State governments face the heat as deficits rise - Views on News from Equitymaster

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State governments face the heat as deficits rise

Feb 22, 2000

The fact that finances of the state governments are in a dismal state often goes unnoticed. This is mainly due to the more pressing concern regarding central government finances. However, there is a need to look into the performance of the state governments with a view to improving the consolidated financial position of the Indian economy.

A recent publication of the Reserve Bank of India (RBI) highlighted the key reasons for the rising deficits at the state level. Before that let's take a look at the performance of the state government finances over recent years.


as % of GDP (market price)

One of the key reasons for the deterioration in the finances of the state governments was the slower growth in the revenue receipts of the state governments. Infact, total revenue mobilisation was 7% lower as compared to the budgeted amount for the year. The contributing factors to this were:

  • Decline in devolution of income taxes and excise duties from the centre. This was mainly due to the economic slowdown, which resulted in a lower pool of tax and excise collections. Consequently the states' shares were lower than anticipated (12.5% lower than budgeted).
  • State governments have resorted to competitive reductions in sales tax to attract investment in their respective states. This has resulted in the erosion of revenues from this key source (60% of state tax revenues). Infact sales tax collections were lower by 6% as compared to budgeted figures.
  • Finally, the economic slowdown also hurt the states' revenue generation from the levy of taxes on vehicles, commodities and goods among others.

However, it must be mentioned that capital receipts were 20% higher than budgeted for. This was mainly due to higher market borrowings and loans and advances from the centre.

The decline in revenues is only one side of the coin. The sharp deterioration in the finances of the state governments can also be attributed to the rise in expenditures. While developmental expenditure (including education and rural development among others) was higher by 7%, non-developmental expenditure (including interest expenditure and administrative expenses among others) was actually lower by 10% as compared to budgeted figures. Overall, expenditure was higher by 1.6%, mainly due to higher capital expenditure.

The expenditure side of the finances brings an interesting view to light. While the governments have been able to contain revenue expenditure at budgeted levels (despite rise in pay levels and interest expenditure), the rise in capital expenditure has overshot the target. Although this should be acceptable (subject to the size of the deficit) as there will be a future stream of earnings from such expenditure, it highlights the rigidity of the revenues of the state governments. Or looked at from another point of view, according to the RBI, this brings to light the important issue of 'integrity of budgeting'. This refers to the level of accuracy of the budgeted figures vis a vis the actual outcome.

The result of the decline in revenues and the rise in expenditure is evident from the sharp rise in the deficits at the state level (see table).

There is a pressing need for the state governments and the centre to try and correct the deficits at the state level. The main objective should be to plug the revenue deficit. In the medium to long term efforts should be made to eradicate the primary deficit (gross fiscal deficit less expenditure on interest payments). In other words, the situation should be improved to such a level that the state governments do not have to borrow to pay interest on outstanding debt.

The RBI mentions four main heads under which efforts are being initiated to curb deficits:

  1. Revenue mobilisation
  2. Expenditure management
  3. PSU reform
  4. Infrastructure development

On the revenue front, the central and state governments have already agreed on a uniform sales tax to curb the practice of competitive reduction. Further to this measures have been initiated to do away with sales tax based incentives for attracting investment. Harmonisation of taxes across various states will go a long way in improving the tax revenue collections of various states.

The non-tax revenues of the state governments also need to be lifted. Non tax revenues are primarily derived from state public sector undertakings like State Electricity Boards. However, instead of contributing to the resources, the public sector units more often than not are cost centres. The decision to invite private sector participation in public sector units is a welcome step as it would generate resources (for the state) and go a long way in improving the efficiency and productivity of these undertakings.

The most crucial issue relates to expenditure management. It is generally accepted that capital expenditure should not be sacrificed at the altar of fiscal deficit. The rational goes that capital expenditure increases the income generating capacity of an economy and therefore plays a key role in improving the standards of living over a period of time. However, in India the existing standards of living are very low and a large chunk of the population does not have access to even the basic amenities of life. In this context it is essential that developmental expenditure on social services like education and welfare should be liberal. The state governments would therefore have to walk the tight rope while allocating resources.

There is an urgent need to raise revenue and cut expenditure. However, while the former is largely dependent on the devolution of taxes and grants from the centre, the latter is increasingly becoming sticky. As a result the state governments have little control over their finances. Recent developments highlight the determination, both at the central and state level, to correct this mismatch in state level resources. It is unlikely that these measures will show results in the short term. Nevertheless, given their long term potential, they must be pursued with zeal and vigour.

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