States will need years to recover from 'scissor effect' of Covid: RBI

Phenomenon refers to loss of revenues due to demand slowdown, coupled with higher expenditure associated with pandemic, may push the states to great strife

States are witnessing “unprecedented pressures” on their fiscal positions after the Covid-19 pandemic and the next few years are going to be challenging for most of them, according to a report on state finances by the Reserve Bank of India (RBI). 

A possible ‘scissor effect’ - loss of revenues due to demand slowdown, coupled with higher expenditure associated with the pandemic, may push the states to great strife, the report warned. 

"The debilitating combination of compression in tax receipts and ramped-up expenditures has generated unprecedented pressures on fiscal positions at sub-national levels," the report, released on Tuesday said, adding, the “quality of spending and the credibility of state budgets will assume critical importance.” 

The report studied the state budgets, most of which were presented before the pandemic struck. But the RBI added its own analysis on what the states can expect going forward after they are done with their fight against the pandemic. 

 

For example, states that presented their budget before the pandemic had penciled in an average gross fiscal deficit (GFD) of 2.4 per cent of gross state domestic product (GSDP).  However, the states that presented their budgets after the lockdown showed the deficit at an average of 4.6 per cent of GSDP, according to the report. On a consolidated basis, the deficit was coming at 2.8 per cent of the consolidated GDP.  

“Thus, from the financing side, states’ combined GFD-GDP ratio is likely to remain around 4 per cent with a bias tilted to the upside, higher than the budgeted 2.8 per cent of GDP, albeit with state-wise variations," the RBI report estimated.  

For 2020-21, more than half of the states had budgeted for revenue surpluses. But the Covid-19 crisis is likely to undermine fiscal targets and associated receipts for 2020-21.  

“The duration of stress on state finances will likely be contingent upon factors like tenure of lockdown and risks of renewed waves of infections, all of which make traditional backward-looking tax buoyancy forecasting models unreliable,” it said.  

The states will likely cut costs on water supply and sanitation, rural and urban development, spending on energy and transport, even as they budgeted higher spending on education. Although states generally receive and spend about one fifth of their budgeted allocations during the first quarter each year, they have maintained their spending at previous years’ levels in 2020-21, despite receiving only one-eighth of their budgeted revenues, the report noted. 

The revenue impact on states will come mainly from taxes on commodities and services.  Stamp duties, which are a major source of revenue under states’ direct taxes, will likely witness a shortfall because of contraction in construction activity, reverse migration of labourers and social distancing norms.  

Extension of deadlines for payment of taxes to provide relief to businesses and citizens may further exacerbate the already worsening revenue situation of states. 

State GST plummeted by 47.2 per cent during the first quarter of 2020-21 - sharper than the overall GST decline – but in the second quarter ended September, the decline moderated to 6.4 per cent.  

Central tax transfers to states could also witness a fall by a significant margin. Of the total revenue receipts of states, central tax transfers comprise 25 to 29 per cent, while own tax revenues have a share of 45 to 50 per cent. But it is “highly likely” that there would be a large shortfall in the divisible pool in 2020-21, the report said. 

To garner some additional revenues, 22 states and union territories hiked their duties on petrol and diesel, while 25 states and UTs hiked duties on alcohol. 

 

However, revenue receipts are likely to be cushioned by revenue deficit grants, which compensate for deficits that prevail even after devolution, and the GST compensation cess. The share of grants is particularly high for special category states, mainly due to higher revenue deficit grants. The revenue deficit grants in 2020-21 are, in fact, more than double the average of the previous few years. 

“On the whole, states’ fiscal response to Covid-19 should reflect in a larger increase in revenue expenditure in 2020-21 than budgeted. These spendings coupled with revenue receipts shortfall are likely to convert revenue surpluses as budgeted in 2020-21 into large deficits," the report observed.  

To make good their deficits, the states are increasingly borrowing from the markets. From about half of their consolidated fiscal deficits till 2016-17, the share of market borrowings has increased to about 90 per cent in 2020-21. Part of the reason for such higher borrowing is rising redemption pressure, which will more than double from 2026 onwards. 

The report praised states like Odisha and Haryana for being pragmatic in trying to meet their higher fiscal deficits by “using their own rainy funds without recourse to higher permissible market borrowings.” But there are states “like Gujarat and Punjab which have over-borrowed despite consolidation, with Uttar Pradesh being an extreme case - it has borrowed above 20 per cent of the budgeted amount, despite registering a fiscal surplus as against a budgeted deficit in 2019-20.” 

States that are at the frontline of the battles against Covid will witness their fiscal arithmetic for 2020-21 suffering the most. 

“While the focus during the first few months of 2020-21 has been on managing the health crisis, it is the regional and spatial dimensions of structural features like demography, health care systems, migrant workers, digitisation and strength of the third tier which are likely to play an important role going forward in determining the fuller macroeconomic impact of the pandemic on state finances,” the RBI report said.