Centre vs states: Who's fiscally more profligate?

The past few days have seen a flurry of news reports stating of the Centre and RBI are warning state governments against their off-budget borrowing and borrowing against future revenue, giving an impression that the latter are fiscally profligate and irresponsible. The RBI went to the extent of telling banks to stop funding states using future revenue.

But do official statistics bear this out? Not really. In fact, since 2005, the Centre’s record is far worse than states when it comes to fiscal management.

It should be kept in mind that both the Centre and states are bound by the Fiscal Responsibility and Budget Management (FRBM) Act of 2003, which puts limits to debt and fiscal deficit with some leeway for deviations under certain conditions.

After the 2018 amendment in the law, the “fiscal management principles” say about these limits: “The Central Government shall (a) take appropriate measures to limit the fiscal deficit up to 3% of gross domestic product by the 31st March, 2021; (b) endeavour to ensure that (i) the general Government debt does not exceed 60%; (ii) the Central Government debt does not exceed 40% of gross domestic product by the end of financial year 2024-2025...”

How do the Centre and states measure up to these limits?

Debt burdens of Centre and states

While the FRBM limit for the Centre is 40% of the GDP, it has consistently clocked above the limit since FY05 – the data provided by the Economic Survey of 2021-22 shows. Of late, it has mounted further. In FY19, it was 45.7% which climbed up to 49.1% in FY20 and 59.3% in FY21. For FY22, the Centre has claimed recently that the ratio would come down to 56.3% – as against 59.9% projected in the revised estimates (RE) of the budget in February 2022.

How do states fare in comparison? Their share of debt-to-GDP should be 20% (as the upper limit for the Centre+ states is 60%). The Economic Survey of 2021-22 shows, it has been above 20% since FY14 (not mapped for earlier fiscals), which went up to 25.3%, 26.3%, 31.1% and 31.2% for the corresponding years of FY19, FY20, FY21 and FY22 (BE).

But there is a good way of knowing who has been more profligate: the percentage of deviations.

Going by the percentage of deviations in the past four fiscals, the annual average deviation works out to 12.6 percentage points for the Centre, as against 8.5 percentage points for states.

That is, states have performed better than the Centre consistently.

Fiscal deficits of Centre and states

The FRMB Act puts the fiscal deficit limit at 3% of the GDP for both the Centre and states.

The 2022 budget document shows, the Centre’s fiscal deficit was 9.2% in FY21 (actual) and 6.9% in FY22 (RE) – far above 3%. The RBI’s report on state finances shows, states’ fiscal deficits were 4.7% and 3.7% for the corresponding years. Here too, the deviations are far greater for the Centre and is in keeping with long-term trends.

For the entire 11 fiscals (pre-pandemic and pandemic) of FY12-FY22, the annual average fiscal deficit for the Centre was 4.9% and for states 2.8%.

Both debt-to-GDP and fiscal deficit numbers demonstrate that states are more fiscally prudent and responsible vis-à-vis the Centre – both before the pandemic and after the pandemic. Hence, the Centre and RBI should worry less about states.

Despite such historic trends, the Centre has imposed stiffer conditions on states.

In the 2021 budget speech, Finance Minister Nirmala Sitharaman set the fiscal deficit target for states at 3% of the GSDP (individual states’ GDP), to be achieved by FY24. But for the Centre, she set the target for the Centre at 4.5% (of GDP) to be achieved by 2025-26. Further, she set the limit for states for borrowing at 4% of the GSDP for FY22. There was no such target for the Centre.

For borrowing up to 4% of the GSDP (additional 1%), the Finance Ministry had already put four reform conditions:

• Implementation of One Nation One Ration Card System;

• Ease of doing business reform;

• Urban Local body/ utility reforms; and

• Power Sector reforms

In an unprecedented move, amidst the pandemic disruptions, it allowed states to borrow additional 1% of the GSDP in October 2020 subject to four reforms – (i) ‘one nation one ration’ system (ii) improvement in ease of doing business (iii) power sector reforms and (iv) urban local body reforms. As Govind Rao, member of the 14^th Finance Commission, has pointed out, this happened for the first time “in the history of independent India”.

True, in 2022 budget, the Finance Minister also announced allocating Rs 1 lakh crore interest-free loans to states for a period of 50 years “to assist the states in catalysing overall investments in the economy”. This is “over and above the normal borrowings allowed to the states”. This is a wise since states have a better record of capital expenditure and are fiscally more responsible than the Centre.

As for accusing state governments of off-budget financing, it may be pointed out that they are following the precedence set by the Centre for many years.

For example, a 2018 CAG report (number 20) had commented that the Centre was “increasingly resorted to off-budget financing” for revenue spending. It found this in the case of food, fertiliser and irrigation spendings funded through off-budget borrowings by the FCI and NABARD and through special banking arrangements (SBA). The report found several other fiscal mismanagements: (i) understatement of public account liability by Rs 7.63 lakh crore in FY17, thereby reducing the total liability from 50.5% of the GDP (actual) to 45.5% (window-dressed) and (ii) refunds of Rs 1.72 lakh crore in FY17 finding no corresponding disclosure.

For FY17, the off-budget finances from SBA, FCI and NABARD add up to Rs 1,29,446 crore. In that fiscal, revenue deficit (actual) stood at 2.1% of the GDP and fiscal deficit (actual) at 3.5% of GDP, as per the 2018 budget. But adding up the off-budget numbers would take the “actual” revenue and fiscal deficit to 2.9% and 4.3% of the GDP, respectively.

The hidden food and fertilisers would be finally adjusted in the 2021 budget. The government spent Rs 1.3 lakh crore on fertiliser subsidy, against the budgeted Rs 71,309 crore (1.9 times more) and Rs 4.2 lakh crore on food subsidy, against the budgeted Rs 1.2 lakh crore (3.5 times more) in FY21.

Even for “strategic disinvestments” (privatisation) in the previous years, the Central government asked PSUs to pick up the tabs, which they did even by borrowing from market. For example, it made strategic disinvestments in five CPSEs – HPCL, REC, HSCC, NPCC and DCIL – the tabs for which were picked up by other CPSEs like ONGC, PFC, NBCC, WAPCOS and public sector consortium of ports, respectively.

The CAG said, in its 2020 report: “Such disinvestments only resulted in transfer of resources already with the public sector to the Government and did not lead to any change in the stake of the Public Sector/Government in the disinvested PSUs.” That is, such receipts – which get reflected in revenue deficits – hide the real fiscal status of the Centre.

Resources and capital expenditures

The big brotherly approach of the Centre is also inappropriate for many other reasons.

For instance, states have consistently out-performed Centre in capital expenditure. The Economic Survey and RBI reports and budget documents show that during the 11 years of FY12-FY22, the share of capital expenditure – to boost growth – of the Centre and states in reverse order: 37:63. That is, the Centre spends less, states more.

These statistics reveal, the Centre’s capital expenditure, an annual average, is 1.8% of the GDP during these 11 fiscals. In contrast, states’ capital expenditure has been 3.1% of the GDP, on average.

However, during the same period, a comparison of tax revenues shows an opposite trend.

While the Centre’s tax revenue was, on an annual average, 10.3% of the GDP, the state government’s “own tax” was just 6.4% of the GDP.

The share of tax revenue of the Centre and states, thus, work out to be 61.6:38.4.

Both the data sets show that while the Centre spends less on capex its tax revenue sources are far more than state governments.

The Centre generates more tax because it enjoys certain exclusive tax rights, like corporate tax, income tax from non-corporate entities; exclusive indirect taxes like Customs; Cess and Surcharge, plus it collects other indirect taxes like Excise (as do states). Having given up most of their indirect tax rights while opting for the GST, they are disadvantaged.

Why does the Centre behave big brotherly?

There are two obvious reasons. One, it seeks to win a perception war against states about managing the economy. Two, it seeks to centralise more fiscal powers by tightening controls on states in accessing financial resources.

Given that India is a “Union of States”, a federal structure, and some of the states are far bigger in population and geography than many developed economies, states would need more fiscal autonomy to propel India’s growth and development – not less as the Centre and RBI’s recent directives suggest.