states with limited access to organic revenue as those that will be most affected. “The impact of a slower growth of devolutions and transfers from Central government would be more severe on smaller states, which receive a larger share of their revenues from the Central government. However, the impact on bigger states with a higher share of their own taxes in their revenue receipts will be less.”
But this economic crisis could affect all states regardless of their size because many states have expenditures that are inflexible, such as on health, education and social welfare. To mitigate the effect of slowing revenue, the Centre has increased the states’ borrowing limits by 0.5 percentage point to 4% of gross state domestic product. Devendra Kumar Pant, director of Fitch in India, calls this “the only saving grace for the states”.
But for some of the states their fiscal problems may only get worse. Some states had not implemented fiscal responsibility laws prior to the economic slowdown; for example West Bengal and Sikkim, which leaves them more exposed to the risk of fiscal indiscipline in the future. Other states already had large fiscal deficits in 2007-08; Jharkhand had a fiscal deficit of around 8% of the state gross domestic product (GDP). When revenue receipts are declining due to the slowdown in the economy, Jharkhand’s non-Plan expenditure continues to grow.
An analysis conducted by the National Institute of Public Finance and Policy (NIPFP) in June is more optimistic about state finances. “Smaller states have managed their finances more prudently in recent years,” said M. Govinda Rao, director of NIPFP.
Rao expects some deterioration in state finances due to the impact of the slowing economy: a drop in the states’ aggregate revenue surplus to 0.4% of GDP in 2008-09 from 0.6% in their original estimate and a 0.7% aggregate increase in the states’ fiscal deficit.
But Rao is hopeful that the 13th Finance Commission, which reports to the government in October, will devise a road map for fiscal recovery for the states and the Centre, which should ensure that the states’ finances are put back on track.
Of course, some states will be better off than others. To shore up revenue receipts, Rajasthan has increased the tax levied on alcohol and cigarettes. The state also increased value added tax (VAT) from 12.5% to 14% when it announced its 2009-10 Budget on Wednesday.
But measures taken by the states to boost organic sources of revenue (those that do not come from the Centre) could disrupt the implementation of a proposed goods and services tax (GST).
“The GST will be a much stronger, well-structured tax…but a tax like GST can be a jungle,” said Satya Poddar, partner at Ernst and Young’s policy advisory group, in a phone interview. “VAT uniformity between the states is now degenerating, that is very bothersome because these changes could affect the simplicity of GST.”
Poddar says the smaller, poorer states are likely to benefit more from GST than their larger, better-off counterparts because these states have a weaker administration facility to collect taxes. A centralized scheme such as GST can help shore up tax revenues for the long term.
The benefit from GST might not be realized during this economic downturn. Both Poddar and Rao think the government’s expectation that the GST could be implemented with effect from 1 April is too optimistic. Poddar thinks a two-year time limit is more appropriate, but first the government needs to put in place a mechanism for organizing the GST.
“Once GST is in place, I think it will boost growth by 2% of GDP,” says Poddar. “But at this junction political skills are essential to keep the states harmonized.”