Fiscal marksmanship: A look at budgets of states over 15 years shows they consistently overestimate revenues

February 23, 2021 6:50 AM

The fiscal marksmanship is poor due to the ‘Grants from Centre’ component of their revenue budgets

States either raise their own revenue through taxes or receive money from central transfers as the state’s share of central taxes and grants.States either raise their own revenue through taxes or receive money from central transfers as the state’s share of central taxes and grants.

By Prakhar Misra & Sharmadha Srinivasan

The first Union Budget of the Covid-19 crisis has garnered a great deal of speculation and attention, understandably so. Now, that attention should move to states that have experienced a massive revenue shock. Many states, from Maharashtra to Tamil Nadu, will present their budgets in the coming weeks. The states’ difficulty in crafting effective responses to Covid-19 has underscored the mess state finances are in and just how important state budgets are.
Given the lack of financing options, the states are looking to the Centre to finance their revenue gap, but poor fiscal marksmanship could severely hamper these efforts.

A look at the budgets of 28 states over 15 years shows that states consistently overestimate their total revenues. The fiscal marksmanship is particularly poor due to the ‘Grants from Centre’ component of their revenue budgets. The average overestimation of total revenues across all states and all 15 years was 10.79%. Some states clearly perform worse than the rest–Kerala overestimated its revenue in all 15 years by 7.14%, but Assam overestimated its revenues in 14 out of 15 years by an average of a massive 18.18%. The overestimation of revenues, despite different political economy contexts, points to a common structural problem.

States either raise their own revenue through taxes or receive money from central transfers as the state’s share of central taxes and grants. Data shows that the states do a much better job of estimating their own revenues as opposed to the transfers they receive from the Centre. The mean overestimation of the grants component (11.02%) is more than double the mean overestimation of state’s own revenues (4.47%). Grants are also much more volatile as measured by the standard deviation, which is 24.67% compared to the states’ own revenues at 7.9%. There are multiple reasons why marksmanship is especially poor for grants.

First, the grant-making process involves multiple institutions, which leads to problems such as poor computations and misaligned incentives. States project their revenue gap and basis that the Finance Commission recommends grants. Revenue gap estimation is a supremely complex task given the number of budget heads and sub-components under various departments and schemes. This naturally leads to errors. Additionally, there is also a problem of incentives. Given the importance of the revenue gap in grant allocations by the Finance Commission, states undertake fiscal dentistry—tinkering with the numbers so as to garner maximum revenues, moving numbers away from their true estimates.

Second, the Centre adds to the missed marksmanship in two ways. First, it simply cuts back on its grants when facing a higher deficit—creating a wedge between the estimates and actuals for the states. Admittedly, the latest Union Budget has been different, where the Centre has devolved more funds despite a massive tax revenue shortfall. But these are extraordinary circumstances.

In the normal course of things, the marksmanship of central government budgets has quite consistently been off the mark. Second, the centralised design of grants, especially those of centrally sponsored schemes, are such that they impose numerous exacting conditions on the states. When states are unable to adhere to these conditions, which are often unrealistic, the subsequent transfers of grants are held back by the Centre.

Finally, the states bear responsibility here as well. Beyond their poor estimation methods, budgeting is also held hostage to arbitrary expenditure policies by the government in an election year in order to woo votes. States also struggle to implement their own schemes well and adhere to timelines, contributing to variation in their own spending from the budget estimates. There are cyclical reasons, too, due to exogenous random shocks. The current crisis is a case in point, but governments can’t possibly control these. Poor fiscal marksmanship contributes to various issues beyond just budgeting. While estimation can never be accurate—there is enough scope to minimise these issues to a great deal.

 

Misra is a senior associate, and Srinivasan is an associate, IDFC Institute. Views are personal

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