Red flags on State Finances

It is well recognised that India lives in the States and the road to the nation’s development passes through the progress of the States. Given that, the budgetary performance of the States is an important subject, perhaps more so than the Union budget. But it is the latter that is the focus of many a discussion; such a spotlight is rarely on the States.

So we must be grateful for any compendium on the States and their budgetary allocations and performance.  The Reserve Bank of India’s “State Finances: A Study of Budgets 2015-16”, which was released earlier this month, is a service to the nation and deserves to be studied threadbare if we are to understand where the States’ finances are headed and if the nation is truly on course to achieving the outcomes it has set for itself.

The report this year brings some good news and a lot of not-so-good news though all of it is couched in language that communicates none of the clarity or the urgency with which the findings must be received.

First the good news:  While public finances of States deteriorated in 2013-14 and 2014-15, most States have budgeted to come back on track, particularly by working to reduce revenue deficits, the money the government spends to keep itself going on heads like interest payments, salaries and pensions.

All States consolidated had modest revenue surpluses (in 2011-12 and 2012-13), dipped into revenue deficits (in 2013-14 and 2014-15) and have budgeted to return to revenue surplus in 2015-16. Of course, estimates are estimates and the pendulum can and does swing to the red. For an example, the 2014-15 number showed a revenue surplus of Rs.543 billion in the budget estimates but ended up in a revenue deficit of Rs.183.4 billion in the revised estimates. Such deviations raise questions on fiscal integrity.

Directionally though, the budgeted decline is positive but it comes with some significant concerns on how this deficit reduction is sought to be achieved, notably because of the decline in capital outlays, the expenditure which supports growth, and social sector spending.

The gross fiscal deficit (broadly the revenue account balances plus capital expenditure) to GDP ratio for 2015-16 has been projected at 2.4 per cent, a number that looks good when seen against the recommendations of the 14th Finance Commission, which gives State governments the leeway of a fiscal deficit to GDP ratio of up to 3.5 per cent.

But that’s where the good part might end.

Despite the budgeted reduction in fiscal deficit relative to GDP, the RBI holds that outstanding liabilities of the State governments would only increase due to the issuance of power sector bonds under the Ujjwal Discom Assurance Yojana (UDAY), the much-touted Central scheme to revive the debt-laden State power distribution companies (about Rs.4.3 lakh crore of outstanding debt in 2014-15 at interest rates of 14-15%).

The Power Minister has come out strongly against this observation but the RBI position reflects the RBI Governor’s observations earlier this year that “with UDAY…it is unlikely that states will be shrinking their deficits, which puts pressure on the centre to adjust more.”

That apart, the rising trend in committed expenditure (interest payments, pension wages and salaries etc.) remains a matter of concern. This can only rise further with the cascading impact on salary and pension burdens across the States with the implementation of the seventh pay commission recommendations.

These red flags come coupled with stagnation in expenditure on education and health, which, as the RBI report correctly notes is a “prerequisite for harnessing the benefits of a rapidly increasing young workforce…”

Critically, “almost all heads of development revenue expenditure under social and economic services are budgeted to grow at a slower pace in 2015-16 compared to a year ago.” Spending on services related to housing, urban development, soil and water conservation, rural development, irrigation, flood control and energy all will take a hit.

Furthermore, there is an absolute decline in capital outlay on services like family welfare, water supply and sanitation, housing, warehousing, science & technology and the environment.

Thus, social sector expenditure, which had increased in 2014-15, is budgeted to decline in 2015-16 in as many as 21 states. Clearly, as the report notes, what the States have budgeted does not augur well for the quality of human development. The kind of expenditure rationing to arrest the erosion in State finances raises serious concerns on the quality of fiscal consolidation.

What emerges is a picture of States not realising the full potential of two key policy steps that were meant to be empowering: one was the Fiscal Responsibility and Budget Management (FRBM) Acts at the State level to enforce fiscal discipline in the States. The other was the enhanced share of tax devolution from the Centre to the States, which jumped up from 32 per cent to 42 percent of the so-called divisible pool in accordance with the recommendations of the 14^th Finance Commission.

States were meant to get more money and use it better. 

In effect, rule-based fiscal policy has put a ring fence around spending but what has got cut to force-fit and balance the numbers is infrastructure expenditure and social expenditure.

Also, the dependency of the States on the Centre has increased resulting in their own efforts in resource mobilisation taking a hit. States own revenue receipts have remained stagnant while the head of shareable taxes from the Centre have grown.

This is obviously not sustainable and makes the States vulnerable to vagaries of revenue collections at the Central level. Should any adverse macroeconomic event impact growth and therefore tax collections to that extent, it will inevitably lead to tax devolutions coming down with a cascading effect on the States.

In essence, it is high time States act on augmenting their own tax revenues and enhance the quality of expenditure as well as prioritise expenditure on physical and social infrastructure.

That said, it must also be noted that the RBI as the debt manager and banker and in that respect also the fiscal advisor should have used the occasion of the report to provide clear actionable advise and directions. The RBI study has gems but these are concealed within loads of gobbledygook.

(Dr. R K Pattnaik is a Professor at SPJIMR. Jagdish Rattanani is Editor at SPJIMR.)