INDIA GOT A REALITY CHECK earlier this year when Sri Lanka went through a massive turmoil that saw its distressed populace — facing the brunt of food/fuel shortages as well as sky-high prices and job losses — taking to the streets to protest against mishandling of the economy by their government. The violent uprising even led to the ouster of President Gotabaya Rajapaksha in July. The political crisis, which was a fall-out of fiscal mismanagement as government continued to borrow and spend despite falling tourism revenues due to Covid-19, forced economists in India to take note of the poor finances of state governments. Prime Minister Narendra Modi also cautioned state governments about overspending to please their vote banks and retain power, kicking off an animated debate over freebies/subsidies and budget imbalances (See Pressure Points).

Amid this raging debate over freebies — doles to garner votes — a top Central government functionary shared a story about assembly elections in Punjab where Aam Aadmi Party (AAP) won 92 out of 117 seats. One of the reasons for its resounding win was promise of a bunch of freebies such as free electricity and ₹1,000 per month to every woman over 18. But just two weeks after the results, the newly-elected chief minister, Bhagwant Mann, met the prime minister and sought Central assistance of ₹1 lakh crore in view of the state's poor financial health. "The government demanded Central assistance in tranches of ₹50,000 crore each for next two years," the functionary said. A top BJP leader, taking a dig at AAP, says the party made tall promises in public but sought PMO's help silently.

More skeletons started tumbling out of the closet when Reserve Bank of India (RBI), prompted by the unrest in Sri Lanka, initiated a study of the health of state finances. The findings were alarming. Average gross fiscal deficit (GFD) to GDP ratio of states, at 2.5%, was well within the Fiscal Responsibility Legislation ceiling of 3% between FY12 and FY20, that is, till the pandemic stuck, says its June Bulletin. "States' fiscal position deteriorated sharply in 2020 with sharp dip in revenue, increase in spending and sharp rise in debt to GSDP ratios," the bulletin says, naming Punjab, Rajasthan, Kerala, West Bengal, Bihar, Andhra Pradesh, Jharkhand, Madhya Pradesh, Uttar Pradesh and Haryana as states with the highest debt burden. "Their GFD/GSDP ratios were equal to or more than 3% in FY22," says the report. Government data reveals that total outstanding debt of the bottom ten states, at ₹36,72,000 crore on March 2022, was more than half the total outstanding debt of all the states for the fiscal. PRS Legislative, an independent legislative research body, has estimated that states' outstanding debt has risen from 19.1% of GDP in FY19 to 25.1% of GDP in FY22. It has not factored in ₹2.69 lakh crore that Centre raised in FY21 and FY22 to pay states for shortfall in GST compensation during the pandemic. States are not required to repay this loan.

What's the way out for state governments?

Debt Bomb: The Cause

Finance minister Nirmala Sitharaman attributes the high debt of states and Centre to a "difficult" 2020, when Covid-19 hit economic activity across the country. "The year 2020 was difficult for both Centre and states and borrowings spiked for both. No one would have questioned the borrowings," she said in an interaction at Brookings Institute during a visit to the US in early October. Total outstanding debt of states rose 45% from ₹47,86,769 crore in pre-pandemic FY19 to ₹69,47,045 (Budget estimates) in FY22.

While some increase in debt can be explained by the pandemic, experts also point at quality of expenditure undertaken by states and debt on books of their quasi-government bodies. "Reckless announcement of schemes and subsidies is a key reason for deteriorating fiscal condition of states," says Sushil Modi, Rajya Sabha MP and former finance minister of Bihar.

"Fiscal health hinges on expenditure remaining in line with revenues. Expenditure of most states is geared towards welfare schemes, some of which are populist and do not have any long-term impact. Some states have huge debt parked with quasi-government entities such as power distribution companies," says Suvodeep Rakshit, senior economist, Kotak Institutional Equities. States had taken over debt of state-owned power distribution companies under the UDAY Scheme. This was one of the main reasons for rise in public debt in FY16 and FY17, says PRS Legislative. Power distribution subsidy is still a huge burden on states — according to power ministry, 27 states paid ₹1,32,000 crore power subsidy in FY21. This has been adding to the woes of state governments, which were already reeling under the impact of the pandemic.

In order to give states more leeway in managing finances during the pandemic, in FY21 and FY22, they were allowed to incur fiscal deficit of up to 5% and 4% of GSDP, respectively, depending on economic reforms undertaken by their governments. The pre-pandemic ceiling was 3%.

Another factor worsening state finances is Centre's dominance in taxes. Central government has been steadily imposing new cesses/surcharges over the years. Article 270, which lists taxes in the divisible pool, does not mention cesses/surcharges imposed by Central government. In May 2020, for example, Centre levied cess and surcharge of ₹10 per litre on petrol and ₹13 per litre on diesel. Thereafter, in February last year, it announced another hike of ₹1.5 per litre on petrol and ₹3 per litre on diesel. The aim was to cushion its finances from the impact of falling tax revenues due to Covid-19.

Revenue, Debt Servicing

While rising debt remains a cause for worry, there are also several red flags regarding the quality of expenditure being undertaken by states. There are three concerns — skew towards revenue account (everyday expenses) instead of capital account (building assets that will support economic activity for years in the future), shortage of avenues to generate additional revenue and debt-servicing capability. States raise funds in the form of tax and non-tax revenue and devolution from Central government. Sources of their own tax revenue include stamp and registration fees, sales tax, state excise duty, electricity charges, professional and entertainment tax, vehicle tax and SGST (state goods and services tax). Non-tax revenues include interest receipts, dividend income and mining royalty. States also get a share of the money Centre raises from income tax, basic excise duty and additional excise duty. As per the recommendations of the 15th Finance Commission, Centre has to share 41% tax collections with states. Expenditure, meanwhile, is incurred on revenue and capital accounts. Revenue expenditure covers salary, pension, interest, subsidies, while capital expenditure includes investment in infrastructure.

The lopsided nature of expenses is clear if one looks at account books of states. Maharashtra's FY23 revenue expenditure, for instance, is projected to be ₹4,27,780 crore, compared with capital outlay of ₹65,201. Uttar Pradesh's revenue expenditure is estimated to be ₹4,56,089 crore, while capital outlay is ₹1,23,920 crore. Gujarat's revenue expenditure is ₹1,81,000 crore, while capital outlay is ₹35,898 crore. Low investment in capital assets negates any future scope of revenue generation, says the RBI report. "Some states like Rajasthan, West Bengal, Punjab and Kerala spend 90% (of their budget) in revenue account. This results in poor expenditure quality, as reflected in their high revenue spending to capital outlay ratios. Although welfare-enhancing, the impact of revenue spending on economic activity lasts for just about a year. In contrast, impact of capital outlay is stronger and lasts longer, with peak effect materialising after two-three years," says the RBI bulletin.

The ability of states to raise revenue is also in question. Data analysed by Fortune India reveals that FY22 tax revenue of 14 states was lower than the FY20 number. These are Assam, Bihar, Karnataka, Chhattisgarh, Goa, Haryana, Karnataka, MP, Mizoram, Maharashtra, Odisha, Punjab, Tamil Nadu and West Bengal. In Tamil Nadu, for example, share of own tax revenue to total of all states and Union Territories is estimated to have declined from 8.8% in FY20 to 7.9% in FY22. In Bihar, it's expected to have dipped from 2.5% to 2.2%. Karnataka is estimated to have witnessed a decline from 8.4% in FY20 to 7% in FY22. RBI study has also pointed out decline in tax revenue of four of the 10 vulnerable states — Madhya Pradesh, Punjab and Kerala — making them fiscally vulnerable.

A number of states may face difficulties in debt servicing. According to RBI, debt of a state is sustainable if annual interest outgo is less than 10% of its revenue receipts. "The interest payment to revenue receipts ratio, a measure of debt servicing burden on states' revenues, was more than 10% in eight states," says the RBI report.

Way Forward

States are on a sticky wicket as far as quality of financials is concerned. Now, the key question is: What needs to be done to help them build fiscal muscle considering the huge external and internal challenges the country will continue to face in the near future? After all, that the ongoing geo-political situation will hit India's GDP growth is a foregone conclusion. Multilateral agencies have been lowering national GDP growth estimates. In the latest such update, International Monetary Fund slashed India's 2022 GDP growth estimate from 7.4% to 6.8%. A dent on national income will impact states, too. Governments need to act on an urgent basis.

Modi suggests a two-pronged approach. "Centre decides the limit of state borrowings. Central government can lay conditions so that a large chunk of money is not spent on freebies. Government is also trying to discourage off-budget borrowings. This can improve the situation."

"In order to revert to a healthier fiscal state, states need to be transparent about off-budget expenditures, contingent liabilities and shift from populist expenditure to capital expenditure. Further, borrowing costs of states should depend on their fiscal health, which can ensure market-determined fiscal adjustment," says Rakshit. Additionally, reforms suggested by the 15th Finance Commission need to be implemented as soon as possible. These include amendments to state fiscal responsibility legislation to ensure consistency with Centre's legislation and uniform standards for reporting with full disclosure of broader public debt and contingent liabilities and their risks. The commission had also recomm- ended the setting up of an independent Fiscal Council with powers to assess records from both Centre and states.

Sitharaman stressed during her recent US visit that reforms in India are an ongoing process. Perhaps it is time to use the policy levers to improve the fiscal prowess of states.

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