Fiscal weakness

State finances can impede growth

The Covid-19 pandemic-related disruption has had a material impact on government finances all over the world. In the Indian context, while the focus usually is on the Union government, it is critical to not lose sight of state government finances as they do the bulk of the general government spending. States were at the forefront of battling the pandemic, both in terms of providing medical care and supporting the vulnerable sections of the population at a time when revenues took a severe hit. Their finances, as a result, were hit considerably. However, aside from this one-time shock, there are other underlying weaknesses that are affecting a number of states and could become a risk for overall growth and development. Economists at the Reserve Bank of India have done well to highlight some of these risks in their latest monthly bulletin. 

Before the onset of the pandemic, the average gross fiscal deficit (GFD) to gross domestic product (GDP) ratio was at 2.5 per cent, though some states ran fiscal deficits above 3.5 per cent. But the pandemic significantly affected government finances. The study has highlighted 10 vulnerable states based on their debt stock in 2020-21. Their GFD to GSDP ratios were also at 3 per cent or above. These states — Punjab, Kerala, West Bengal, Bihar, Jharkhand, Rajasthan, Madhya Pradesh, Andhra Pradesh, Uttar Pradesh and Haryana— are critical as they account for half of the total expenditure by state governments in India. The study further points to a subset of five highly stressed states —Bihar, Kerala, Rajasthan, Punjab, and West Bengal. 

There are a number of reasons why state finances should worry the policy establishment. While revenue collection has been an issue in general, some states are witnessing a decline in their own tax revenue. Further, the quality of expenditure is not as desired. Revenue expenditure constitutes about 80-90 per cent of total expenditure in these states, which clearly affects their ability to spend on growth-enhancing asset creation. The study also underlines several risks to state government finances. The growing preference for distribution is a big risk at a time when finances are under pressure. Some states reverting to the old pension scheme is also a cause for concern. The guarantees extended to state-owned enterprises and the mounting debt of power distribution companies are another source of risks for states. According to estimates, the off-budget borrowings of state governments have increased to about 4.5 per cent of GDP. 

What is worrying is that the situation in some of the indebted states is unlikely to improve in the medium term. Projections suggest that most states would have a debt-GSDP ratio of over 30 per cent by 2026-27. Punjab is likely to be in the worst position with debt in excess of 45 per cent of GSDP. The study also underscores that debt in the five most indebted states is not sustainable anymore and is growing at a pace higher than the GSDP. The end of the compensation regime under the goods and services tax would further weaken the fiscal position of the states. Given that the general government debt has increased sharply, India needs an overall medium-term consolidation road map. An unsustainable level of debt in some of the large states would not only affect growth prospects, but could also pose risks to macroeconomic stability.