There are growing concerns that the two major sources of tax revenues for state governments, the state goods and services tax (SGST) and central tax devolution, are likely to fall well short of their budget estimates for 2019-20. This may result in large fiscal slippages or cutbacks in expenditure at the state level towards the end of this financial year. The latter is a risk for the economic growth outlook of the country, and for the liquidity position of corporates that are engaged in projects at the state level.
Tax revenues earned by state governments are classified as own tax revenues and devolution of central taxes. Own tax revenues of the states are now dominated by SGST, which is budgeted to account for over 40 per cent of the states’ own tax revenues in FY20, while tax devolution to states is governed by the formulae prescribed by successive Finance Commissions, and takes its cue from the actual collections of the central government.
There are multiple concerns building up related to SGST collections. First, there are substantial discrepancies in the data available from the Rajya Sabha questions and the states’ own budget on revenues related to SGST and GST compensation received by them in FY19. Our analysis suggests that several states had over-estimated such revenues in their revised estimates for FY19.
This optimistic forecasting of SGST collections seems to have persisted in the budget estimates for FY20. State governments, in aggregate, have estimated their SGST to expand by 11 per cent in FY20 (budget estimates) relative to their FY19 revised estimates. However, the growth in headline GST collections was only 5 per cent in the first half of the financial year. If the pace of growth of GST revenues doesn’t pickup in the second half, SGST collections may trail what states had forecast by around Rs 350-400 billion.
Compounding this concern, the GST compensation cess collected in FY20 (April to September) has fallen short of the compensation released to the states this year. Moreover, many states continue to require compensation. This is becoming an acute concern as the five-year compensation period for GST losses will end in 2022. At that point, states will have to reset their expenditures in line with their actual SGST collections, unless the compensation period gets extended. With the axe unlikely to fall on social sector spending, infrastructure creation at the state level may get compressed.
Moving to tax devolution, as per the recommendations of the Fourteenth Finance Commission, 42 per cent of the shareable central taxes of the central government are being devolved to states for the period FY16-FY20. But, shareable tax collections exclude surcharges and cess collections. Thus, in effect, the taxes devolved to states are closer to 35 per cent of the gross central tax collections.
The “provisional actuals” published by the Controller General of Accounts indicate that the GoI’s tax revenues in FY19 stood at Rs 20.8 trillion, a considerable Rs 1.7 trillion lower than the revised estimates for that year. Presumably, the taxes devolved to the states in that year were based on the Centre’s estimates of tax collections in revised estimates, which suggests that the devolution of taxes to states year was higher than mandated. We estimate this excess transfer at around Rs 0.6-0.7 trillion. A portion of the adjustment for this excess devolution in FY19 appears to have already been undertaken during April-August 2019, with a year-on-year reduction of 4 per cent or Rs 117 billion in tax devolution to states in these five months.
Moreover, the pace of growth of the Centre’s gross tax revenues stood at a subdued 4 per cent in April-August 2019, sharply lower than the target of 18 per cent enshrined in the budget estimates relative to the “provisional actuals”. We thus estimate that the gross tax revenues of the Centre would need to expand by a sharp 25 per cent in the remainder of this financial year to meet the budget estimates for FY20. This appears challenging given the subdued economic outlook as of now.
In addition, the recently announced corporate tax cut would result in a revenue loss which the government has pegged at Rs 1.45 trillion. This would be shared by the Centre and states. Thus, in our assessment, based on the shortfalls in central tax collections in FY19 and the estimated gap in FY20, the aggregate tax devolution to states may be as much as Rs 1.5-2 trillion lower in the current year than what was budgeted by the government.
To avoid a substantial fiscal slippage at the state government level, a sizeable expenditure reduction or deferral is likely to be required, given that the borrowing limit set by the central government acts as a soft constraint to the size of the states’ fiscal deficits. Some states may resort to cutting productive and capital expenditure towards the end of this year which poses a key risk to the economic growth outlook, in our view. Moreover, such cutbacks or deferral in state government spending could have serious implications for liquidity levels of corporates that are engaged in projects at the state level.
Looking ahead, a key factor that will influence state tax revenues is the percentage of central taxes that the Fifteenth Finance Commission recommends as devolution to the states for the period FY21-25. Will this be the same as the 42 per cent recommended by the Fourteenth Finance Commission? Or will it be higher or lower? Some states seem apprehensive that the terms of reference of the Fifteenth Finance Commission signal that the percentage may be reduced from the prevailing 42 per cent which would constrain their fiscal space over the medium term. The answer will be known in a few months.
Roy is group head corporate sector rating, Nayar is principal economist, ICRA Limited
— This article first appeared in the October 4, 2019 print edition under the title ‘A taxing time for states’