States' fiscal space rapidly shrinking, here's why...

The Centre seems to have rediscovered the fiscal prudence of state governments by dramatically raising its 50-year interest-free loans to them under the “Scheme for Special Assistance to States for Capital Expenditure”. Finance Minister Nirmala Sitharaman said the scheme was being extended for another year with “a significantly enhanced outlay of ₹1.3 lakh crore” – up from ₹1 lakh crore allocated in the Budget 2022.

The jump is dramatic, given that the revised estimate for FY23 brought the budgeted allocation of ₹1 lakh crore down to ₹76,000 crore – which jumps 71% to ₹1.3 lakh crore. It is even more so given that the actual disbursements under the scheme for FY21 and FY22 were ₹11,830 crore and ₹14,186 crore, respectively (Economic Survey 2022-23). The higher allocation to states for capex goes hand-in-hand with the Centre’s claim of raising its own capex by 33% in FY24 (BE) over FY23 (BE). But budget documents show, the Centre’s “total” capex, that of the Centre and its public sector enterprises, for FY24 (BE) is 4.9% of the GDP – the same as the total “actual” capex in FY20.

What is even more impressive is that such faith in states’ fiscal abilities comes after several months of severe criticism of their fiscal performance. It began with the RBI’s “State Finances: A Risk Analysis” report of June 2022, which accused states of giving “non-merit freebies” and “off-budget” borrowing to cause “rising subsidy burdens” and debts going up to “4.5% of the GDP”, even while their “own tax revenue” was on a “slowdown”. Both the RBI and Centre pulled up banks for lending money to states with the RBI even asking the SBI and others to stop lending against future revenues – a normal banking practice. A national debate raged over states’ fiscal profligacy, arising out of “freebies” and “revdi culture” into which the Supreme Court and the Election Commission were sucked in.

What changed in 2023?

From fiscal profligacy to fiscal prudence

The RBI corrected its assessment of states’ fiscal performance in its January 2023 report, “State Finances: A Study of Budgets of 2022-23. This report lavished praise and reversed earlier charges. It commended states for “recognition of off-budget borrowings”; borrowing “within” the ceilings; “improved” fiscal health from “a sharp pandemic-induced deterioration in 2020-21”; “secured” financial positions “in terms lower deficit indicators (viz., gross fiscal deficit/ revenue deficit/primary deficit as a per cent of GDP)”; “increased” fiscal headroom (savings) for undertaking higher capex etc. At the same time, it advised states not to adopt the old pension scheme (OPS), unlike a strong warning against this in June 2022 report, by stating that this would eat into their “annual saving in fiscal resources”.

Here are a few more revelations from the January 2023 report:

· States “have budgeted higher capital outlay” in FY23 (BE) than in FY20, FY21 and FY22.

· 19 of 31 states/UTs are revenue surplus in FY23 (BE) – up from 13 in FY22 (RE) and 7 in FY21.

· States’ gross fiscal deficit (GFD) is budgeted to decline from 4.1% of the GDP in FY21 (first pandemic fiscal) to 3.4% in FY23 (BE).

· States’ debt is budgeted to ease to 29.5% of the GDP in FY23 (BE), as against 31.1% in FY21 (pandemic fiscal), which is “still higher” than 20% recommended by FRBM Review Committee in 2018, warranting “prioritisation of debt consolidation”.

Evidently, the RBI’s June 2022 report was a rush job. It relied more on data of the pandemic fiscals (FY21 and FY22). In contrast, its January 2023 report looked more closely at the budget documents of FY23 (BE). By then, Finance Ministry think tank National Institute of Public Finance and Policy (NIPFP) had already examined the budget documents of states to produce a comprehensive study of 18 major states in August 2022 and presented a contrasting picture.

The NIPFP report showed only one state, Punjab, overshot the 15th Finance Commission’s limits on debts in FY23 (BE) – as against ten states the RBI had named in June 2022, five of which had been called “highly stressed” (Bihar, Kerala, Punjab, Rajasthan, and West Bengal). The NIPFP also found that out of 18 major states, eight were revenue surplus and five had fiscal deficits of 3% or less (of their GSDPs).

The Economic Survey of 2022-23, released on January 31, 2023, echoed the assessments of the NIPFP and the revised RBI report. Besides, it said states’ capital outlay was 31.7% more than what was budgeted for FY22 and commended the states’ capex performance.

Increasing fiscal restrictions on states

Despite good fiscal performance of states, the Centre continues to impose restrictions on them.

While budgeting Rs 1.3 lakh crore loans for capex, two conditions have been put. One, the entire amount has to be spent by states “within 2023-24”. Two, “a part will be conditional” and seven conditions are listed: (i) Scrapping old government vehicles (ii) urban planning reforms and actions (iii) financing reforms in urban local bodies to make them creditworthy for municipal bonds (iv) housing for police personnel above or as part of police stations (v) constructing Unity Malls (vi) children and adolescents’ libraries and digital infrastructure and (vii) paying state share of capital expenditure of central schemes.

This is a continuation of recent practices.

While giving the interest-free loans in FY21 and FY22, the Centre made it conditional to (a) “privatisation/disinvestment” of state PSUs and (b) “monetisation/recycling of assets”.

During the pandemic fiscal of FY21, the Centre allowed additional borrowing of 1% of GSDP to states (from 3% to 4%) with four “reforms”: (a) “one-nation-one-ration” system (b) ease of doing business (c) power sector reforms and (d) urban local body reforms. Govind Rao, a member of the 14th Finance Commission, said such conditionalities was never heard of “in the history of independent India”. In 2022, Centre reduced the borrowing limit to 3.5% of GSDP but allowed “extra borrowing” to the extent of contributions by employers and employees to the New Pension Scheme (NPS), implying that this was not for states opting for old pension scheme (OPS). This arrangement continues in FY24. This is aimed at Rajasthan, Punjab, Jharkhand, Chhattisgarh and Himachal Pradesh which have reverted to the OPS.

Strangling states for resources

The conditions reflect how the Centre is insisting on its own “reform” agenda from states and tightly regulating their finances after having discarded the “one-size-fits-all” policy paradigm with the dismantling of Planning Commission in 2014 and thereafter championing “cooperative federalism” while adopting the GST in 2017.

States are finding their fiscal space rapidly shrinking in many ways.

· With the GST, states lost rights to indirect taxes. From July 2022, GST Compensation was stopped. A NIPFP study of 2022 showed that the GST Compensation averaged 34% of the states’ GST receipt (SGST) during FY18-FY21.[xv] Any talk of a fall in states “own tax” (as the RBI did in June 2022), therefore, is inappropriate.

· States are short-changed in devolving tax awarded by the 14th and 15th Finance Commissions – 42% and 41% of central taxes, respectively. During FY16 to FY24 (BE), the shortfall averages 8.9 percentage points – far higher than 4.6 percentage shortfall during the 12th and 13th Finance Commission periods (FY06 to FY15).

· States are short-changed by imposing more Cess and Surcharges, which are not shared with states. These taxes surged from 9% of Centre’s gross tax revenue in FY15 to 13.6% in FY23 (RE) and budgeted at 12.6% for FY24.

· Centre restricts fiscal space of states by increasing central schemes (CS) and centrally sponsored schemes (CSS), reversing the UPA’s early 2014 move to cut those and hand over the money to states. CS and CSS as percentage of the Centre’s budget spending has risen from 40.5% in FY16 to 44.5% in FY23 (RE), and budgeted at 43.2% in FY24. This is contrary to “one-size-fits-all” approach discarded in 2014.

That is not all.

By converting the “subsidised” ration (PDS) to 62.5% of households under the National Food Security Act of 2013 to “free” from January 1, 2023 and mandating that the Centre alone will pay the entire money, states have been denied their space in this welfare programme. Earlier, states subsidised the “subsidised” PDS further.

All these developments are counter-intuitive, given that state governments have outperformed the Centre in every single fiscal parameter for a long time.

States outperform Centre in fiscal prudence

Here is what the Economic Survey of 2022-23, the RBI and budget documents say about the relative fiscal performances during the ten fiscals of FY14-FY23 (Centre’s FY23 (RE) against states’ FY23 (BE)).

·Debts: Centre and states both have crossed the FRBM’s debt limits of 40% and 20% of the GDP, respectively. But Centre’s average of 52% is 12 percentage points higher, against states’ average of 25.9%, which is 5.9 percentage points higher.

·Fiscal deficits: Centre’s average is 5% of GDP (above the FRBM limit of 3%) while states’ average of 2.9% is below the FRBM limit of 3%.

·Revenue deficits: Centre averages 4.9% of GDP against states’ 0.4%. 19 states/UTs are revenue surplus in FY23 (BE).

·Capex: Centre averages 1.9% of GDP against states’ 3.4% (1.8 times higher).

Centre must not lose sight of the fact that constitutionally, India is a “Union of States”, that is, it is a federal state rather than a unitary state and states are independent entities. Besides, fiscal independence and decentralisation of power are universally accepted good governance practices which are also essential for the realisation of the Centre’s avowed goal of “cooperative federalism” and decentralised growth and development model.