The worrying state of State finances

India’s fiscal health is a two-sided coin. While the Centre has consolidated its books, States have run in reverse. The aggregate States’ fiscal deficit widened from 2 per cent of GSDP (Gross State Domestic Product) in FY11-12 to 3.6 per cent in FY15-16. These deficits are likely to stay wide this year, keeping borrowings high and delaying consolidation plans.

This was not always the case. In the decade to 2014-15, States were more prudent than the Centre. The State-level Fiscal Responsibility and Budget Management (FRBM) thresholds were adopted in a staggered fashion from the early 2000s. Consolidation got underway from 2005, leading to smaller revenue deficits and sub-3 per cent fiscal deficits.

Somewhat naturally, these deficits deteriorated during the 2008-09 crisis but stabilised thereafter until 2014-15. Strong growth, better collections with the value-added tax, lower interest payments and the shifting of some spending to the Centre’s books all helped keep deficits under control. The quality of expenditure amongst States was also more favourable than at the Centre.

More recently, these trends have weakened. States’ spending commitments have risen as revenues stagnate. This is mainly due to higher revenue expenditure (i.e. recurring-committed expenses) which make up three-fourths of all spending, narrowing the scope for capital-productive expenditure. Consequently, the revenue-to-capital ratio has ticked up. Revenue expenditure will remain sticky this year and weigh on the FY17-18 fiscal balance. (As revised FY16-17 and budgeted FY17-18 data are not yet available for all States, my observations are based on budgets of 12 States.)

Ongoing and upcoming spending commitments include:

A) Public sector wages-pensions increased in FY16-17, following the Seventh pay commission’s (PC) proposals. The burden is particularly high as States are bigger employers than the centre. The Fifth and Sixth Pay Commissions pushed up expenditure by 1.0 per cent and 1.4 per cent of GSDP over a two-year period. The Seventh PC was implemented last year and, given lower arrears, the cumulative impact will be within 1 per cent of GSDP over last and this year. With wages and pensions accounting for more than one-third of revenue expenditure, we see upside risks to the budgeted pace of 12 per cent YoY for FY17-18 (against vs 22 per cent in FY16-17). Accordingly, the revenue surplus will be smaller than the budgeted 0.5 per cent.

B) The interest burden from a funding scheme for distressed power distribution companies (UDAY initiative) will also weigh on the books. Under this arrangement, States took over 75 per cent of the outstanding debt of the companies in a staggered manner in FY15-16 and FY16-17. Interest due on this debt will lift revenue expenditure from FY16-17 onwards.

Currently, 27 States have agreed to be a part of the scheme, of which about half incur high distribution losses, according to industry reports. The Economic Survey estimates that fiscal deficits can widen by an average of 0.5 per cent of GSDP due to this initiative. In a few States the adjustment could be higher. For instance, detailed budgets of one State points to a revised FY16-17 deficit of 4.3 per cent of GSDP including UDAY, double the budgeted scale.

C) The rollout of the Goods and Services Tax in July 2017.

D) Farm loan waivers add to the pressure. The Uttar Pradesh government was the first to outline such a waiver last month and could cost the exchequer an estimated ₹360 billion. Maharashtra and Punjab followed soon after, with Madhya Pradesh and Tamil Nadu reportedly considering such an initiative. Demerits of such a scheme and resultant moral hazard is being debated. But that aside, if more States jump into the bandwagon, revenue spending is likely to accordingly rise further and widen states deficits;

Given all this, it is reasonable to believe that above-budgeted revenue expenditure will keep the FY17-18 deficit above 3 per cent of GDP.

At the other end of the equation, while State spending is rising faster than the Centre, revenue growth trails. More than half of the States’ total revenues are raised through taxes, primarily sales taxes and excise duties, which have been moderating in recent years.

The other source of revenue support is aggregate transfers from the Centre, which comprises States’ share of central taxes and grants-in-aid. Last year, the States’ share in the Centre’s pool of taxes was raised from 32 per cent to 42 per cent. Nevertheless, the benefit was offset by lower grants.

This meant that in exchange for higher tax transfers, the Centre lowered its funding support for centrally sponsored schemes (CSS), obliging States to fund their own programmes. Netting off the two, State revenues are estimated to have declined by 0.3 percentage points last year, according to the central bank. This is likely to impact this year’s finances as well as the CSS list expands.

The next thing to watch is the rollout of the GST. The GST is meant to be revenue-neutral but some gains will accrue with a lag. States have been assured compensation for five years if revenue growth falls below 14 per cent. There will, nonetheless, be inter-state variations.

My observation of pre and post GST of revenue sub-heads suggests that the States’ share might rise from the present 42:58 share of the pool. In the long term, this move to consolidate the tax structure is expected to help boost India’s tax to GDP ratio.

In view of higher spending requirements and easing revenue growth, we expect fiscal consolidation to take a backseat this year. The FY16-17 deficit is likely to average 3.5 per cent of GSDP, well above the budgeted level of less than 3 per cent. The aggregate FY17-18 fiscal deficit is likely to average 3.0-3.2 per cent of GSDP, breaching the FRBM threshold for a third consecutive year. The government has approved a leeway of 50-75 bps in the fiscal targets until 2019-20, provided certain pre-conditions are met. The majority of the States however don’t qualify.

Consolidated deficit levels are likely to be elevated at 6.5 per cent this year and above 6 per cent of GSDP next year. This has two implications. Firstly, higher deficits have led to a steady climb in the States’ borrowings. These threaten to harden borrowing costs and crowd out the private sector.

Secondly, India’s cumulative fiscal deficit has been a constraint on the sovereign’s credit rating. This is one of the reasons why, despite the positive reform momentum, rating agencies have been reluctant to raise India higher in the investment grade status.

The writer is an economist and vice-president of DBS Bank, Singapore