When states overtake the Centre

Much of the debate on public finance in India in recent years has been focused on how the Union government manages its expenditure and revenue flows. Public policy commentators have written in plenty on why the Centre must adhere to a path of fiscal prudence even while it allocates adequate resources to promote growth. Much less attention, however, is paid to what the 29 states in India are doing with regard to fiscal prudence.

It’s true that institutions like the International Monetary Fund or the rating agencies worry more about the consolidated fiscal deficit in the country that includes the fiscal gaps at the Centre as also in the states. But with most media commentaries remaining primarily focused on the fiscal deficit levels of the Union government, necessary pressure on the states has been lacking in nudging them to a more responsible path of steady fiscal consolidation. This must change.

Until about five years ago, the combined size of budgets of all the states used to be less than the total Union Budget. In 2011-12, the Union Budget size was ~13.04 trillion, higher than the combined size of the state budgets estimated at ~12.85 trillion. The following year saw the state budgets at ~14.55 trillion surpass for the first time the size of the Union Budget estimated at ~14.1 trillion. The gap has been widening since then and in 2016-17 the combined size of the state budgets at ~27.24 trillion was more than a third of the Union Budget size of ~20.14 trillion.

States have become even more critical as far as fiscal prudence is concerned. For instance, in 2011-12, the combined fiscal deficit of states was estimated at 1.9 per cent of gross domestic product or GDP, compared to the Centre’s fiscal deficit of 5.8 per cent. In 2016-17, the combined fiscal deficit for states rose to 3.66 per cent, surpassing the fiscal deficit of the Union government estimated at 3.5 per cent of GDP.

So, it is not just the size of the budgets of the states, but even their fiscal deficit is more than that of the Centre. Yet, barring a few commentaries here and there, the debate on fiscal consolidation continues to be largely focused on what the Union finance minister plans to do about reining in the Centre’s fiscal deficit. There is a clear imbalance in this focus and this must be corrected.

Take a look at the reforms scorecard for states and the Centre. The latest World Bank report on the ease of doing business in India provides a perspective that few policymakers can ignore. India’s overall rank has improved from 130 to 100. Remarkably, though, the areas where India has notched the largest gains pertain to paying taxes, resolving insolvency, getting credit and protecting minority investors. And all these gains are a direct outcome of the procedural improvements introduced by the Union government in these four areas.

In sharp contrast, the policies and procedures, overseen by the states, are where the World Bank report shows India’s ranks either deteriorating or languishing at a poor score. Indeed, India slipped by a few notches in the ranking for starting a business, getting electricity and registering property. All these activities are governed by rules framed and overseen by state governments. And in enforcing contracts and issuing construction permits, once again areas governed by the states, India’s rank has slightly got better, but continues to be pretty low at 164 and 181, respectively.

Foreign investors, too, have become conscious of this dichotomy. They are usually very keen on subscribing to bonds issued by the Union government, but their interest in loans issued by state governments is lukewarm. Foreign portfolio investors have used up almost 99 per cent of their investment limit of ~1.9 trillion in central government bonds. They are allowed to invest an additional ~300 billion in state government bonds, also known as state development loans or SDL. But till now this year, these foreign investors have subscribed only up to 17 per cent of this limit.

This will have serious implications for the state governments’ finances. Last year, they borrowed over ~3.5 trillion and with their fiscal deficit widening, they are expected to borrow an estimated ~4.5 trillion in the current fiscal year. Muted interest of foreign investors in SDLs is perhaps a reflection of inherent weaknesses of the states’ finances. But what is of greater concern is that it adversely affects the pricing of these bonds at a time when states are going for higher borrowing.

Foreign portfolio investors have pointed out that their lukewarm response to state bonds is because of the lack of transparency in the way state governments conduct their financial operations. Indeed, the manner in which state governments present their finances makes it difficult for analysis and comparison without much delay. The central bank does come out with these numbers, but that happens after a lag of a couple of years. This is also a big hurdle most commentators and analysts face. There is, thus, an urgent need for a standardised format in which budget numbers could be presented by each of the 29 states without any delay.

The fact is that the combined budget size of all the states and their deficit are now bigger than those of the Centre. The states, therefore, cannot be allowed to follow different formats for presenting their budget numbers. The international rating agencies might soon cite this as a major drawback and this might influence their overall rating of India. India’s rank in the World Bank’s ease of doing business index cannot get better unless more attention is paid to bringing about procedural reforms in the way states run their governments and provide various approvals for trade and industry.

Paying attention to improving transparency and fiscal policy norms is in many ways a federal responsibility as any neglect of these areas will impact the entire country. The Narendra Modi government often talks about cooperative federalism. It is time the spirit of cooperative federalism was taken to its logical conclusion by compelling the states to introduce greater transparency in their public finances and expedite their reform initiatives. Can NITI Aayog take this up as one of its major tasks?