The annual study of State budgets released this month by the RBI comes amid important developments in the fiscal architecture of the Indian federal system. The Central government has a revised FRBM framework with the fiscal deficit alone as the target variable, which will be mirrored sooner rather than later in the States.

This comes alongside the GST revenue stream on one hand and pressures on the State budget caused by agriculture debt waivers, implementation of the Seventh Pay Commission and a higher recourse to market borrowing on the other.

Against this backdrop, the big picture of State finances during 2018-19 shows that States have budgeted a substantial fiscal correction in terms of fiscal deficit and revenue deficit relative to GDP. The fiscal deficit in budget estimates for 2018-19 reported by all States put together stood at 2.6 per cent of GDP with a revenue surplus of 0.2 per cent of GDP.

This is a correction from 3.1 per cent of the fiscal deficit for 2017-18 and 3.5 per cent in 2016-17. It may be noted that the fiscal deficit (revised estimates) has consistently crossed the FRBM threshold of 3 per cent for the third consecutive year now.

Expenditure on development

The above outcome, however, comes at a cost, which is seen in the decline in the developmental expenditure to GDP ratio by 0.3 percentage point. This is largely attributed to a lower order of developmental expenditure in critical sectors like rural development (9.6 per cent increase as against an increase of 16.5 per cent in 2017-18), and transport and communication (2.2 per cent increase as compared with 4.4 per cent in 2017-18).

In addition, the capital outlay is budgeted to increase at 14.3 per cent, down from 20 per cent in 2017-18. The deceleration is largely contributed by a sharply lower increase in outlay on transport, at 2.9 per cent against 13.9 per cent in the previous year.

This consolidated picture has to be seen in conjunction with a higher level of fiscal deficit (above the FRBM target of 3 per cent) budgeted by six of the major States, namely Goa (4.8), Kerala (3.2), Madhya Pradesh (3.3), Odisha (3.4), Punjab (3.9), Telangana (3.5), and three States in the “special category”, namely, Jammu and Kashmir (4.5), Meghalaya (3.4), and Nagaland (3.2).

But the real conundrum is States that have a revenue surplus and, at the same time, a higher fiscal deficit, perforce driven to higher borrowing.

These States are Odisha (revenue surplus of 2.2 per cent), Telangana (0.7) and Goa (0.2). Uttar Pradesh toasted the FRBM target of 3 per cent fiscal deficit and reported a revenue surplus of 1.8 per cent.

It is clear from this that State governments have taken recourse to higher borrowings to provide for higher capital expenditure being guided by the conventional fiscal philosophy that all capital expenditure is good and development oriented.

However, evidence suggests to the contrary in terms on return on capital translated to non-tax revenue, which has been stagnant at 1.2 per cent of GDP for the last four years.

This means capital outlay has not been self-financing. To the extent that borrowing cost is higher than return on capital, the situation will eventually lead to an unsustainable pattern of expenditure and a rising debt-to-GDP ratio.

Given this, what is the way forward for State finances keeping in view the changing fiscal architecture?

The budgetary process so far mandated budgets to be balanced in terms of fiscal deficit as well as revenue deficit. Even then, there was a tendency to reduce fiscal deficit at the cost of developmental expenditure, as there is a downward rigidity in committed expenditures like interest payments, pensions, and wages and salaries.

Now, with revenue deficit off the radar and fiscal deficit as the sole target variable, it will be easier to fit the norm by the simple act of reducing developmental expenditure even more. It makes it easier for States to make cuts to fit the numbers even as they go scot-free on ballooning revenue expenditure. This carries the risk of making the entire FRBM exercise meaningless.

Besides, it is not the level of fiscal deficit but also the financing of fiscal deficit that becomes critical through the instruments of market borrowing like State Developmental Loans (SDLs) with a maturity of around 10 years. The cost of this market borrowing depends on the financial health card of the State.

In the end, it is tempting for the States to report good headline numbers fitting into the required target but at the cost of sound fiscal management and the direction of expenditure to build human capital through education and health expenditure for long-term growth.

Here, the Fifteenth Finance Commission has the onerous task of defining the fiscal architecture, setting milestones and providing the broad direction of inclusive growth. On the one hand, the path to fiscal corrections should continue. But on the other, the quality and direction of expenditure are also critical to ensure that taxpayers’ money delivers more bang for the buck.

Game-changer

GST is turning out to be a game-changer of sorts. The RBI report says States have budgeted GST revenues at 2.6 per cent of GDP as against 1.6 per cent in 2017-18. This has helped fiscal consolidation and opened up a route that is largely stable, forward looking and likely to bring more revenues as the GST system further stabilises and becomes all-pervasive.

Looking ahead, the budgetary exercise must also factor in better expenditure management. For example, payouts like the Seventh Pay Commission are neither sudden nor an external shock.

There should be preparedness to meet this expected expenditure and fiscal space should be created for the purpose. Every five years, a Pay Commission comes along (that is the subject of another debate) and every five years we regress. Similarly, a loan waiver need not be a fiscal disaster if the budget has the wherewithal to create fiscal space to accommodate the financial burden.

State budgets are not as much the stuff of headlines as the Union Budget. But it is the States that can set the tone of growth and development at the grassroots.

Focussing on making State budgets more responsive, accountable and geared to the needs of the people will give a thrust to growth and development across the nation.

The writers are faculty members at SPJIMR. Via the Billion Press.

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