When Covid-19 pandemic started in India, given that health is a state subject, individual states reacted as best they could under state-level legislations. However, as more than 60% of all economic activity was shut down with the announcement of a nation-wide lockdown on 24 March, the result was a sudden and sharp drop in states’ own taxes at the time when their expenses shot up. In this post, Pronab Sen discusses how state finances have been dealt a devastating blow.

The SARS-CoV-2 (also known as Covid-19) pandemic has given rise to one of the biggest fiscal challenges faced by India in recent memory. There are three distinct dimensions of the problem:

• the direct costs of detection and treatment of the disease;
• the costs associated with containment of the disease by ‘social distancing’ and the consequent loss of livelihoods; and
• the loss of tax revenues arising from the sharp decline in economic activity.

When the pandemic started in India, given that health is a state subject, individual states reacted as best they could under state-level legislations. Containment, detection, and treatment were and are all being carried out by them; the Centre was nowhere in sight. Most states implemented some form of lockdown, but did allow a range of economic activities to be carried out. The extent, of course, varied from state to state. Nevertheless, such decisions were taken keeping in mind a balance between containment of the disease and the minimum livelihood needs.

The only measure taken by the Centre was announcement of the PM Garib Kalyan Yojana (PM-GKY) in mid-March – essentially a centrally conceived and implemented direct benefit transfer (DBT) – which did nothing to help the states in bearing the costs of managing the disease and hunger, but garnered political goodwill, although the net amount involved was merely 0.4% of GDP (gross domestic product).

Then on 24 March, the Prime Minister announced a nation-wide lockdown – the most comprehensive and draconian in the world. In particular, more than 60% of all economic activity was shut down with no notice. Only certain listed ‘essential goods and services’ were permitted, and that too with riders. This dealt a devastating blow to state finances on two counts. First, the livelihoods problem became even more acute, forcing the states to step up their humanitarian expenditures significantly, in terms of both cash and free or subsidised food. This was further complicated by an avalanche of return migration, which imposed costs on all states from the origination point to the destination and every intervening area in between. Unfortunately, there was no further contribution by the Centre after the original PM-GKY announcement.

Second, since practically all state taxes (mainly goods and services tax (GST)) accrue from ‘non-essentials’, the revenue implications were serious indeed. This measure alone would reduce states’ own tax collections for April 2020 by about 40%. It is certainly true that the Centre also loses an equal amount, but it does have other taxes that would continue – mainly income tax, corporate tax, and customs duty. More importantly, about 40% of Centre’s GST revenues are shared with the states, which means that a significant part of the decline is actually borne by the states. The net result was a sudden and sharp drop in states’ own taxes exactly at the time when their expenses shot up.

It should be remembered that the states, unlike the Centre, face a ‘hard budget constraint’, which means that they can spend only what they get from taxes (own taxes plus a share of central taxes mandated by the Finance Commission), non-statutory transfers from the Centre, and from what the Centre approves as state market borrowings. To be sure, the Centre has been punctilious about releasing the states’ share of central taxes for April 2020 as per the Finance Commission award without any cut due to its tax loss, but not a paisa more than that.

To make matters worse, indeed much worse, whatever was left of the already tattered state revenues was blocked. In the original list of “essential goods and services”, there were two items which provided some succour to state tax revenues – alcohol and e-commerce. Almost all states, other than those with prohibition, collect somewhere between 30-40% of their own tax revenues from alcohol; and e-commerce (particularly e-retailing) permits sale of non-essentials on which GST would be payable. On 14 April, while extending the lockdown, the central government banned these as well without any ostensible reason. This will reduce state taxes further to somewhere between 25-30% of what they would have been otherwise.

The states’ fiscal woes do not stop here. There are three other body blows that they have to cope with. First, the Centre has quietly announced expenditure cuts of 5-10% on all Ministries/Departments except 10, which may be further extended. Having been in this game for many years, its outcome is quite evident – the entire cut will be made on Centrally Sponsored Schemes (CSS). The CSS are schemes that are implemented by the states but financed by the Centre, and constitute a significant portion of the non-statutory transfers from the Centre to the states. Typically, whenever there is any expenditure cut by the Centre, practically all the Ministries/Departments protect budget heads, which are directly controlled by them. The CSS do not fall in this category, and practically all cost-reduction adjustments are made in them.

Second, the crash in world oil prices created an opening for additional resource mobilisation for oil-importing countries like India. On earlier occasions, such revenue opportunities were shared between the Centre and the states. This time, however, the Centre has pre-empted the entire space by raising its own taxes before the states even became aware of the possibility. In a situation where demand for petroleum products is sharply down because of movement restrictions and serious hardships being faced by the transport industry, any possibility of states raising their own taxes is effectively foreclosed (although a few small states have done so).

Third, the central power-generating companies have demanded that states make advance payment for any electricity they purchase. This poses a very difficult dilemma for the states. In their current cash-strapped situation, up-front payment for electricity will necessitate slashing expenditures elsewhere, perhaps including their humanitarian efforts. On the other hand, if electricity is cut off, its consequences on all ongoing activities and on people’s living conditions will be incalculable. It is not clear yet how this trade-off will play out.

Thus, the only option left to the states is to increase their borrowings. As far as state borrowing limits are concerned, the Centre has so far not permitted any additional borrowings for the year. What has been done is to permit the states to front-load their borrowing programme within the approved annual limits. In effect, this means that unless the borrowing limits are relaxed at some future point in time, the states will have to impose massive spending cuts in the future, aggregating to all the expenditure that they are incurring.

In view of the dire situation facing them, many states have floated additional state government bonds and, quite predictably, have paid a high price for it. The interest rate on these additional bonds shot up by about 1.5 percentage points from around 7.5% earlier, which means an additional future interest payment liability of about 20% on these borrowings. As things stand, the Centre can still borrow at less than 7% interest and on-lend to the states, but there is no indication that this on the cards. This sad state of affairs is likely to continue for a while, and more and more states will end up with large permanent liabilities on their budgets.

If all of this was not enough, the Centre has added insult to injury. The PM-CARES fund, an opaque, discretionary, and apparently non-auditable fund has been set up by the Centre, which has been made eligible for use of CSR (corporate social responsibility) expenses of corporates. This provision has not been extended to the Chief Minister’s Relief Funds that all states have for meeting humanitarian needs. Consequently, even if corporates wish to support the states in which they are located, they are debarred from doing so by a centrally imposed rule.

Thus, when all the smoke and dust clears, state government finances will be in shambles, and they will have to approach the Centre with begging bowls in hand to continue their day-to-day activities.