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The evolving state of Indian states

LiveMint logoLiveMint 11-06-2017 Narayan Ramachandran

A quiet revolution with respect to Centre-state finances is upon the Indian Union.

The well-known recommendation from the 14th Finance Commission to devolve more taxes to the states combined with a rationalization of centrally sponsored schemes and the imminent introduction of the goods and services tax (GST) will result in a gradual but significant change in the relative finances of states and Centre.

According to the Reserve Bank of India (RBI), even as the fiscal position at the Centre remains stable (Central budget deficit for 2017-18 pegged at 3.2% of gross domestic product), there has been a marked deterioration in the gross fiscal deficit of states taken as an average (over 3% of GDP in 2015-16 and 2016-17 relative to an earlier five-year average of 2.5%). The figure for 2016-17 is not finalized yet but could be as high as a deficit of 3.4%. Fortunately, the revenue deficit at the aggregate state-level remains close to zero (-0.1% of GDP for 2016-17). Revenue expenditure of the states has risen sharply in recent years with greater financial devolution and increased expenditure. In aggregate, the states spend about 30% more than the Centre. This gap will further increase with GST. Despite the increase in magnitudes, the categories and priority of state expenditures have not changed materially. State revenue expenditure is concentrated on education, health and rural development.

In most states, the single largest item is debt service (average of 21% for all states) followed by education (average of 15%) for all states. Debt service is widely variant between states with Punjab and West Bengal spending significantly more than Bihar and Madhya Pradesh. One reason for the increase in state fiscal deficit (approximately 0.6% addition to the aggregate fiscal deficit comes from this) is the issue of bonds under the Ujwal Discom Assurance Yojana (UDAY) scheme—a state-led bailout for state-owned power distribution entities.

Revenue receipts for states have grown faster than the Centre because of greater transfer from the Centre and because the principal source of state revenues is consumption tax (sales and excise tax), which has a wider footprint than income tax. Under the principles agreed upon for GST, states will be protected for a period of five years on their own revenue (both at the start and ensuring 14% growth each year). This has added complexity to the GST regime—one nation, one tax has become one nation, three types (Central goods and services tax, state goods and services tax, integrated goods and services tax), eight tax rates.

The revenue protection for states could result in a greater transfer between Centre and states in the first five years, if the rate of nominal GDP growth of the Centre is lower than 14%, as is rather likely. On the expenditure side, states may see a dramatic increase in the wage bill if they follow the lead of the 7th Pay Commission that increased the Central wage bill by 23%. Several states are in the advanced stage of discussions related to their own pay commissions. Bihar has already adopted a 13-15% increase while Gujarat has accepted a whopping 124% increase to its fixed pay employees. Karnataka, Maharashtra, Tamil Nadu and many other states will likely follow in coming months with retroactive effect from 1 April.

Where do we go from here?

India remains consumption obsessed at the level of states—consumption taxes raised are ploughed into government consumption (wages). With states operating at border-line revenue deficit levels and a significant part of expenditure going to debt service, capital expenditures are likely to remain modest and constrained. Debt is being raised to deal with revenue deficits in states like Punjab and in all states to fund past liabilities of power discoms. Investment in the future through the building of schools, irrigation projects, affordable housing, roads and district hospitals will remain hostage to the poor debt sustainability of states. Farm loan waivers add another item of stress on state budgets. Fulfilling a poll promise, Uttar Pradesh chief minister Yogi Adityanath, announced a farm waiver for loans below Rs1 lakh. On an annual state budget base of about Rs3.5 trillion this will represent a write-off of about Rs35,000 crore or 10%. If, as announced, this is financed by issuing specific bonds, there will be a material increase to the debt service bill because of the waiver. Farmers from Maharashtra and Tamil Nadu are clamouring for a similar waiver (as an aside, this “culture of periodically waiving farm loans” has had a significant impact on collections in the micro-finance sector after demonetization. As a consequence, the micro-finance sector is likely to see non-performing assets of over Rs5,000 crore in 2017-18).

Each state will have to evolve a different path based on its topography, its business mix and its initial financial position. States that are constrained by both current and future resources, like Kerala, Punjab and West Bengal, will have to fundamentally rethink their economic model. Other states like Madhya Pradesh or Odisha, where debt burdens are low, could choose to invest wisely for the future. All states will need to focus on widening their tax base, reducing leakage and prioritizing their wage bill (police force versus other forms of inspection for instance).

P.S. “Adjust the microcosm and the macrocosm will adjust for you. It is like the hydrostatic paradox, one drop of water can balance the universe,” said Swami Vivekananda.

Narayan Ramachandran is chairman, InKlude Labs. Read Narayan’s Mint columns at

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