Status of State finances in India

State finances are in dire straits. A reliable indicator of this is the steady rise in state debt after a long hiatus. Total debt of the states has gone up by 4.6 percentage points of the gross domestic product (GDP) over the last six years, as highlighted in the recent report on state finances by the Reserve Bank of India (RBI), from a low of 22% of the GDP in 2014–15 to touch a peak level of 26.6% as per the budget estimates of 2020–21. The rapid build-up of the state debt is a sharp reversal of the previous trends when the state debt shrunk by around 10 percentage points of the GDP from a peak level of 31.8% in 2003–04. Moreover, the pace of growth of the debt burden of the states was almost four times faster than that of the central government whose debt levels have only edged up by 1.2 percentage points of the GDP, from a low of 49.4% of the GDP in 2017–18 to 50.6% in the budget estimates for 2020–21.

The sharp acceleration of the state debt, as compared to that of the centre, indicates that deterioration in state finances has certainly to do with something much more than just the slowdown in the economy. One important reason for the fiscal distress in the states is the compression in the resource flows from the centre to the states. Though the Fourteenth Finance Commission has substantially increased the state’s share of central taxes from 32% to 42%, the central government has unfortunately thwarted the commission’s mandate by mobilising additional resources through non-shareable cesses and surcharges. By one count, the use of non-shareable cesses and surcharges by the centre to mobilise additional resources has effectively reduced the state’s share of the central taxes, from 42% assigned by the Fourteenth Finance Commission to just 32%. Similarly, the cut in corporate tax rates and goods and services tax (GST) rate cuts, as prompted by the centre, have also negatively affected resource flows to the states.

Another reason for the surge in state debt is their escalating expenditures, which has gone up by more than a percentage point of the GDP over the previous five years to reach a peak level of 18% of the GDP in the revised estimates for 2019–20. The reasons for this are many. Apart from inflation and the implementation of the pay commission award by the states, other acts of commission and omission by the central government have also burdened the states. The states had to take over the debts of the power distribution companies as a part of their financial restructuring under the Ujwal Discom Assurance Yojana (UDAY). Similarly, the loan waivers declared by the states in response to the growing farmer distress in the country, also cost the states dearly. In contrast, the states’ own tax revenues and total states own revenue crept up by a meagre 0.2 and 0.5 percentage points of the GDP during the period. The main reason for the flailing own tax receipts of the states is the glitches in the GST roll out, which has negatively hit tax collections.

The surge in state debt and the compression of their fiscal leeway has already had a negative effect on the spending patterns. Development spending by the states, which peaked at 67.6% of the total state government spending in 2016–17, has fallen to 63.4% in 2020–21. Numbers indicate that despite the fiscal compression, the states have so far been able to buoy up their social development expenditures, the largest allocations of which are for education, health, and water supply and sanitation, which went up by a few marginal points to around 57% of the total development spending. In contrast, the share of economic services in development spending, the largest allocations of which are for agriculture, rural development, transport and energy, have been reduced to around 42%. This will certainly constrain medium-term growth.

It is in this scenario that the states have now been left to fend off the pandemic and its impact, which has already further bloated the fiscal deficit of the states. While the average fiscal deficit was 2.4% of the gross state domestic product (GSDP) in the 2020–21 state budgets presented before the pandemic, it almost doubled to 4.6% of the GSDP in the budgets presented after the break of the pandemic. Current trends indicate that even the conditional increase in the states borrowing limits from 3% to 5% of the GSDP is likely to be inadequate to meet the ballooning resource needs of the states if the expected recovery remains evasive. The partial recovery of state GST collections in the second quarter has somewhat softened what the RBI has called the scissor effect, with expenditures surging and revenues collapsing. But the huge pandemic-related spending on healthcare and income support for the worst affected will also push down the investment spending by the states, which will affect growth and kick off a vicious cycle that feeds on itself.

Countering this would require the states to reprioritise spending with a special focus on high multiplier capital projects with low gestation periods and also in building healthcare facilities and support systems like better social security nets. Similarly, universal health coverage has to be rolled out in the deficit states. Finally, fiscal policy of the states also has to be re-engineered so that fiscal spending becomes anti-cyclical, rather than procyclical, and function as a stabilising tool. But all this can happen only if there is a substantial shift of resources to the states, hopes of which now rest on the second report of the Fifteenth Finance Commission providing a more generous share of the resources to the states to meet their rapidly growing responsibilities.

What could be the key elements of a 

virtuous post-pandemic fiscal response by states? 

First, reprioritising expenditures towards more 

productive high multiplier capital projects has to 

be made centre-stage and insulated from being 

sacrificed repeatedly at the altar of the expediency of shortsighted fiscal arithmetic. Investing in health care systems and social safety nets in line with the states’ demographic and co-morbid profiles and strengthening urban infrastructure have to be an integral part of the fiscal strategy. 

Protecting human capital is as important as investing in physical capital formation, with equally strong Keynesian multipliers. In this context, expanding states’ spending on health towards achieving the universal health coverage goal of 2.5 per cent of GDP at the aggregate level must be brought forward in the agenda of fiscal priorities of states. 

States with limited fiscal space can focus on low 

gestation and high labour intensity projects that 

also crowd in private business.

Second, improving revenue mobilisation 

has to be frontloaded to make up for the tax base 

and accruals lost in the pandemic. Clearly, the 

revival of strong growth is the best way to boost 

tax revenues, but in order to make up for lost 

ground, concomitant engines have to be directed 

to harnessing efficiency gains via improving tax 

compliance, and greater digitalisation of the 

tax administration to expand the tax base (RBI, 

2019a; RBI, 2020).

4.6 Digitalisation can give dual benefits. 

First, it will help states lower cash dependence and physical access to banking infrastructure in times of social distancing and build resilience against future epidemics.

 Second, digitalisation can foster 

improvements in direct benefit transfer systems, 

including through e-governance initiatives. Digital 

platforms can also be utilised to reduce tax evasion and to expand the tax base. It is estimated that the direct benefit of digitalising government payments Could create gains of 0.5-0.8 per cent of GDP for India (Lund, S. et al., 2017) and pave the way for the formalisation of the economy. 

It will also help in job creation in the digital space.

The future of sub-national finances in 

India will be shaped by inter-state coordination 

and close engagement between various layers 

of sub-national administrations and health 

authorities. A cohesive national agenda built up 

on these blocks can mitigate vertical as well as 

horizontal imbalances and promote co-operative 

federalism. In this endeavour, special attention will be needed for ULBs, the weakest link and lagging behind similar bodies in other parts of the world in terms of capacity to raise resources, including financial autonomy to do so. Empowering local governments with higher resources and enabling them to raise resources has to be mainstream into the fiscal fabric of governance, including 

improving their market access. Viewing from the 

spatial lens, setting up uniform and timely database 

collection systems across states with regard to 

– nature of employment and migrant workers, 

health infrastructure and human resources, local 

government capabilities and resources – could be 

the first step towards identifying and prioritising 

the associated service gaps.

4.8 Good house-keeping will require 

maintaining fiscal transparency on assessing 

and quantifying the fiscal risks, particularly 

from ‘below the line’ items. Fiscal transparency 

also encompasses provision of ready access to 

reliable, comprehensive, timely, understandable, 

and internationally comparable information on 

government activities, so that the electorate and 

financial markets could accurately and easily 

assess the government’s financial position as 

well as the true costs and benefits of its activities. 

Linking higher borrowing with financing capital 

expenditure, and central transfers to transparent 

fiscal would bring in incentive-compatibility.

 Keeping in mind the inter-generational 

burden of debt, it is important for states to chart 

out a glide path back to fiscal rectitude. Like the 

centre, states may also consider revising their 

fiscal legislations by bringing in the desired 

counter-cyclicality and by incorporating debt as a 

medium-term anchor. No fiscal rule is static and 

the cross-country evidence suggests that fiscal 

rules should improvise on the basis of experience 

and new developments, so long as goal posts are 

not moved as a matter of expediency stemming 

for camouflaging breaches. By and large, while 

states have succeeded in adhering to their fiscal 

discipline targets, their fiscal policy has failed 

to act as a macroeconomic stabilising tool.

Budgetary constraints on fiscal spending have 

made their fiscal policies pro-cyclical. Laying 

down a transparent institutional mechanism in 

terms of revised FRLs, coupled with productive 

incentive systems, has potential to move states 

towards playing an effective balancing role in 

supporting growth while meeting their debt-deficit targets.

The next few years are going to be 

challenging for the Indian states. They need to 

remain empowered with effective strategies to 

drive through these difficult times. Sub-national 

fiscal policy has to be judicious and calibrated. 

Across states, maintaining overall stability, 

quality of spending and credibility of budgets may distinguish one state’s resilience from another.