Illustration: Jayachandran/Mint
Illustration: Jayachandran/Mint

Opinion | Need to focus on state government finances

States need to be cautious as they get higher expenditure responsibilityand this is not going to be easy given their limited autonomy in revenue collection

The widening of the fiscal deficit has re-emerged as a cause of concern for the Indian economy. There is a fear that the Central government could overshoot its fiscal deficit target for FY19 as goods and services tax (GST) revenue has been falling short of target and there could be increased expenditure commitment in a pre-election year. Also worrying are the finances of state governments. As per a recent Reserve Bank of India (RBI) report on state government finances, the consolidated fiscal deficit of the state governments in FY18 was 3.1%, against the budget estimate of 2.7%.

A look at the long-term trend shows that while the Central government fiscal deficit has narrowed—aided by the hike in excise duty on petrol and diesel—from a high of 5.9% in FY12 to 3.5% in FY18, the state government fiscal deficit has been widening. The share of state governments in the combined (Centre plus state) fiscal deficit has widened from 18% in FY12 to 44% in FY18. Consolidated state government expenditure is around 1.4 times the size of the Central government expenditure. Five years ago, state government expenditure was around the same as Central government expenditure.

While the state governments’ expenditure commitment has increased over time in line with the spirit of fiscal federalism, they still have limited autonomy in revenue collection. The states’ own revenue as a percentage of total revenue receipt is around 50%, while the rest is transferred by the Centre. As highlighted by the Economic Survey, 2017-18, this ratio is at a much higher level of 75-80% for other economies such as Brazil and Germany that have a federal government structure like India’s. With the introduction of the GST, state autonomy reduces further as states do not have the power to independently decide GST rates. The rates are decided jointly by the Centre and states.

While, in the past, state government finances did not attract much attention, their significance has increased in the last few years. With rising expenditure commitment, it is critical to emphasize the need for fiscal prudence among states. State finances also become important because of state governments’ increased reliance on market borrowings. The share of market borrowings in financing states’ fiscal deficit is estimated to increase from 63% in FY15 to 91% in FY19. Hence, the widening of state fiscal deficit now has more direct implications for interest rates in the economy.

State governments are bound by the FRBMA (Fiscal Responsibility and Budget Management Act) limiting fiscal deficit to around 3% of gross domestic product (GDP) and revenue deficit to 0%. On a consolidated basis, state governments had managed to keep their fiscal deficit below 3% since FY06. However, in FY16 and FY17, as state governments took over the debt of power distribution companies under the UDAY (Ujwal DISCOM Assurance Yojana) scheme, the fiscal deficit breached the 3% level. What is worrying is that fiscal deficit exceeded 3% in FY18 even after the termination of the UDAY scheme. The revenue deficit has also been widening. Revenue deficit averaged 0.3% in the last four years, worsening from an average of 0% in the five years before that. State governments have budgeted a narrower fiscal deficit of 2.6% and a revenue surplus for FY19. A surplus in the revenue account is a good indicator as it implies that borrowings will be done only for productive capex outlays and not to meet regular revenue expenditure. While revenue surplus looks good on paper, achievement of this target looks difficult.

In the last fiscal year, farm loan waivers and the pay hikes of state government employees (considered revenue expenditure) were important factors putting pressure on government finances. Total farm debt waiver accounted for 0.3% of GDP and we may see a similar story being repeated in FY19. Non-productive expenses like farm loan waivers are eating into the capital expenditure of states. Capital expenditure as a percentage of total state government expenditure has fallen to 17% in FY18 and FY19 from 20% in FY17.

On the revenue front, total devolvement to states from the tax collected by the Centre has increased to 42% since FY16 (earlier, 32% was transferred to the states). However, after including the cesses/surcharges, the share of states in the Centre’s gross tax revenue fell to 34.6% in FY18 (from 35.4% in FY15) and is budgeted at about the same for FY19.

The introduction of GST is expected to widen the tax base and increase tax revenue in the long run. But, so far, the monthly collection from GST has been falling short of target. While states will be compensated by the Centre for the shortfall of GST revenue collection, the shortfall is nevertheless concerning. The recent reduction in GST rates for many items heightens concerns about revenue collection.

State governments’ debt has risen sharply in the last few years due to the UDAY scheme, farm loan waivers and pay revisions. The state government debt-to- GDP ratio has risen from 21.5% in FY15 to 24%. While the consolidated state government debt-to-GDP ratio is lower than the Centre’s (46%), the sharp rise in the last three years is cause for concern.

States need to be cautious as they get higher expenditure responsibility—and this is not going to be easy given their limited autonomy in revenue collection. On the expenditure front, states have to ensure that the quality of the expenditure is not adversely impacted—as reflected by the rising ratio of revenue to capital expenditure—in their bid to achieve the fiscal deficit targets.

Rajani Sinha is a corporate economist based in Mumbai.

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