Key Trends and Issues in India’s State Finances

Session Report
Aasthaba Jadeja

Contours of the Public Policy in India in the Amrit Kaal, An Online International Autumn School Programme was organized by IMPRI Centre for the Study of Finance and Economics in September 2023. It was also A One-Month Immersive Online Intermediate Certificate Training Course graced by various experts in the field.

Radhika Pandey conducted a session titled ‘Trends and Issues in State Finances.’ She initiated the session with an introductory overview of key concerns related to state finances that could potentially create vulnerabilities in the fiscal situation of the economy. While some aspects may have connections to the central government, the main emphasis of the discussion was on state finances.

Trends in State Finances

Ms Pandey discussed the state deficits in an aggregated manner, focusing on the impact of the COVID-19 pandemic. During the pandemic, the overall state deficit soared to 4.1%, primarily due to a sharp decline in revenues and an increase in state expenditures. It’s worth noting that the Fiscal Responsibility and Budget Management Act (FRBM) mandates that the fiscal deficit should be limited to 3% of GDP. However, in the fiscal year 2020-21, states were unable to meet this target and had a fiscal deficit of 4%. Even the central government’s fiscal deficit rose to 9% during that period.

In the subsequent year, the state fiscal deficit decreased to 2.8%, and in the 2022-23 fiscal year, based on revised estimates, it stood at 3.4%. For the current fiscal year, the budgeted fiscal deficit is 3.1%. It’s noteworthy that the FRBM, which governs the trajectory of the fiscal deficit, has not been amended post-COVID to reflect the altered fiscal deficit trajectory. The roadmap for reducing fiscal deficit and debt from 2021-25, provided by the 15th Finance Commission chaired by N. K. Singh, continues to be followed.

Furthermore, she emphasized the importance of assessing how states have performed in the first four months (April to July) of the current fiscal year. Monthly reports on this matter are available on the Comptroller and Auditor General of India’s website. Regarding capital expenditure, the total budget estimate was 7.88 lakh crores, of which 1.49 lakh crores has been spent, indicating that 18.88% of the total amount has been utilized.

Capital Expenditure

It’s also important to examine year-on-year growth. In terms of capital expenditure, there has been a substantial increase of 49.91% when compared to the first four months of the previous fiscal year. In contrast, when looking at revenue expenditure, the growth rate is a more modest 7.11%. This trend aligns with the budget estimates of the central government, which also aims for a higher growth rate in capital expenditure compared to revenue expenditure. One of the possible reasons for this could be that the central government is providing a 50-year interest-free loan and offering incentives to states to boost their spending.

Analyzing state-wise capital expenditure, we find that Andhra Pradesh has performed the best, with its capital expenditure reaching 47.79% of its budget estimate in the first four months of this fiscal year, a significant improvement compared to the 10.48% of the previous fiscal year. On the other hand, Karnataka’s capital expenditure was only 5.36% of the budget estimate from April to July, in part due to elections and the successive announcement of schemes, which contrasts with the 19.54% spent during the same period last year.

States such as Andhra Pradesh and Telangana have shown positive year-on-year growth in capital expenditure, while states like Punjab, Maharashtra, and Karnataka have experienced a decline in this area.

Tax Revenues

In terms of tax revenues, the state-level revenues appear to be relatively stable and promising. However, the central government has faced challenges, particularly in the context of a decline in direct and corporate taxes. For the current fiscal year, tax revenues have reached 28.3% of the budget estimate from April to July, slightly lower than the 28.5% achieved in the previous fiscal year. A similar situation is observed in revenue receipts.

Tax revenues are subject to fluctuations, and there has been an increase in the share of Union taxes compared to the previous year. The 15th Finance Commission has recommended a 41% share for states in central taxes for the period from 2021 to 2026. For the fiscal year 2024, the Union Budget has allocated Rs. 10 lakh crores for this purpose. The government has also been releasing advance installments to assist states in accelerating their capital expenditure. It’s worth noting that GST (Goods and Services Tax) has been the most significant source of tax revenue, contributing around one-third of the total tax revenue.

Issues in State Finances

  1. Issues in the bond market

The state’s bond market is notably smaller compared to the central government’s bond market. State Development Loans (SDLs) constitute a relatively minor portion of overall securities trading and the broader bond market. In the debt market, the central government securities take the lion’s share, followed by treasury bills, with SDLs coming in third. Despite the increasing financial needs of the states, their borrowing activities represent a very small proportion of the overall bond market trading.

The trading market and trading volumes exhibit a degree of volatility, with SDLs accounting for only around 5% to 6% of the total trading volume, while government securities dominate. This situation calls for policy reforms to develop state bond markets akin to the government securities market. Such development would entail increased liquidity, diversification, and a greater reliance by states on the market, which could contribute to improved fiscal discipline.

One of the challenges is that the top five states account for a substantial share, approximately 61%, of primary market borrowings and about 52% of secondary market transactions in SDLs. Andhra Pradesh, Tamil Nadu, Maharashtra, and Rajasthan were the top four borrowers during the quarter. In terms of secondary market trading, the bonds of Maharashtra, Gujarat, Tamil Nadu, and Andhra Pradesh saw the highest trading activity. This underscores significant disparities in how states rely on the bond market and how their securities are traded. Only a handful of states generate substantial interest in their securities, making them more liquid, while others face lower demand.

This issue represents a critical challenge in the state bond market that requires policy attention. As the financial requirements of states continue to grow, it is essential to ensure they have access to a deep and liquid bond market to meet their borrowing needs effectively.

  • Off-budget liabilities

These are financial obligations that don’t appear in the state governments’ official budgets but still represent a financial burden that must be addressed in the future. This situation can create intergenerational inequality and, in some instances, obscure the true extent of a state’s overall debt and deficit. Many governments have used off-budget liabilities as a way to bypass debt limits and fiscal responsibility regulations. While the central government has taken steps to tackle this issue, a number of these liabilities have become more transparent and have been incorporated into the official budget.

Southern states, in particular, bear a significant load of off-budget liabilities. States such as Andhra Pradesh, Telangana, Karnataka, Kerala, and Tamil Nadu account for off-budget debts totaling approximately Rs. 2.34 lakh crores, which represents about 93% of the combined off-budget liabilities of all states. These states have been provided with guidelines on how to treat off-budget liabilities, including factoring them into the borrowing limits set for states, with off-budget borrowings being adjusted against the net borrowing ceilings.

  • States Tax Revenue

It is reasonable for states to initially rely on central government grants and tax devolution to support their financial needs. However, it is imperative for them to develop the capacity to gradually finance a larger share of their expenditures using revenue generated from their own tax sources as time goes on. Take Haryana as an example of a state that has made significant progress in this regard. In Haryana, an impressive 87.1% of its total revenue is derived from its own tax revenue. This demonstrates a high degree of self-reliance and financial independence.

On the other hand, states like Bihar have a more substantial dependence on the central government, with a mere 32.6% of their revenue being sourced from their own tax collections. The majority of their revenue comes from central government allocations. This discrepancy highlights the importance of states gradually enhancing their ability to generate revenue internally and reduce their reliance on central funds, thereby achieving greater financial autonomy and self-sufficiency in meeting their expenditure requirements.

Conclusion

In conclusion, Radhika Pandey’s session on ‘Trends and Issues in State Finances’ shed light on several critical aspects of state finances and fiscal management in India. These discussions touched upon key challenges and opportunities facing the states, as well as the broader fiscal landscape in the country. One significant issue highlighted was the impact of the COVID-19 pandemic on state deficits. While the pandemic led to a temporary spike in deficits due to declining revenues and increased expenditures, there was a subsequent effort to bring them under control. The adherence to fiscal responsibility guidelines, despite the pandemic’s economic disruptions, was emphasized.

The bond market’s status and challenges faced by states in raising funds through State Development Loans (SDLs) were also explored. Policy reforms to enhance the liquidity and participation in state bond markets were suggested, acknowledging the need for a deep and liquid market to meet the growing financial requirements of states effectively. Lastly, the importance of states developing their own tax revenue capacity over time was emphasized. States like Haryana, with a high proportion of their own tax revenue, serve as examples of financial self-reliance, while others, like Bihar, rely more on central grants.

Overall, Radhika Pandey’s session underscored the complex and dynamic nature of state finances in India, calling for continued attention to fiscal management, transparency, and the development of financial self-sufficiency at the state level to ensure sustainable and resilient fiscal systems.

Acknowledgement: Aasthaba Jadeja is a research intern at IMPRI.

Read more event reports of IMPRI here

Knowing-Doing Gap in Public Policies

Using Feedback Loops for Policy-making