How is it that, in these times of distressingly slow economic growth, most state governments have been able to improve their revenue deficits? There’s a huge difference between the finances of the central government and the combined finances of the states—it’s a study in contrast. While the centre’s revenue deficits have been increasing, the states together have a revenue surplus.

But that’s not the whole story. The combined fiscal deficit of the states in 2011-12 is lower than the deficit in 2005-06, during the last boom. That takes some doing, because growth rates were much higher then. And while the states have managed to go back to the revenue surpluses they had during the boom years, the revenue deficit at the centre is far higher than the levels it was at during that time.

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There’s also another, bigger irony. The complaint against the central government is that it spends too little on investment and too much on subsidies and consumption. But RBI says the quality of expenditure of the states improved in 2011-12, with increases in development and social sector expenditures as well as capital outlay in proportion to GDP. And although there was an increase in the fiscal deficit to GDP ratio in 2010-11, this was used to fund higher capital outlays and not frittered away in consumption. Here are the numbers: in 2010-11, the combined development expenditure of the states as a percentage of GDP was 10.2%, higher than the 9.1% average during the 2004-08 boom years. What’s more, combined expenditure on the social sectors was 6.4% of GDP for the states in 2010-11, well above the average of 5.2% of GDP during 2004-08. The states seem to be able to have their cake and eat it too.

Of course, the performance among the states varies greatly, with West Bengal, Punjab and Kerala continuing to have high revenue deficits. The Prime Minister’s Economic Advisory Council (EAC) says the deficits in West Bengal and Punjab are well above the targets laid down by the Finance Commission.

But the key question is: how were the states able to manage this feat? One reason is higher grants from the central government. Central transfers have increased from an average of 4.7% of GDP during 2004-08 to around 5.4%. Most of the increase has happened, not in shareable taxes, but in grants-in-aid. But the states have taken care to direct the funds towards development. The share of non-development expenditure in the combined state budgets has dropped, as a percentage of GDP, from the levels they were at during 2004-08. Also, the improvement in the states’ fiscal position over the years can’t be explained by grants alone. In its macroeconomic review RBI says the consolidated revenue surplus of the state governments is budgeted to increase in 2012-13, mainly on account of an increase in the revenue receipts-GDP ratio, which is to be supplemented by a reduction in the revenue expenditure-GDP ratio.

In a study by BNP Paribas on state finances, Gautam Mehta and Manishi Raychaudhuri give a few reasons why the states have been fiscally more prudent. They write, “With no RBI open market operations to bailout government borrowings, state governments are subject to a lot more discipline by the bond markets. Moreover, the incentives of state governments are skewed towards fiscal prudence. The 13th Finance Commission has set the criterion for devolution to states based on four parameters—population (25%), area (10%), fiscal capacity (47.5%) and fiscal discipline (17.5%). States performing poorly on the fiscal discipline criterion may have to forgo a part of their share of central taxes or grants, and are, therefore, incentivized to be fiscally prudent." They also say single party state governments face less constraints in taking unpopular decisions. They point to the Trinamool Congress government in West Bengal, which has increased electricity tariffs, lowered state subsidies to urban transport and raised the price of milk supplied by state-owned corporations, despite being rabidly populist and opposing every move by the centre to raise fuel prices.

Of course, the state governments do have a big hole in their finances—their electricity boards are in terrible shape. The EAC says one estimate of projected losses of power distribution utilities puts them at 0.8% of GDP this fiscal.

Even so, the fact remains that, in spite of the constraints on revenue generation, many states have been able to go in for fiscal consolidation at a time when the centre has been very profligate. For example, the rise in the consolidated revenue deficit (centre + states) in 2011-12 is entirely due to the centre. The central government has a lot to learn from the states.

Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at capitalaccount@livemint.com.

Also Read | Manas Chakravarty’s earlier columns

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