By Dr. Gyan Pathak
Centre and State governments in India are in need of raising both tax and non-tax revenue, dismantling the administered pricing mechanism, reducing subsidies, and reorienting expenditure toward national and state-level priorities. This is essential to ensure India remains on a sustainable fiscal path with higher growth, given the high public debt at the Centre and state level.
It is the conclusion of a recent IMF working paper titled “Growth Convergence and Public Finances of India and its States” prepared by the authors Rajan Govil and Khyati Chauhan. Additionally, the paper says that there is a lack of convergence in per capita income across Indian states which requires greater resources for lower-income states for investment and improved public services. The observed wide differences in fiscal parameters across states require a tailored policy for each state. The large stock of debt of several states puts at risk the adequate financing of growth-enhancing expenditures.
“We find that low-income states in India have grown slower than high-income states from FY2002 – FY2023leading to a lack of convergence in per capita income, contrary to neo-classical growth theory predictions,” the paper read. “The lack of growth convergence hampers both overall national growth as well as balanced regional growth. From a macroeconomic policy perspective – labour, capital, and technology are mobile across the states, monetary and exchange rate policy as well as other national institutions are common. Fiscal policy remains distinct for each state.”
The paper notes that overall general government revenue has been stagnant over the last three decades at a low of 20% of GDP leading to inadequate availability of resources for development and investment purposes. Expenditure at 30% of GDP has mea4101nt a large fiscal deficit of 9.5% of GDP and a public debt of 82% of GDP inFY2023, leaving only some fiscal space. An adverse event could further negatively affect the fiscal situation and lead to fiscal dominance including greater monetization, inflationary pressures, financial repression, and macroeconomic instability, the paper warns.
Indian states combined account for around 60% of total general government (central and states) expenditures amounting to about 18% of GDP in FY2023. The majority of capital expenditure is undertaken at the state level although the gap has narrowed in recent years as some capital expenditure undertaken by state-owned enterprises has been brought on to the central government budget. Fiscal developments at the state level therefore have a substantial bearing on economic developments in each of the states as well as the country as a whole. We find that several of the lower income states have built up a high debt/GDP ratio, leading to their limited ability to increase expenditure on development and investment, the authors said, adding that fiscal consolidation is needed although this may come at the cost of slower economic growth.
In addition to the redistribution of revenue through the Finance Commission Awards, the central government has deployed additional schemes, such as the Central Sector Scheme and the Centrally Sponsored Schemes, to support states’ development needs, and has recently provided interest-free loans to support states’ public investment. Still, we find that states with low per capita income have little fiscal space as they are running large fiscal deficits to meet their capital expenditure requirements and have built up large outstanding liabilities that need to be reduced, the paper read. The limited resources lead to inadequate spending on public services (such as education, health and investment for public infrastructure) which in turn leads to low growth. This is compounded by the fact that private investments are lower in those states that are unable to provide adequate skilled labor and public infrastructure, leading to a vicious cycle.
Low-income states therefore, the authors of the paper said, need to raise their own revenue as a share of their Gross State Domestic Product(GSDP) and be provided with additional central transfers to enable investment in the necessary infrastructure and public services to escape the low-income trap. Simultaneously, both the central and state governments need to eschew the administered pricing model to raise revenue and reduce subsidies sharply, which will allow states to target expenditure toward investment and provision of improved public services. This will ultimately attract more private investment and achieve higher rates of sustainable growth.
States above more than 20 million population in 2002 were classified by the paper as large states and others are as small states. In FY2002, 96.2% of India’s population was concentrated in the large states and these accounted for 95.4% of the country’s nominal GDP. The large states are further categorized into high-, middle- and low-income states based on their per capita real income (measures in rupees Rs) in FY2002 (i) High-Income States, that had a real per capita GSDP over Rs 40000: Andhra Pradesh, Gujarat, Haryana, Karnataka, Kerala, Maharashtra, Punjab and Tamil Nadu (ii)Middle-Income States, with real per capita GSDP between Rs 27000 and Rs 40000: Assam, Chhattisgarh, Jharkhand, Madhya Pradesh, Odisha, Rajasthan and West Bengal; and (iii) Low-Income States, with real per capita GSDP less than Rs 27000: Bihar and Uttar Pradesh. The two low-income states accounted for 24.7% of the total population of the states in FY2002, which increased to more than a quarter in FY2023.
Seven out of the eight high-income states and one of the middle-income states (Odisha) grew at the fastest pace amongst the 17large states during FY2002 – FY2023. During this period, the real GSDP per capita for high-income states, except Punjab, grew at more than India’s average per capita GDP growth of 4.8%. Consequently, Punjab dropped from the second spot amongst the high-income states in FY2002 to the last spot in FY2023.
Most middle- and low-income states grew at around or less than India’s average growth of 4.8%, except Odisha which grew at 6.1%. These states comprised 56% of the population in FY2002 and are also high on the multi-dimensional poverty index (MPI) potentially impeding their ability to grow at a faster pace. For instance, availability of skilled labour would be low in states with a high MPI score. Credit per capita as well as credit/GSDP ratio remain low in these states, possibly implying fewer investment opportunities.
Fiscal space is limited especially for middle- and low-income states, as they are already above their Fiscal Responsibility and Budget Management Act (FRBM Act) implied target for public debt of lower than 20% of GSDP.
The borrowing limit for state governments (i.e. the fiscal deficit each state can run) has been set at 3% of GSDP and has been relaxed in recent years for the near-term mainly to mitigate the impact of the Covid pandemic and for states that meet the requirement for reforms undertaken in the power sector. At the same time, their own revenues are barely sufficient to meet their committed expenditures – RNDE that comprises interest, pensions, and administrative services. Consequently, they are heavily reliant on central transfers to meet their revenue development expenditure. Their capital expenditures are financed almost entirely by borrowings and the current level of spending will need to be reduced to adhere to the FRL targets that had been relaxed to meet the needs of the states to mitigate the impact of the Covid-19 pandemic. This will limit the public investment of the low- and middle-income states going forward thereby reducing their potential GSDP growth leading to further divergence in per capita income across states.
Interest expenditure on general government borrowings is high at 5% of GDP or about 25% of total revenues, restricting availability of resources for development and investment purposes. While the fiscal deficit was higher in FY2023 by 3.1% of GDP compared with FY2019 and mainly driven by higher expenditure, the consolidated public debt increased by 12% of GDP during this period to 82% of GDP in FY2023.
The states’ share in total taxes collected by the central government have however declined from 4% of GDP inFY2019 before the pandemic to 3.5% of GDP in FY2023, while the central government’s share has increased during this period from about 7% of GDP to 7.7% of GDP. The states’ share in total taxes collected by the central government came down from about 37% in FY2019 to about 31% in FY2023 instead of the 42% of shareable tax revenues collected by the central government recommended by the Finance Commission. This decline in the states share mainly reflects an increase in non-shareable cesses and surcharges.
States’s expenditure has increased sharply from FY2016 to 16.5 – 17% of GDP from around 14.5-15.5 per cent in FY2015 as a result of all financial assistance and expenditures under the Centrally Sponsored Schemes being routed through state budgets.
States’ combined revenue non-development expenditure (NDE) has increased to 5% of GDP in recent years mainly due to rising interest costs and pensions. It takes up 65% of states own revenue and 35% of states total revenues (including central transfers), leaving little for development expenditure. (IPA Service)
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