How over-dependence on central funds is driving states to fiscal peril

The RBI report on state finances shows that states' own revenues are faltering, while its social spending is rising squarely on account of centrally-sponsored schemes

The Reserve Bank of India’s latest study on the financial situation of Indian states has underlined several key pain points that they face, such as their weakness in servicing debt, the falling quality of their spending, and the load of specific initiatives such as farm income support and power sector bailout on finances. 

A closer look at long-term data trends suggests states’ ability to garner their own revenues has been seriously curtailed in recent years. While their revenues from sales tax are dwindling, the Centre is sharing fewer resources with them by levying more and more taxes on which they do not enjoy collection rights. 

Then, their actual revenue mobilisation has mostly been lower than their projections at the beginning or in the middle of a financial year. States are now frequently overestimating their revenues in their budgets, only to settle at lower revenue and expenditure numbers later. Overestimation has been the highest in grants-in-aid. 

Many big states are also reeling under the spectre of a revenue deficit, meaning that a good part of their loans will go towards inefficient spending instead of being productively allocated. While capex, or capital expenditure is the money spent on producing or buying physical financial assets, revenue expenditure is that spent on relatively unproductive components such as administration, salaries and pensions. 

However, this has resulted into an uptick in the social sector spending of states. The report also shows that the focus of social sector spending is changing: housing and urban development are eating into the share of health and education, relative to economic growth.

“As these revenues have proved inadequate, relative to rising expenditure, states adapted by shifting towards other sources of taxes such as those on alcohol and stamp duties,” Care Ratings said in a report. 

States’ (in)ability, Centre’s smart moves

States’ revenues can be broadly divided into their own revenue from taxes such as goods and services tax (GST), sales tax and share in central taxes, and non-tax sources like dividends, power user charges and grants from the Centre. 

A big chunk of states’ own tax revenue was subsumed under GST, which is now controlled by the GST Council, whose chairman is the union finance minister. The second major part of own tax revenues, sales tax, has become a big pain point. 

States’ sales tax collection shrank from Rs 3 trillion in 2017-18 (four months of older sales tax and eight months of GST) to Rs 2.4 trillion in 2018-19 (revised estimate or RE). It has only grown to Rs 2.7 trillion in 2019-20 (budget estimate or BE). States’ projection of sales tax collection (BE) was the same in 2018-19 and 2019-20 (See Chart 1). 

State GST or SGST, which subsumed most of the sales taxes, grew strongly according to revised estimates for 2018-19. But its growth has fallen in 2019-20 BE to 11 per cent. This is being defied by current data on SGST revenue, which has shown a contraction over the previous year. 

GST revenues, fully dependent on the impact of decisions taken by the GST Council, are growing slowly due to excessive rate cuts in the first two years of implementation. 

Sales tax revenues, on the other hand, are growing slower due to political constraints on raising taxes on petroleum products, which contribute the most to sales tax. Moreover, a large chunk is levied in the form of ad valorem rates on base price after the application of the Centre’s excise duties over the landed price of the particular fuel (petrol or diesel), making states dependent on oil prices, which have been lower than normal. 

Things have further deteriorated due to the Centre's gradual reliance on cess and surcharge, rather than normal taxes. These types of tax revenues are not shared with states. Their share in gross tax revenue collected by the Centre rose from 8.8 per cent in 2012-13 to 15 per cent in 2019-20 (BE). 

Subsequently, the legitimate share of states in tax revenue collected by Centre dropped from the peak of 35.4 per cent in 2016-17—a year after the 15th Finance Commission recommendation to share 42 per cent of tax revenue with states was implemented—to 32.9 per cent in 2019-20 (See Chart 2). 

Estimates and reality

All the estimates provided by the states for 2018-19 are the revised estimates. But the actual collection/spending, expressed by the provisional accounts, are quite lower than the RE, the report says. 

Revenue receipts of states have been overestimated by a massive Rs 2.4 trillion, or more than one per cent of India’s GDP, in the RE, compared with the provisional accounts (See Chart 3). As a share of the economy, both receipts and expenditure have been severely cut in 2018-19 if better estimates are considered. 

“Revised estimates usually get revised downward when they crystallise into accounts,” the RBI report said. 

This means that the required growth in revenue receipts is now 20 per cent, against the 10 per cent required growth expressed by revised estimates. This 20 per cent requirement is too high compared to 8 per cent, the nominal economic growth achieved in the first three months of 2019-20. 

A recent report by Icra also underlined this point, especially on account of SGST. 

“Icra’s analysis shows that actuals were 6-7 per cent lower than the revised estimates. Accordingly, it is possible that the SGST collections and the GST compensations indicated by some of the states in the 2018-19 RE may subsequently be revised lower,” its note said.

Revenue deficit halting productive spending

The 2018-19 budgets by states together had projected a revenue surplus of 0.2 per cent of GDP (nearly Rs 34,000 crore surplus). This is important, as it means states had projected that they will earn more revenue than they need to spend on unproductive expenditure such as salaries, giving more leeway for productive capex. 

But in reality, they achieved a revenue deficit of nearly 0.1 per cent of GDP (deficit of Rs 13,000 crore). Large domains such as Maharashtra and Tamil Nadu run a revenue deficit of 0.7 per cent and 0.8 per cent of GDP, respectively, forcing them to allocate nearly half their borrowings to unproductive spending. 

Punjab and Haryana run a revenue deficit of more than 1.5 per cent of GDP, forcing them to expand their fiscal deficit to near or more than 3 per cent of GSDP. 

Social spending rises 

Looking at it in a silo, social spending now takes a bigger share in states’ overall expenditure. In the last decade or so, its share has grown from 41 per cent to 44.6 per cent. As a share of GDP, it has risen from 6.2 per cent to 8 per cent of GDP this year. 

But a lot has to do with a change in accounting practices used in state budgets, especially with regard to centrally sponsored schemes (CSS). 

All CSS funds are now routed through state budgets. As a result, CSS spending by all states, as accounted for in their budgets, rose massively from Rs 50,000 crore in 2016-17 to Rs 3.8 trillion in 2019-20 (BE). 

Earlier, CSS funds were routed directly from Centre to the implementing agency, which is now routed through state budget books, as a part of their non-tax revenues. 

This has inflated non-tax revenues in state receipts, from nearly Rs 5 trillion in 2016-17, to Rs 9 trillion in 2019-20 (BE).