Leave States to fix their own fisc

India works with the principles of cooperative federalism under which expenditure made and taxes raised are both responsibilities shared between the Centre and the States. In principle, these responsibilities are shared in a finely-held balance. In practice, the balance is skewed, like it is in many other federal systems in the world. While the Centre has a larger share of  the revenue, the States are closer to the ground and have greater responsibilities, especially in economic and social services. In India, the States incur over 60 per cent of the total general government (both Centre and State combined) expenditure. This skewness, technically called ‘Vertical Imbalance’ in fiscal management, is corrected through the transfer of resources (which covers taxes and grants) from the Centre to the States.

Guidelines for use of interest-free loans to States not clear, raising concerns over accountability

The Finance Commission recommends the tax devolution and grants to States. In addition to this, the Central government also gives loans to State governments. The 12th Finance Commission however recommended that the Centre should not provide loans to States as it is tantamount to financial intermediation by the Centre. The resource requirement in place of loans from the Centre should be met by market borrowings. This fiscal management in terms of tax devolution and providing grants creates a fiscal environment of dependency of the State governments on the Centre, even though the tax devolution and non-discretionary grants are constitution-based.

Many of the State governments have not had the privilege of raising resources through market borrowings even though the RBI as the debt manager facilitates such borrowings. However, raising resources through market borrowings has an element of fiscal stress in terms of market-determined interest rates.

In the above context, two key issues are the 50-year interest free loans to State governments and the Central government fixing the target of 3.5 percent fiscal deficit to GDP ratio for all the State governments. Both of these take the appearance of doing good for the States – one gives money and the other seeks responsibility in spending. But in fact, both are limiting the States. Loans make States more dependent and less market-oriented by having an easy arrangement with the Centre rather than market logics that borrowings will bring.

The fixing of a fiscal deficit target of 3.5 per cent of fiscal deficit to the GDP ratio by the Central government is a paternalistic imposition that ignores and therefore undermines the fact that there are fiscal rules in terms of Fiscal Responsibility Legislation (FRL) for State governments at 3 per cent of the GDP.

The Union budget announced 50-year interest free loans amounting to Rs. 1.3 lakh crore or 0.43 percent of the GDP for 2023-24 to the State governments to be spent on capital expenditure within 2023-24. Most of this will be at the discretion of the States, but a part will be conditional on the States increasing their actual capital expenditure. Parts of the outlay will also be linked to, or allocated for, the following purposes: a) scrapping old government vehicles, b) urban planning reforms and actions, c) financing reforms in urban local bodies to make them creditworthy for municipal bonds, d) housing for police personnel above or as part of police stations, e) constructing “unity malls”, f) children and adolescents’ libraries and digital infrastructure, and g) the State’s share of capital expenditure of Central schemes.

This is the second year the loans are on offer. The Union budget for 2022-23 allocated Rs. 1 lakh crore or 0.37 percent of the GDP to assist the States in catalysing overall investments in the economy. These 50-year interest free loans during 2022-23 and 2023-24 are over and above the normal borrowings allowed to the States. This allocation was meant to be used for the PM Gati Shakti-related spends and other capital investment of the States. It will also include components for: a) supplemental funding for priority segments of PM Gram Sadak Yojana, including support for the States’ share, b) Digitisation of the economy, including digital payments and completion of the OFC network, and c) reforms related to building bye laws, town planning schemes, transit-oriented development, and transferable development rights.

Thus, in both the budgets, there are too many purposes and there is no continuity. It is not clear whether the loan can be given for any one of these purposes or a combination of purposes. The principle of the disbursement of loans to the State governments is also not clear.  To that extent, there is scope for favoured treatment to certain State governments, violating in spirit at least the idea of cooperative and competitive fiscal federalism. It would have been appropriate for the Union budget 2023-24 to record some of the developments for the 50-year interest free loans such as the total amount disbursed, principles of disbursement of loans and number of States availing of the disbursement. Without that, the exercise lacks rigour and represents a further lowering of standards with which the fisc must work.

State governments often sacrifice capital outlays during business cycle downturns to contain overall spending for achieving their deficit targets

As mentioned in the Union budget 2023-24 and 2022-23, these interest-free loans have been provided to State governments to enhance the allocation of capital expenditure. The RBI annual study on State budget 2022-23 has raised some concerns. First, the actual capital outlay of States during a year is considerably lower than the budget estimates made at the beginning of the year.  For e.g. in 2020-21, the States were able to execute only 69 per cent of their budgeted capital outlays. Secondly, the deviation from budgetary targets is comparably much smaller for revenue expenditure, which is mostly committed expenditure in nature. Third, State governments in India often sacrifice capital outlays during business cycle downturns to contain overall spending for achieving their deficit targets. Fourth, fiscal marksmanship relating to capital outlay varies significantly across States.

While the average capex cut vis-à-vis budget estimates for the three-year period from 2017-18 to 2019-20 was 21.3 per cent (cumulatively for all States), States and UTs like Jammu and Kashmir, Goa, Tripura, Punjab, Andhra Pradesh and Delhi have cut their budgeted capex by more than 40 per cent. Fifth, the highly skewed monthly distribution of capital outlay by States poses another cause for concern. For e.g. during the last five years, on an average, States were able to spend only a third of their full year spending during H1, with more than a quarter of the total spending being undertaken in the last month i.e., March. This suggests a residual approach to spending – which essentially is covering up with spends that may and often are poorly executed just to meet deadlines.

The Central government should set an example to the States by adhering to its own FRL target

Another important aspect is the fiscal deficit target fixed by the Union government when each State government has its own FRL. According to article 293 (3), the State governments have to take permission of the Centre to access the market. However, fixing the target by the Central government for State government borrowings is not in the interest of cooperative fiscal federalism particularly when the States have their own FRL. It may be noted that the RBI study of State Budgets 2022-23 has mentioned that in 2020-21, States’ consolidated gross fiscal deficit (GFD) rose to 4.1 per cent of gross domestic product (GDP), the highest level since 2004-05. The spike, however, was short-lived and a reversion to consolidation was crafted in 2021-22 (actuals) taking the GFD down to 2.8 per cent of GDP, as against the Budget Estimates of 3.5 per cent and Revised Estimates of 3.7 per cent for that year. This correction was brought about by a higher-than-expected growth in both tax and non-tax revenues. In 2022-23, the States have budgeted a consolidated GFD of 3.4 per cent of GDP, which is within the indicative target of 4 per cent set by the Centre, albeit, with substantial inter-State variations.

In the interest of prudent fiscal management, the sooner the State governments return to the FRL target of 3 per cent and the debt level of 20 per cent, the better will the fiscal management be.  The Central government should set an example to the States by adhering to its own FRL target.

(The writer is a former central banker. Views are personal)