Deficit danger: The perilous state of state finances

By: |
November 03, 2020 7:45 AM

A 10% Contraction in tax revenues and a shortfall of Rs 50,000 cr in non-tax revenues & central grants means states will see a revenue shortfall Rs 5.5 lakh crore

RBI must be complimented for its analysis and the annual compilation of all the states’ and Union Territories’ (with legislatures) budget data.RBI must be complimented for its analysis and the annual compilation of all the states’ and Union Territories’ (with legislatures) budget data.

Usually, media focus on the fiscal situation is confined to the Union government, but states raise 37% of the total government revenues and implement over 60% of total government expenditures. They incur almost two-thirds of total government capital expenditure.

The only time the finances of the state governments get noticed is when the Reserve Bank of India (RBI) publishes the annual State Finances: A Study of Budgets. The report for the current year presents the budget estimate for 2020-21, the revised estimate of 2019-20 and the actuals of 2018-19. The analysis also refers to the provisional actuals for 2019-20 compiled by the Comptroller & Auditor General (C&AG). RBI must be complimented for its analysis and the annual compilation of all the states’ and Union Territories’ (with legislatures) budget data.

This is the only source of detailed data on revenues, expenditures, deficits and debt for all states available in one place. Of course, the researchers should use the data with caution for, in the report, the data on revenues and expenditures from items such as lotteries and departmentally-run public enterprise (Punjab Roadways for example) are shown in gross terms, inflating both revenues and expenditures. RBI will do well to make these adjustments to ensure inter-state and inter-temporal comparability, but that is not for discussion in this column.

The analysis presented in the report highlights several important issues. First, the budgetary data for this year are completely irrelevant.

The aggregate fiscal deficit of the States for 2020-21 is budgeted at 2.8% of the GDP. This is expected to go completely off-track owing to the pandemic, because both the numerator and denominator will likely change drastically. The denominator will change as the GSDP will decline. The sharp decline in revenues and pandemic-related additional expenditure will likely increase the deficit numbers sharply.

Despite many observers branding states as profligate, history shows, that states, in aggregate, have adhered to the FRBM targets on fiscal deficits in the past. Although, in FY20, the revised estimate shows aggregate fiscal deficit at 3.2%, the provisional accounts by the C&AG show that the states compressed both revenue and capital expenditures to 2.6% to conform to the budget estimate. Thus, states tend to comply with the FRBM targets, but at the cost of displacing capital and maintenance expenditures.

In fact, capital expenditures in the states tend to be residual.  The report does not make any guesses about the likely impact of the pandemic on states’ finances, except stating that FY21 state budgets have lost relevance, owing to a sharp decline in own-revenues and transfers from the Centre. However, it is not very difficult to guess the likely impact. The aggregate states’ own tax revenue is budgeted at Rs 15 lakh crore and tax devolution at Rs 8.17 lakh crore.
Assuming a 10% contraction in the revenues, the shortfall in states’ own tax revenue would be Rs 2.8 lakh crore and in tax devolution Rs 1.8 lakh crore. Assuming a shortfall of Rs 50,000 crore in non-tax revenues and grants from the Centre, the total tax revenue shortfall is likely to be close to Rs 5 lakh crore. If contraction in own revenues and additional pandemic-related expenditures are factored in, the shortfall in revenues and additional expenditures will add up to Rs 5.5 lakh crore, which works out to 2.8% of the GDP.

This would result in a sharp increase in revenue deficit. Although the Union government has permitted the states an additional borrowing of 2% of the GDP on fulfilling four sets of conditions, all states may not fully avail this, and the additional borrowing could be about 1.5% of the GDP. Thus, of the 4.5% borrowing, almost 2.8% will be for financing the revenue deficit. Capital expenditure will be compressed to 1.7% as compared to 2.6% in FY19 and 2.9% in the revised FY20 estimates.

The ratio of outstanding liabilities of states has steadily increased from 22.6% of the GDP at the end of March 2013 to 26.3% at the end of March 2020. With the gross fiscal deficit at the state level close to 4.5% of the GDP and with substantially lower GDP, the ratio of outstanding liabilities could be as high as 33.6% by end-March 2021, which is almost seven percentage points higher than the budget estimate. In addition, with the state governments being given Rs 90,000 crore liquidity for power utilities, the contingent liabilities are likely to be higher than the 3% of the GDP laid down as a part of the FRBM.

All states are faced with serious fiscal challenges in the current year. In fact, there has been a deterioration in the fiscal balances even before the pandemic set in. In FY19, while the aggregate revenue deficit was just 0.1% of the GDP, 10 out of 31 dtates had varying ratios of revenue-deficit-to-GDP, with Andhra Pradesh (1.6%), Kerala (2.2%), Punjab (2.5%), Rajasthan (3.1%) and Tamil Nadu (1.4%) showing large numbers. In FY20, the situation worsened with 15 out of the 31 states showing revenue deficits and others, lower revenue surpluses. Andhra Pradesh (2.7%), Bihar (3%), Chhattisgarh (2.9%), Kerala (2%), Punjab (2.2%), Rajasthan (2.7%) had large revenue deficits. The situation is similar with regard to fiscal deficits.

In 2018-19, among the large states, the ‘3% of the GDP’ limit was crossed only by Andhra Pradesh (4.1%), Kerala (3.4%), Rajasthan (3.7%), and West Bengal (3.1%). However, in FY20, the revised estimate shows ‘higher than 3%’ limit breached for as many as 16 states, and, among the large states, the situation was really worrisome in Bihar (9.5%), Chhattisgarh (6.4%) and Kerala (3.6%).

Not surprisingly, the sharp erosion of revenues caused by the pandemic has forced several states to initiate measures to contain expenditures and raise additional revenues. The measures taken to limit expenditures include deferment of salaries, freezing of DA, suspension of leave encashment, rationalisation of travel, vehicle and establishment expenditures.

The revenue augmentation measures include additional taxes on alcohol and petroleum products. Some states have initiated measures like monetising land through their urban development agencies and regularisation of transgressions at a high fee. Some of the states, like Kerala, Punjab and Tamil Nadu, have appointed committees to recommend reforms for the revival of the economy. The actual implementation of the measures remains to be seen, but, hopefully, the opportunity provided by the pandemic will not be wasted.


Chief economic adviser, Brickwork ratings. Member of 14th Finance Commission and former Director, NIPFP. Views are personal

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