States do Centre a good turn

A sharp reduction in states' deficit augurs well for the Centre's fiscal planning

Until about 10 years ago, the Centre’s Budget size would be more than the combined expenditure of all the states. That changed in 2012-13. The states’ Budget size in 2012-13 rose to Rs 14.55 trillion, which for the first time was a little higher than that of the Centre’s at Rs 14.1 trillion.

Since then, the states’ share in total government expenditure in the country began rising steadily, and by 2019-20 it was as much as 55 per cent. The Covid pandemic led to a sharp rise in the Centre’s Budget size and changed that equation, but only for a year. While in 2020-21, the states’ expenditure was estimated at Rs 34 trillion, a little lower than that of the Centre at Rs 35 trillion, the following year saw the states regain their lead. Their share in total government expenditure inched up to 51 per cent, and in 2022-23 it is set to go up further to 53-55 per cent.

The purpose of bringing up the point on how the states’ combined Budget size has exceeded that of the Centre is to underline the importance of India’s 31 states and Union Territories in assessing India’s fiscal situation. Even as the nation will be debating and discussing the Centre’s Budget for 2023-24 to be presented about a week later on February 1, it would be useful to examine the fiscal impact of the states on the economy and how the states, compared to the Centre, have fared in terms of fiscal consolidation after Covid. After all, these states now account for more than half of India’s total government expenditure.

Illustration: Binay Sinha

On the fiscal consolidation front, the states have done much better than the Centre. In 2019-20, a pre-Covid year, the fiscal deficit for the Centre was 4.6 per cent of gross domestic product (GDP), while that for the states was 2.6 per cent, making a total government deficit of 7.2 per cent of GDP. This widened to 13.3 per cent in 2020-21, with the Centre’s share pegged at 9.2 per cent and the states accounting for 4.1 per cent. In 2021-22, the total government deficit was reduced to 9.5 per cent, of which the Centre’s share was 6.7 per cent and the states’ was 2.8 per cent. Clearly, the states have quickly cut their deficit down to less than the 3 per cent target, helping bring the total government deficit down to single digits.

What’s more, the states are expected to maintain their fiscal deficit to well below the 3 per cent mark even during 2022-23, even as the Centre would strive hard to keep its deficit below the Budget target of 6.4 per cent. According to government figures, the fiscal deficit for the states in the April-November 2022 period was only 35 per cent of the full year’s Budget deficit target of 3.4 per cent. In comparison, the Centre’s fiscal deficit in the first eight months of 2022-23 was 59 per cent of the full year’s Budget target.

According to some estimates, the states may well end the current year with a fiscal deficit of about 2.3 to 2.5 per cent of GDP, thanks to a healthy rise in State Goods and Services Tax (SGST) collections, an increase in the states’ share in buoyant Central GST collections, higher transfers from the Central tax kitty to the states (tax transfers in the April-November 2022 period rose by 37 per cent to Rs 5.5 trillion) and a marked slowdown in spending by the state governments, particularly on the capital account.

While the improved revenue collections by the states are an unambiguously positive development, the spending slowdown could harm the economy’s growth prospects. Traditionally, the states’ spending on their various capex programmes gathers speed in the last quarter of the financial year. Analysts expect that the states would start spending more on their projects, but in spite of that the deficit would be below 3 per cent as there are, after all, limits to a state machinery’s expenditure capacity. 

If the states can keep their deficit below 3 per cent for the second year running, there could be two other benefits. One, with the states borrowing less from the market through their state development loans, the bond market would remain relatively stable with yields likely to soften, helping the Centre in managing its borrowing plan. Two, with the states reining in their deficit, the Centre could enjoy some flexibility without affecting the overall government deficit level.

The states’ healthy revenue collections have benefitted the GST regime as well. The system of paying compensation to states, which report an annual GST collections growth rate of less than 14 per cent, ended early this year. There were initial fears that this would become a major area of dispute between the Centre and the states. But with higher revenue collections, most states have come to terms with the reality of a compensation-less GST regime. Indeed, barring 10 states, all other states and Union Territories have so far reported an annual GST collection growth rate of over 14 per cent in 2022-23.

While the GST compensation cess would continue to be levied till March 2026 to help the Centre repay the back-to-back loans it had taken for funding the states, the possibility of a GST rate rationalisation, combined with the removal of the compensation cess, would be an attractive policy option.

Debt and outstanding liabilities, however, continue to be an area of concern for the states. The combined debt level of the states declined to 28.7 per cent of GDP at the end of March 2022, from 31.1 per cent a year ago. But this is set to go up again by March 2023 to 29.5 per cent of GDP. Add about 4 per cent of GDP as outstanding guarantees that the states have to honour, the debt sustainability for the states is a cause for concern. A few more years of deficit containment will be needed before the states can claim that they can march towards fiscal sustainability.