Even before the pandemic, the economic slowdown had created a challenging fiscal environment for the states. And over the past few weeks, frenetic attempts have been on to raise taxes on fuel and liquor, and sell land assets. But it may be far from sufficient, especially given that states are at the forefront of battling the pandemic, and are having to spend more to protect lives and livelihoods.
Right now, even base expenditure is threatened, the effect of which will eventually be felt by citizens. Expenditure by states on new infrastructure like roads and bridges spurs businesses, creates jobs, adds incomes, and boosts consumption. Similarly, expenditure in developmental spheres provides the country’s most vulnerable citizens access to critical social services. A reading of state government moves till now shows that the imminent revenue shortfall will either compel states to borrow more or cut back on expenditure, both of which could have far-reaching consequences on their financial sustainability and their compact with the Centre.
The World Bank has estimated that India’s gross domestic product (GDP) will contract by 3.2% in 2020-21, resulting in a significant reduction in revenues realized by both the Union and state governments. India’s federal fiscal structure allows for a system of sharing of revenue and expenditure between states and the Centre. The Finance Commission, an independent constitutional body, determines the criteria for this revenue sharing. According to budget estimates for 2019-20, aggregating across all states, 52.5% of the states’ total revenue were to be generated on their own, while 47.5% came via central transfers.
Within the states’ own revenue pie, about 85% comes from various taxes (Chart 1). The main tax head is collections from the goods and services tax (GST). But states can’t revise these tax rates, which are determined by the GST Council. Another 10% of the revenue inflow is via levies on land transactions, which have stalled.
About one-third of the tax component is sales tax and excise—basically, taxes on liquor and petrol, the two main levers states are pulling today. Several states, including Delhi and Maharashtra, have taken the Centre’s lead and increased duty on fuel. They also hiked duties on liquor to capitalize on the pent-up demand. Delhi, for example, levied an additional duty of 70% as a “corona fee”.
But the expected gains didn’t always stick. Karnataka, which earns about 18% of its tax revenue from excise duty, increased excise on alcohol on 6 May. The pent-up demand resulted in an initial surge in sales. But subsequently, sales fell, and the state fell short of its monthly excise target of ₹19 billion by ₹4 billion.
To tide over the imminent crash in revenues, states have resorted to various ad hoc measures. For instance, Karnataka is looking to raise ₹150 billion from the sale of corner plots within the jurisdiction of the Bangalore Development Authority. It also plans to utilize ₹10 billion set aside for the Rajiv Gandhi University of Health Sciences. Collectively, this is about 13% of the state’s budgeted tax revenue.
Karnataka is a rare example of a state pressing to monetize assets. So far, there’s been little from states on big monetization attempts or other left-field ideas to raise revenues. One option they have are the 1,450-odd public sector undertakings owned by state governments, in which they have invested ₹14.6 trillion so far.
There are large disparities among states’ ability to generate their own revenues. As per budget estimates of 2019-20, while Delhi was projected to generate 86.5% of its own revenue, this share was just 8.4% for Nagaland. More prosperous states such as Haryana, Maharashtra and Telangana rank higher in this regard, while Bihar, Jammu and Kashmir, and north-eastern states are laggards.
While states that are more self-reliant will feel the immediate brunt of the lockdown, the loss of central revenues will also affect states dependent on grants. They are likely to receive significantly lower central revenues than what they budgeted for. Already, payments from the Centre to states are delayed. The Centre has assured states an annual 14% increase in GST revenues for five years. Compensation for December 2019 to February 2020 was released only on 4 June, starving states of scarce revenue during the lockdown months. It is highly likely that normal GST collections this year won’t be enough to meet that 14% annual growth promise. Either the Centre or the GST Council will have to borrow to meet the shortfall to states. A meeting of the GST Council has been called in July to discuss the various options.
States also suffered huge revenue losses during April and May, primarily on account of lower taxes. In a meeting of the GST council on 12 June, Union finance minister Nirmala Sitharaman told state representatives that only 45% of the indirect tax target had been met in these two months.
The number of e-way bills generated provides a measure of taxable transactions. These are documents for movement of consignments above ₹50,000 in the current GST system. The total e-way bills generated in April was 8.6 million, against 57.1 million in February, a fall of nearly 80%. This increased to 25.6 million in May, but is still less than half of normal months. Considering that the states’ share of GST comprises nearly 20% of their total revenues, this is a significant loss.
In mid-April, less than three weeks into the nationwide lockdown, Karnataka said the state had cash reserves for a maximum of 45 days. An analysis by India Ratings and Research, a credit rating agency, estimated that the largest 21 states collectively faced a revenue loss of ₹971 billion in April alone, led by Maharashtra ( ₹131 billion) and Uttar Pradesh ( ₹111 billion). An extrapolation shows that 17 of these 21 states saw a 70% revenue shortfall in April (Chart 2).
The pandemic has underscored the fiscal vulnerability of states, and consequently, raised questions about their longer-term financial sustainability. In the absence of broad-based tax handles available to the Centre, states have two options: borrow more or cut spending. Both have consequences.
India’s hierarchical federal fiscal structure entails the imposition of certain thresholds on the states’ fiscal functions. In an Economic And Political Weekly (EPW) article titled “Fiscal Federalism in India since 1991″, authors Chirashree Das Gupta and Surajit Mazumdar, professors at the Jawaharlal Nehru University, say that the states’ fiscal behaviour has been governed under the overarching paradigm of “sound finance”, in which states are competing with each other to attract private investment. The “sound finance” paradigm mandates keeping taxes and fiscal deficits within stipulated limits.
Under the Fiscal Responsibility and Budget Management Act, passed in 2003, states are mandated to restrict their fiscal deficit to within 3% of their gross state domestic product (GSDP). Only 12 of the 36 states and Union territories were able to adhere to this in 2018-19.
Post-covid, several states asked the Centre to increase their external borrowing limits. The Centre has allowed states to borrow an additional 2% of their GSDP from the open market, but with strings attached. While the first 0.5% can be borrowed without any conditions, the remaining 1.5% would require them to undertake reforms in various spheres, including the public distribution system of foodgrains, ease of doing business, the power sector and urban local bodies.
In a 5 June piece in The India Forum, M. Govinda Rao, member of the 14th Finance Commission and former director of the National Institute of Public Finance and Policy, said states may not be able to fulfil all the stipulated reform conditions. This will discourage them from borrowing more, and they will consequently be compelled to cut expenditure. Rao also noted this is the first time the Centre has imposed conditions on states for external borrowing. Even if these reform conditions are desirable outcomes, these are signs of the Centre impeding on the financial autonomy of states, which may be a cause for concern, he added.
Even as revenues decline, and with barriers to borrowing, states have limited leeway to reduce revenue expenditure, which comprises committed payments towards interest, salaries and pension. According to PRS Legislative Research, these committed expenditures consume nearly 50% of states’ total revenues.
Therefore, cutbacks are more likely in capital expenditure, which have a multiplier effect and accounted for 17% of total expenditure by states in 2018-19. States have driven India’s capital expenditure over the past decade. According to PRS, in 2019-20, the capital outlay of states is estimated to be 2.8% of India’s GDP, against 1.8% of GDP by the Centre. Further, states are channelling capital expenditure into critical sectors such as transport, irrigation, energy and rural development. Any cutbacks here would have severe consequences on an economy that is set to contract.
A situation in which desperate states are not only competing for grants from the Centre, but also for private investment would be detrimental in the long run. Rao, in the same piece, argues for an institutional mechanism that enables inter-government bargaining, cooperation, conflict resolution, and non-predatory competition among states. The immediate focus, though, is on revenues, where the questions are many and the answers too few.
Arjun Srinivas is with www.howindialives.com, which is a database and search engine for public data