In recent times, economic discussion in India has focused largely on the stress on central government finances. But state government finances are also facing headwinds. And as states increasingly account for a larger share in general government (Centre and state) spending, this has grave implications for the economy. As an RBI report on state finances notes, over the past two years, the overall size of state budgets has reduced which may have “inadvertently deepened” the economic slowdown. The situation is unlikely to change this year. States have pegged their revenues to grow at a slower pace largely due to lower tax devolution and grants. And as revenue expenditure tends to be sticky in nature — it is also rising due to higher interest and pension payments — states have offset slower revenue growth by curtailing capital spending, which will lower overall public sector capex.
The strains on state finances stem from several sources. First, states are increasingly undertaking capital expenditure through state public sector enterprises. And though states extend support to these enterprises through guarantees on their borrowings, “weak cost recovery mechanisms”, as in the case of the power and transport sectors, pose a fiscal risk. Second, under UDAY agreements, states have to take over incremental losses of power discoms. This exerts pressure on already stretched finances. Third, sharp cuts in corporate taxes and sluggish GST collections will also impact tax devolution to states. And then there are concerns over the fiscal costs of Ayushman Bharat. The RBI report also notes that state debt to GDP has surged to 25 per cent of GDP in 2019-20. Bringing it down to 20 per cent, in line with the recommendations of the FRBM (fiscal responsibility and budget management) review committee, will be challenging given the current trajectory of state finances.
On its part, the Centre has been increasingly relying on collections through cesses and surcharges to fund its expenditure. And as revenue through these sources does not form part of the divisible tax pool, it is not shared with states. In 2019-20, the Centre hopes to mop up Rs 3.69 lakh crore through cesses and surcharges (or 15 per cent of its gross tax revenue), implying that states’ share in gross tax revenue works out to just 32.9 per cent. To put this in perspective, this amount is more than the Centre’s capital expenditure or its allocation to centrally sponsored schemes. Further, the Centre has also asked the 15th Finance Commission to look into the possibility of providing funds for defence and internal security. These are likely to come at the expense of states. In this scenario, states must focus on resource mobilisation. But with little scope to raise own-tax revenue, they must focus on raising non-tax revenue, through hiking user charges on services like power and irrigation.