We must worry about State finances

The Reserve Bank of India’s annual study of the State budgets (which is the primary source for disaggregated State-wise fiscal data) released earlier this month has highlighted three important factors which will guide the finances of the State governments in the medium term. These are Goods and Services taxes (GST), greater devolution of resources through statutory transfers from the Centre, and adherence to rule-based fiscal policy. The undertone of the RBI study reflects cautious optimism with a focus on GST, which has been termed as a ‘game changer’ for India.

The RBI study presents the accounts data for 2014-15, revised estimates data for 2015-16 and budget estimates data for 2016-17. An important development is that a preliminary analysis of State finances for 2017-18 has also been covered. This is a welcome step.

The deterioration in the consolidated fiscal position of States reflected in the Gross Fiscal Deficit (GFD) to GDP ratio in 2014-15 (2.6 per cent) and 2015-16 (3.6 per cent) resulted in the worsening of the average position of the last five years (2011-2016) at 2.5 per cent as against 2.1 per cent in the previous quinquennium. The fiscal deficit relative to GDP at 3.6 per cent was a record in recent history, crossing for the first time in 10 years the fiscal legislation deficit threshold of 3 per cent.

A part of this can be explained by loans and advances for power projects going up sharply due to the Ujwal Discom Assurance Yojna (UDAY). In 2015-16, eight States borrowed ₹989.6 billion under UDAY. Net of these bonds, the consolidated GFD-GDP ratio would be moderated by a 0.7 percentage point, coming down from a high of 3.6 per cent to 2.9 per cent — yet almost touching the threshold of three per cent prescribed by rule-based fiscal policy.

Another disquieting development in State finances (consolidated position of 25 State governments) is the large fiscal slippage in 2016-17 with the fiscal deficit as a proportion of the Gross State Domestic Product (GSDP) at 3.4 per cent in the revised estimates as compared with 3.0 per cent in the budget estimates for the same year. Such a wild deviation under the fiscal legislation regime brings into question budget integrity and raises grave doubts on the moderation of this ratio to 2.6 percent, the figure given in 2017-18 budget estimates.

The deterioration in the deficit indicator has been witnessed despite a much higher level of current transfers relative to GDP (6.6 per cent in 2015-16 from 5.1 per cent in 2011-12, 4.8 per cent in 2012-13 and a low of 4.7 per cent in 2013-14) from the Centre in terms of shareable taxes and grants-in-aid.

This highlights the simple fact that the deterioration is due to the stagnancy of States’ own tax revenue, which is unmoved from about 6.4 per cent of GDP and own non-tax revenue at about 1.2 per cent on an average since 2011-12. This stagnancy in revenue is coupled with higher provisioning of capital expenditure and non-interest revenue expenditure.

One of the most significant features in the 2016-17 State budgets has been stagnancy in capital outlay and increase in non-developmental expenditure in terms of GDP. This will impact economic growth translated from State budgets. The so-called budgeted improvement as set out in the 2017-18 budget needs to be assessed in the context of downside risks emanating from the implementation of States’ pay commission recommendations, farm loan waivers and the revenue uncertainty on account of implementation of GST.

The deterioration of the fiscal deficit resulted in higher borrowing for the States and consequent acceleration of debt to GDP ratio. A perusal of this data revealed that the outstanding liabilities of the State governments have increased from 22 per cent as a proportion of GDP as on end- March 2014 to 23.2 per cent at end–March 2016 and is budgeted to go up to 23.9 per cent at end- March 2017.

This is away from the 20-per cent level recommended by the FRBM Committee headed by NK Singh. Not only do State finances face a higher debt to GDP ratio, there is also the problem of repayment of maturing loans. The relevant data revealed that the residual maturity below five years comprises of 32 per cent of the total outstanding debt. These repayments will put pressure on fresh market borrowings by States and consequently fuel the vicious cycle of deficit and debt by generating an unsustainable fiscal position through higher interest payments.

As the RBI study shows, GST has many positive points for State finances, such as higher devolution of shareable tax because cess and surcharge will be clubbed in the total divisible tax pool. Also, GST will also facilitate tax collection because of the value added feature. This was also seen when we moved from the sales tax regime to the value added tax regime.

But to what extent will tax buoyancy go up due to GST? At this stage we have only the RBI’s perception and optimism on GST. The actual position will depend upon the effectiveness and efficiency of tax administration and voluntary compliance. The heavy reliance on central statutory transfer has contributed to a large extent to the improvement in finances of States. The States should make concerted efforts to enhance their own tax and non- tax revenue. In this context efficient delivery of services and commercial principle pricing of merit goods such as education, health, irrigation, etc assume critical importance. A smart fee structure coupled with efficient delivery of services will ensure that the offerings are truly beneficial to the people and are also well subscribed, and provide the added advantage of balancing budgets better.

The State budgets have an inherent problem of fiscal slippage with deterioration in finances when the budget estimates are translated in to revised and subsequently to accounts. Since the time lag is two years, public opinion on the budget integrity is not sharp. It is expected that the State governments under the fiscal legislation should refrain from this kind of budgeting.

The constitutional expenditure responsibility of States is vast. The unsustainable finances of States will not only hamper growth but will also come in the way of achieving a credible Human Development Index. This remains a weak link in the Indian system.

Pattnaik is a professor and Rattanani is an editor at at SPJIMR, Mumbai. Through The Billion Press