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The State of State Finances

Only a generous award by the Fifteenth Finance Commission can restore fiscal balance.

State finances are in dire straits. A reliable indicator of this is the steady rise in state debt after a long hiatus. Total debt of the states has gone up by 4.6 percentage points of the gross domestic product (GDP) over the last six years, as highlighted in the recent report on state finances by the Reserve Bank of India (RBI), from a low of 22% of the GDP in 2014–15 to touch a peak level of 26.6% as per the budget estimates of 2020–21. The rapid build-up of the state debt is a sharp reversal of the previous trends when the state debt shrunk by around 10 percentage points of the GDP from a peak level of 31.8% in 2003–04. Moreover, the pace of growth of the debt burden of the states was almost four times faster than that of the central government whose debt levels have only edged up by 1.2 percentage points of the GDP, from a low of 49.4% of the GDP in 2017–18 to 50.6% in the budget estimates for 2020–21.

The sharp acceleration of the state debt, as compared to that of the centre, indicates that deterioration in state finances has certainly to do with something much more than just the slowdown in the economy. One important reason for the fiscal distress in the states is the compression in the resource flows from the centre to the states. Though the Fourteenth Finance Commission has substantially increased the state’s share of central taxes from 32% to 42%, the central government has unfortunately thwarted the commission’s mandate by mobilising additional resources through non-shareable cesses and surcharges. By one count, the use of non-shareable cesses and surcharges by the centre to mobilise additional resources has effectively reduced the state’s share of the central taxes, from 42% assigned by the Fourteenth Finance Commission to just 32%. Similarly, the cut in corporate tax rates and goods and services tax (GST) rate cuts, as prompted by the centre, have also negatively affected resource flows to the states.

Another reason for the surge in state debt is their escalating expenditures, which has gone up by more than a percentage point of the GDP over the previous five years to reach a peak level of 18% of the GDP in the revised estimates for 2019–20. The reasons for this are many. Apart from inflation and the implementation of the pay commission award by the states, other acts of commission and omission by the central government have also burdened the states. The states had to take over the debts of the power distribution companies as a part of their financial restructuring under the Ujwal Discom Assurance Yojana (UDAY). Similarly, the loan waivers declared by the states in response to the growing farmer distress in the country, also cost the states dearly. In contrast, the states’ own tax revenues and total states own revenue crept up by a meagre 0.2 and 0.5 percentage points of the GDP during the period. The main reason for the flailing own tax receipts of the states is the glitches in the GST roll out, which has negatively hit tax collections.

The surge in state debt and the compression of their fiscal leeway has already had a negative effect on the spending patterns. Development spending by the states, which peaked at 67.6% of the total state government spending in 2016–17, has fallen to 63.4% in 2020–21. Numbers indicate that despite the fiscal compression, the states have so far been able to buoy up their social development expenditures, the largest allocations of which are for education, health, and water supply and sanitation, which went up by a few marginal points to around 57% of the total development spending. In contrast, the share of economic services in development spending, the largest allocations of which are for agriculture, rural development, transport and energy, have been reduced to around 42%. This will certainly constrain medium-term growth.

It is in this scenario that the states have now been left to fend off the pandemic and its impact, which has already further bloated the fiscal deficit of the states. While the average fiscal deficit was 2.4% of the gross state domestic product (GSDP) in the 2020–21 state budgets presented before the pandemic, it almost doubled to 4.6% of the GSDP in the budgets presented after the break of the pandemic. Current trends indicate that even the conditional increase in the states borrowing limits from 3% to 5% of the GSDP is likely to be inadequate to meet the ballooning resource needs of the states if the expected recovery remains evasive. The partial recovery of state GST collections in the second quarter has somewhat softened what the RBI has called the scissor effect, with expenditures surging and revenues collapsing. But the huge pandemic-related spending on healthcare and income support for the worst affected will also push down the investment spending by the states, which will affect growth and kick off a vicious cycle that feeds on itself.

Countering this would require the states to reprioritise spending with a special focus on high multiplier capital projects with low gestation periods and also in building healthcare facilities and support systems like better social security nets. Similarly, universal health coverage has to be rolled out in the deficit states. Finally, fiscal policy of the states also has to be re-engineered so that fiscal spending becomes anti-cyclical, rather than procyclical, and function as a stabilising tool. But all this can happen only if there is a substantial shift of resources to the states, hopes of which now rest on the second report of the Fifteenth Finance Commission providing a more generous share of the resources to the states to meet their rapidly growing responsibilities.


Updated On : 24th Nov, 2020


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