Capex push in states

Maintaining the momentum will be challenging

State government finances have witnessed significant recovery after the pandemic-induced disruption. According to the latest annual study of state government finances by the Reserve Bank of India (RBI), the consolidated gross fiscal deficit of the states declined to 2.8 per cent of gross domestic product (GDP) in 2021-22 (provisional) from 4.1 per cent in 2020-21, the highest since 2004-05. This sharp consolidation was facilitated by higher tax collection as the economy recovered from the pandemic. For the ongoing fiscal year, in the aggregate, the states have budgeted for a fiscal deficit of 3.4 per cent of GDP, which is within the target indicated by the Centre. Given the revenue position in general, the states should be able to meet the target. While they have done well to manage the deficit, continued effort is required to bring down the debt stock.

In addition to notable consolidation, it is encouraging to see that the quality of expenditure by the states has improved. The consolidated capital outlay for the states is estimated to have increased by 31.7 per cent in 2021-22. It is further budgeted to grow by over 38 per cent this fiscal year. Put differently, the capital outlay of the states is expected to increase from 2.3 per cent of GDP in 2021-22 to 2.9 per cent in 2022-23, which is considerably higher than historical levels. The ratio of revenue to capital expenditure has also improved. While the role of capital expenditure in enhancing growth potential cannot perhaps be overemphasised, higher allocation at state level is more critical because they account for the bulk of the general government capex. Adjusting for the Union government’s capex on defence, the share of the states has averaged about 70 per cent in the capital outlay. Further, the multiplier of the states’ capex is estimated to be higher than that of the Centre.

Although the states improved the quality of expenditure in recent years, maintaining the momentum would be a challenge. Even as they have budgeted for healthy capex growth in the current year, the data shows the actual expenditure has been lagging. It has been observed over the past several years that about a quarter of capital expenditure is undertaken in the last month of the fiscal year. This residual approach must be affecting the efficiency of expenditure. The states would do well to adopt a more structural approach. They could also face challenges on the revenue front apart from expenditure and efficiency. Nominal GDP growth is likely to come down next year on account of both lower inflation and real growth, which will affect tax collection.

Some states are likely to face revenue pressure also owing to the end of compensation payments for shortfalls in goods and services tax (GST) collection. In several states such as Punjab, Himachal Pradesh, and Delhi, on average, GST compensation contributed more than 10 per cent in tax revenue. It will not be easy for the states to increase revenue from other sources in the short run. In terms of longer-term fiscal challenges, the RBI has rightly highlighted the risks associated with reversion to the old pension scheme. Some political parties in state governments are deliberately reversing this hard-won reform for electoral gain. As India is entering a busy election cycle, the risk is that more states may follow this path.