States have been in the firing line in the battle to save lives and livelihoods from the impact of Covid-19. However, the loss of economic activity following the nationwide lockdown, has wreaked havoc on states’ finances. While the Centre has allowed states to raise their fiscal deficits from 3% to 5% of gross state domestic product, riders have been imposed in the form of implementation of reforms. In this post, Mayank Jain and D Priyadarshini examine whether these conditions will facilitate or hinder the effective functioning of states in the current scenario.
States continue to be in the firing line in the battle to save lives and livelihoods from the impact of Covid-19. However, they need ample resources to fight. As yet, there is little certainty on the trajectory or impact of the pandemic, which – along with the loss of economic activity following the nationwide lockdown – has wreaked havoc on states’ finances. But even as the Centre has acceded to the states’ demand to raise their fiscal deficits from 3% to 5% of their gross state domestic product (GSDP), it has imposed some riders. Of the additional 2%, 1.5% is conditional upon states implementing reforms in four areas – ease of doing business, universalisation of ration cards, urban local bodies (ULBs), and power distribution. Given the health and economic crises plaguing the country and weakened states’ finances, it is important to examine if these conditions help states to fight effectively.
Need for borrowing
States’ revenues have taken a significant hit from all directions. First, their own tax revenues, primarily driven by indirect taxes on non-essential economic activity, such as motor vehicle sales and entertainment, have dipped drastically – between 50% and 75%. Second, State Goods and Services Tax (SGST), a major source of tax revenue, is also expected to dip by 30% in FY21 (fiscal year 2020-21). Third, while shortfalls in SGST are compensated by the Centre, the compensation itself is unlikely to be sufficient since it is financed from a cess on luxury, sin, and demerit goods, the sales of which have plummeted due to the lockdown and its economic impact. The amount of SGST compensation for FY20 devolved to the states has already taken a hit due to low overall GST collections at the central level. The compensation fund is unlikely to meet the Rs. 800 billion in SGST compensation that states are still owed for April-May FY21. The devolutions in the past few months have also been delayed. Fourth, the Centre has already transferred the originally budgeted share of states in the divisible pool of taxes till May 2020, as a gesture of goodwill. Going forward, the quantum of devolution is likely to suffer due to lower tax collections in FY20, affecting many states that depend on central transfers for about half of their overall revenue.
Thus, with drastic reductions in own sources of revenue along with reductions in central transfers, states are likely to depend even more on borrowings to deal with the twin health and economic crises. Indeed, aggregate state borrowing more than doubled during April-June 2020, compared to the previous year. This is likely to be so despite measures like the 60% increase in the Ways and Means Advance (WMA) limit. While it may free up an additional Rs. 120 billion and create some fiscal space for states, it is insufficient given the magnitude of revenue decline. For instance, the median state revenue budgeted for FY20 was about Rs. 797 billion. Adding Rs. 120 billion via WMA to a median revenue diminished by 50-75% only meets 65-40% of the original budget. Also, with fewer revenue-generating tools post implementation of GST, some states have attempted to raise revenues with increased taxes on fuel and alcohol. But there is little headroom given the central excise duty hike by the Centre, and the dependence on consumer demand and capacity to pay, which have also been significantly impacted.
Under these circumstances, imposing conditions on borrowing by states impedes timely access to funds, or perhaps any access at all. The State Bank of India (SBI) has estimated that only 8 out of the 29 states will in fact be able to meet the conditions. Timely access to borrowing, however, is crucial. Even under normal circumstances, states spend 1.5 times more than the Centre (states spent Rs. 29.25 trillion in 2017-18 while the Centre spent Rs. 21.42 trillion). They employ five times more people than the Centre. They are responsible for delivering vital public goods and welfare. The capital outlay of states is also much higher at 2.8% of GDP (gross domestic product) compared to 1.8% for the Centre. States’ resources and actions therefore have a critical role to play in meeting the economic, welfare, and public health challenges of the twin crises.
Further, for many states, emphasis is likely to shift towards revenue expenditure, particularly on social security, welfare, and public health, to mitigate the loss of lives and livelihoods. The expenditure pattern will also differ across states. Those with a higher mortality rate due to Covid-19 or with a greater influx of migrants would prefer to spend more on these items. A centrally imposed reform agenda therefore also risks running counter to their current spending needs and the flexibility required for localised decision-making, leaving states to make potentially harmful trade-offs at a time of weakened finances.
In this context, the conditions imposed may in fact serve a limited purpose in achieving their stated objectives of maximising revenues, plugging leakages, and ensuring investment. For instance, capex is a key aspect of creating an environment that spurs economic activity and generates higher revenues. Capex is also important to attract private investment that spurs growth and employment opportunities –– a crucial aspect of an ‘Aatmanirbhar Bharat’ (Reserve Bank of India (RBI), 2019a). Since the increase in the permissible fiscal deficit applies only for FY21, and the borrowing conditions expect the states to demonstrate the sustainability of their debt, states may seek to achieve this by cutting back on capex. Indeed, this is how states have consolidated their finances in the past (RBI, 2019b), and many states have indicated the compulsion to do so now. Thus, even assuming that conditions like randomised industrial inspections and district-level assessments of ease of doing business are necessary, they are unlikely to, in and of themselves, yield their expected outcomes in the near- to mid-term. States that require extra borrowing will devote precious capacity towards meeting these conditions, without necessarily seeing commensurate gains.
No adjudicatory framework
Finally, the Centre has imposed conditions on borrowing without consulting states. The Centre has also pre-empted the recommendations of the Fifteenth Finance Commission, as the conditions that it can impose under Article 293 (3) of the Constitution are still under consideration, with their Interim Report making no mention of it. Irrespective of any inherent merit, it remains to be seen if conditions can be imposed on states’ market borrowings, and if they can extend to non-financial parameters that may not directly relate to macroeconomic stability or be tantamount to influencing state policies. Concerns have also been raised that utilising this framework to impose Centre-led reforms impinges on the financial autonomy of states. These matters too require wider discussion as the implications for autonomy of states, Centre-state relations and coordination are serious, particularly in view of the crises that require both to work together. Moreover, the reforms embodied in the conditions have been suggested in the past too, amidst special interests, trade-offs for stakeholders, and other challenges. They also pre-date Covid-19. Therefore, they may need to be examined afresh due to the impact of the pandemic on state and household finances, as well as lifestyle. Whether their intended outcomes can be achieved through imposition of conditions, particularly in the near-term, needs to be examined in the light of underlying challenges and lack of a consensus-building exercise with the states. Indeed, some states have decried the imposition of the conditions as setting a bad precedent even if they are in a position to fulfil some of the conditions.
In this context, while the Centre has subsequently specified 10 conditions within the four areas for reform, no independent forum has been identified to evaluate state-level compliance; address their concerns fairly and equitably, based on their specific needs and constraints; or help centre-state dialogue in case of disagreements. For example, what is the minimum acceptable threshold for reduction in aggregate technical and commercial (ATC) losses in the power sector? Would this limit apply equally across all states? Can the states opt for direct benefit transfers to avoid crowding around fair price shops due to risk of Covid-19 transmission? Would states be permitted to link property tax rates to alternative metrics like annual rateable values instead of circle rates? Will this count towards fulfilment of the borrowing condition? Will consumers be able to pay the decided rates?
A forum to resolve these questions assumes greater importance in the absence of prior consultations with states, as enabling timely and smooth access to funds is imperative for the reasons set out above. Perhaps the time is fortuitous for providing teeth to an Inter-State Council, with clear norms of consultation, coordination and consensus-building.
Views are personal. The authors would like to thank Amey Sapre and Radhika Pandey for useful discussions.
- The justification for borrowing conditions on the basis that states have not utilised their previous borrowing limits is fallacious for the same reason. As mentioned, state borrowing is increasing fast, and doubled in the first quarter of FY21 compared to FY20. Further, states will naturally utilise relatively cheaper options of raising revenue before borrowing from the market, like selling land for instance. Also, alternative emergency measures, like the WMA limit increase, are unlikely to be sufficient for returning to fiscal normalcy for states, as estimated.
- Authors’ calculations using data from RBI (2019b).
- The RBI has indicated this in RBI (2019b). Given the higher expenditures and employment generation capacity of states, the study underscored the role of cuts in capex spending by states in the economic slowdown preceding the pandemic. States would therefore also have a crucial role in spearheading economic revival post Covid-19.
- The Fifteenth Finance Commission, in its Interim Report for FY2020-21 tabled in the Parliament in February 2020, has proposed a framework for sector-specific grants based on achieving certain milestones, and performance-based incentives in certain areas including the power sector. However, these pertain to grants and not borrowing. The Commission has not earmarked funds (except as regards nutrition). It has instead recommended that the relevant state and central ministries, and departments jointly arrive at metrics such as performance indicators and further, to utilise FY21 to lay the groundwork for utilisation of the funds when awarded subsequently.
- For example, RBI (2019b) has observed the need for states to mobilise revenues, and has suggested raising revenues through improvements in delivery of economic services like power or irrigation, although not necessarily by raising the rates.
- For instance, as per information available on the website of the Ministry of Power, Government of India, on the Ujwal DISCOM Assurance Yojana (UDAY), the ATC losses for the southern states of Kerala, Tamil Nadu, Andhra Pradesh, Telangana and Karnataka, range between 10-15% whereas for some of the central and northern states like Uttar Pradesh, Rajasthan, Bihar and Madhya Pradesh, they range between 20-35%.
- While essentially a defunct body, the importance of an Inter-State Council has been emphasised by various commissions and committees – most recently, in the Fourteenth Finance Commission Report. Also, see Yamini Aiyar’s interview with the Scroll on the need for an Inter-State Council.