Will States toe Centre’s line on Capex?

N Madhavan | Updated on November 25, 2021

Multiplier effect Spending on road construction will yield benefits

Modi Government is right in trying to bring about a behavioural change on how capital expenditure is incurred

It was not without reason that Finance Minister Nirmala Sitharaman met the Chief Ministers/Finance Ministers of all the States and Union Territories on November 15 in what she described as a “rare, one-off” meeting. Though she discussed ways to sustain the economic recovery post the second wave of Covid, her primary objective was to push the States to focus on capital expenditure. She even agreed to front-load a month’s devolution if that will help them enhance their capital spend.

The emphasis on capital expenditure is understandable. It has the maximum multiplier effect, something the Indian economy desperately needs to accelerate its pace of growth. According to a study by the National Institute of Public Finance and Policy, every rupee spent as a revenue expenditure has a multiplier effect of ₹0.98. At the same time a rupee of capex delivers a multiplier effect of ₹2.25 in the year it is incurred and it is ₹4.80 during the course of the entire expenditure. Apart from the higher multiplier effect, government capex catalyses private investment, increases production capacity thereby speeding up economic growth which in turn creates a lot more jobs.

Typically, the States cumulatively spend more on capex than the Centre. In FY21, they spent ₹4.46 lakh crore while the Centre’s spend was ₹4.12 lakh crore. States spending more on capex helps as it has better multiplier effect than the expenditure incurred by the Centre. It is because the Centre’s capex includes defence capital spending (roughly about ₹1 lakh crore) which predominantly consists of imports which provide little impetus to the Indian economy.

Though States spend more on Capital expenditure, they traditionally do so in a manner that is not entirely efficient. The money is not uniformly spent through the year but is bunched up and spent in the last quarter of the fiscal. The reasons are not far to seek. Capex is a discretionary expenditure unlike salaries, pension and subsidies which have to be necessarily spent. Unsure of the revenue flow States prioritise revenue expenditure and asset creation happens towards the end of the fiscal. The Centre too did this till recently.

Sops for States

To bring about a behavioural change among States and get them to spend on capex throughout the year, the Finance Ministry recently fixed quarterly targets and incentivised those that achieved it to borrow more. In the first quarter the States were supposed to spend 15 per cent of the budgeted capex. By Q2 the spend is 45 per cent, 70 per cent by Q3 and 100 per cent by Q4.

Immediate reaction to this move was that such a policy impinged on fiscal federalism. The States, some argued, had the right to spend the money they get from devolution the way they want. But in the end most States have come to accept the intention of the policy and embraced it.

In the first quarter of FY22, combined capex of 23 States rose by 15 per cent to ₹68,659 crore as against ₹59,344 crore in FY20. It is 62 per cent higher compared to pandemic-hit FY21. The Centre’s capex also rose by 55 per cent in Q1 FY22 vis-a-vis FY20.

Eleven States achieved the target set by the Finance Ministry and they qualified for additional borrowings to the tune of ₹15,721 crore. While this may be a welcome development, the overall number however masked a worrying part. Most of the high GDP States like Maharashtra, Tamil Nadu, Gujarat and Rajasthan failed to meet the target.

In Q2, even fewer States — only seven — met the target (of spending 40 per cent of Budgeted capex). High GSDP States like TN (27 per cent of the target), Maharashtra (14 per cent), Gujarat (33 per cent), UP (21 per cent) were still spending way below their target.

This is the reason Finance Minister chose to meet with States and understand their challenges when it comes to increasing capital expenditure. Her decision to release a month’s devolution in advance (₹95,082 crore as against ₹47,541 crore was released on November 22) was to leave enough cash in their hands so that they could ramp up the capex.

Uncertainties abound

But will the States change their approach? Some will but many may not, especially considering the uncertainty that the pandemic has created when it comes to revenue generation. Even though GST collections have risen sharply, it is not clear if it is due to pent-up demand or a sustained recovery. Also, it is too early to say if the Coronavirus has been vanquished.

That many European countries are imposing total lockdown again is a reminder that India too could face possible economic disruptions in the future. Under the circumstances, States may want to wait and watch before ramping up capex. The Centre is better placed to spend more on capex as it gets revenue from various types of cess that are not shareable with the States.

That apart, for many States the additional borrowing is not an incentive. They are already heavily leveraged and would not want to add to the debt. They have no incentive to front-load capex given the uncertainties.

Also, Tamil Nadu, Andhra Pradesh, Sikkim and Manipur, have negative cash balance as of end-October. Front-loading of devolution will certainly help ease their cash flow but it is unclear if they will use it on capex or prefer to clear their pending revenue expenses.

An attempt to bring about a behavioural change on how capex is spent is a welcome move. The policy may meet with limited success now due to the pandemic and the uncertainties it has created in terms of revenue visibility. But the Centre should not lose heart. Better results will come as the economy recovers.

Going forward, both the Centre and the States should also focus on the quality of capex. Spending on roads, power plants, ports and airports generate better multiplier effect than investing in buildings. These changes are necessary if India has to escape its current moderate pace of economic expansion and post strong double digit GDP growth in a sustained manner in the future.


Published on November 25, 2021

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