Indian states are short of money. They need help

Changes of the past six years had put their finances in a precarious position. The current measures aren’t enough

The announcement by Prime Minister Narendra Modi of the ~20-lakh crore Atmanirbhar Bharat Abhiyan (Self-reliant India Campaign) package left many scrambling with the fiscal maths — where would the resources come from and how would they be structured? Over the past five days, details have emerged; these include increasing the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) allocations, easing concerns of micro, small and medium enterprises, ending coal monopoly, and ensuring farmers credit. The last tranche also focussed on a much-needed aspect — addressing the fiscal health of states.

We analysed the revenue and expenditures of 17 states to ascertain the status of their finances prior to the outbreak of the coronavirus disease (Covid-19) and assess their capacity to deal with the crisis. Our findings suggest that recent changes in India’s fiscal architecture — including the Goods and Services Tax (GST) regime, and increase in state shares for the Centrally Sponsored Schemes (CSSs) — had placed state finances in a precarious position, even prior to the crisis.

The dependency of states on the Centre for revenues has increased, with the share of the revenue from own sources declining from 55% in 2014-15 to 50.5% in 2020-21. While part of this is inherent in India’s fiscal structure, wherein states are the big spenders and the Centre controls the purse strings, the situation has been exacerbated by the introduction of the GST. Barring a few exceptions, such as petroleum products, property tax, and alcohol excise, indirect taxes have, to a large degree, been subsumed under the GST regime, eroding the ability of states to raise their own revenues.

Typically, some of this imbalance is corrected through a release of tax devolution to states. Moreover, to offset the loss in revenue due to the changed taxation system, the GST regime includes a provision wherein if tax collection falls below a growth rate of 14% for state GST, the Centre disburses a GST compensation.

Our analysis, however, finds that actual taxes devolved to states have remained consistently lower than those projected by the 14th Finance Commission (FC) — a shortfall of around ₹6.84 lakh crore between 20152020. This has been driven by an increase in the share of gross revenues coming from cesses and surcharges imposed by the Centre — which aren’t shared with states — from 2.3% in the early 1980s to as high as 15% in the recent period as per the Reserve Bank of India, and a shortfall in actual tax collection. While the Centre released ~46,038 crore in April as per the original budget, subsequent instalments will tell us whether the trend of shortfalls will continue.

Adding to state woes is the significant divergence in past periods between the amount of GST compensation owed and the actual payments made, including for states such as Uttar Pradesh, Bihar and Jharkhand that need greater fiscal support. Even before Covid-19 hit, 11 states estimated a revenue growth rate below the estimated 14% level, implying higher amounts will be owed as GST compensation. With the bulk of the states’ GST coming from goods such as electronics, fashion, and entertainment — all of which have been impacted by the pandemic — these revenues are likely to decline further.

The second major source for revenues from the Centre is CSSs that are aimed at ensuring a minimum standard of public service provision across the country. Though the overall funding through CSSs has declined for many states following the 14th FC recommendations, they still constitute a significant portion of revenue.

However, CSSs tend to be unpredictable, with releases determined on meeting certain conditionalities. In 2019-20, the total shortfall between estimated budgets and revised estimates was ~14,794 crore. One such conditionality is the requirement of states to put a portion of their own funds for CSSs. In October 2015, this share increased from 15%-25% to as high as 50% for several schemes, curbing the fiscal flexibility of states by ring-fencing revenues back into CSSs. The recent circular by the Centre, clarifying that it would not cut CSS funds, but will also not decrease the State share, will be of little comfort to states at a time when the greatest need is one of flexibility to meet local needs.

Expenditure analysis shows that in 2020-21, states expected only around 75% of their total expenditure to be met through revenue receipts, with the rest coming from other sources such as external borrowings. This is even after many states had anticipated lower expenditure for health and the social sector.

While expenditures are likely to rise in response to the pandemic, with over onethird of funding already committed to salaries, pensions and interest payments, finding additional resources will be hard. The increase by 60% in the limits for short-term borrowings are unlikely to meet the high, longer-term borrowing requirements. Sunday’s announcement of increasing states’ borrowing limits from 3% of GSDP to 5%, resulting in an additional ~4.28 lakh crore also comes with reform conditionalities and only 0.5% — or ~2140 crore — as untied, which states can spend as per needs.

There is no question that the pandemic and the lockdown have brought various aspects of socioeconomic life to a standstill. The slowdown of production and consumption is expected to generate medium- and longer-term repercussions on the economy, in terms of its revenue-raising abilities as well as expenditures. The ability of the State to respond effectively will be determined by how quickly it can move away from a business-as-usual model to what some have referred to as a war-time economy. It remains to be seen if the measures extended by the Centre and RBI will be adequate for states to tide over the crisis.