Money & Banking

RBI: Difficult years ahead for States, and federalism

Our Bureau. Mumbai | Updated on October 27, 2020 Published on October 27, 2020

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Warns of combined fiscal deficit surging beyond 4% of GDP

The next few years are going to be challenging for States due to the impact of the Covid-19 pandemic, which could also leave lasting scars on federalism, the Reserve Bank of India has cautioned.

With States in the frontline of the battle against Covid, their fiscal arithmetic for 2020-21 is likely to suffer, the central bank said in its report, State Finances — A Study of Budgets of 2020-21.

According to the report, States’ combined GFD (Gross Fiscal Deficit) is projected to widen beyond 4 per cent of GDP in the baseline scenario, higher than the budgeted 2.8 per cent of GDP for 2020-21.

Given the clear inter-linkages between growth and tax revenues and considering that the latter fall faster than GDP when growth is negative, the central bank warned that tax revenues are likely to be reduced for the next few years.

States need to remain empowered with effective strategies to negotiate these difficult times, it added

Scissor effect

Pandemic related spending, particularly on health and other support measures for households and firms, is likely to keep these expenditures high; prolonging the ‘scissor effect’ (surging expenditures and collapsing revenues), it added.

In addition, States’ fiscal position is likely to be affected by a surge in contingent liabilities (guarantees).

In this milieu, State governments may have to face the difficult choice of putting investment projects on hold, but, given the multiplier associated with capital spending, this will inevitably entail growth losses in a vicious circle feeding itself, RBI said.

The central bank emphasised that the pandemic stalled a critical phase in the implementation of targeted structural reforms by the States, including overhaul of the Agriculture Produce and Marketing Committee; land leasing for agriculture; and simplification of labour regulations.

“States are also engaged in re-building the social and economic infrastructure, including public health, urban and digital infrastructure. The pandemic has underscored their criticality and momentum must not be lost,” emphasised the report.

States indebtedness

The pandemic will have a bearing on inter-generational transfers, with lower discretionary spending or higher taxation in future, according to the RBI.

Keeping in mind the inter-generational burden of debt, it is important for States to chart out a glide path back to fiscal rectitude, it added.

“States’ indebtedness is set to rise, and if it is not accompanied by an acceleration in growth, fiscal sustainability will become the casualty, overwhelming the modest gains of the prudence in recent years,” the RBI said.

Post-pandemic fiscal response

The report underscored that re-prioritising expenditures towards more productive high multiplier capital projects has to be made centrestage and insulated from being sacrificed repeatedly at the altar of the expediency of shortsighted fiscal arithmetic.

The central bank said protecting human capital is as important as investing in physical capital formation.

In this context, the RBI felt that 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.

Frontload revenue mobilisation

The report said improving revenue mobilisation has to be front-loaded 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,” it added.

The central bank observed that good house-keeping will require maintaining fiscal transparency on assessing and quantifying the fiscal risks, particularly from ‘below the line’ items.

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Published on October 27, 2020
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