By Invitation. States’ finances: Myths and facts

Myths and presumptions sometimes contain bits of facts. For sound economic analysis, however, it is necessary to disentangle these fragments. This is particularly true for the misconceptions around India’s state finances.

The growing discussion of States’ finances is a positive change — until recently, the focus was largely on Central government finances, even though States account for 40-60 per cent of India’s combined fiscal deficit and spending.

However, the blurred line between perception and facts has to be addressed. Three such misconceptions surrounding States’ finances are highlighted here.

This perception arises from the fact that States’ deficit during FY13-FY17 has offset 50 per cent of the fiscal consolidation at the Central government level. In fact, the States’ fiscal deficit (excluding UDAY bond issuance) was 2.7 per cent of GDP in FY17, significantly lower than the Centre’s 3.5 per cent deficit.

Equally importantly, States’ fiscal deficit over the past decade has remained well below the 3 per cent target mandated by the Fiscal Responsibility and Budget Management (FRBM) Act, again in contrast to the Centre’s finances.

While States’ fiscal deficit rose towards 3.6 per cent of GDP in FY17 after the inclusion of UDAY bonds (issued to restructure state electricity board debt), we see this as an optical rather than an actual breach.

State Electricity Board (SEB) debt has been an off-budget liability for States, so its inclusion in the calculation of States’ fiscal deficit is not a fresh liability.

Recent farm loan waivers in two States are equivalent to 0.4 per cent of GDP, and many more States are considering similar proposals.

This has raised concerns about the potential adverse impact on States’ fiscal deficit.

While this is undoubtedly a negative development, the additional burden on the fiscal deficit is likely to be limited to 0.5-0.7 per cent of GDP, spread over at least two years, rather than just in FY18.

This view is based on the following:

Some States (Andhra Pradesh and Telangana) have already budgeted for farm loan waivers in their FY18 fiscal deficit projections, and our 2.7 per cent estimate of States’ FY18 fiscal deficit already incorporates Uttar Pradesh’s farm loan waivers.

Not all outstanding loans are likely to be waived, either due to fiscal constraints or less political necessity to do so.

States are likely to absorb some of the additional costs of farm loan waivers by reducing other expenditure.

For instance, Andhra Pradesh waived farm loans of 1.2 per cent of GSDP in FY16, but its fiscal deficit widened by only 0.6 per cent of GSDP as it reduced other expenditure/raised revenue.

Implementation of the Goods and Services Tax (GST) from July 1, 2017, is likely to generate higher revenue for all States, offsetting some of the burden of farm loan waivers. States’ fiscal deficit is likely to be contained at 3 per cent of GDP in FY18 even in the worst-case scenario, below the Centre’s 3.2 per cent deficit.

While States have adhered to fiscal consolidation rules at the aggregate level, fiscal performance diverges widely among States. Over the past decade, at least 25 per cent of the 18 States in our sample consistently ran fiscal deficits wider than 3 per cent of GSDP, and 55 per cent ran revenue deficits. Fiscal consolidation rules required States to eliminate their revenue deficits by FY15.

These deviations are not surprising, as the current FRBM rules are not accompanied by stringent penalties. The accountability rules consist of reporting obligations (each State’s Finance Minister must submit a review and a statement explaining deviations to the State Legislature).

Borrowing limits for States (both market and non-market), which are set by the Central government and the Reserve Bank of India, are more closely followed by the States but have also been breached at times, without resulting in significant penalties.

The government is considering recommendations on reduced fiscal deficit targets for the Centre and the States (the NK Singh Committee report recommends a gradual reduction in the combined deficit to 5 per cent by FY23). However, giving teeth to these rules is required to achieve sustainable fiscal deficit and debt levels.

A further argument for stricter penalties is the current lack of credit differentiation among States of varying fiscal health. The yield differentiation between States that have adhered to FRBM rules and those that have consistently breached the targets is negligible.

Also, as States’ indebtedness to the Central government is rapidly declining (the Centre can decide on annual borrowing limits for States until the time States are indebted to it), a framework that ensures greater discipline is needed.

The writer is Head, Economic Research, South Asia, Standard Chartered Bank