Widening cracks in state finances: Revenue deficits risk fiscal stability

India’s federal fiscal policy has behaved well post-pandemic, with both the Centre and states aligning their consolidation path until recently. While the Centre has been able to overachieve its fiscal targets in most years, states in aggregate have also managed to be fiscally prudent, though the nature of consolidation has differed for both. Unlike the Centre, which enjoyed a better revenue stream to fund its spending, most states’ fiscal discipline came at the cost of underspending compared to their budgets — thanks to missed revenue projections versus what was budgeted.

 

While markets tend to mostly focus on the Centre’s budgetary choices, state finances are an equally important component of India’s fiscal policy — states collectively spend more than the Union government (excluding the public sector enterprises), and their gross dated borrowing generally amounts to approximately 65 per cent of the Centre’s. Empirical evidence also points to higher multipliers for state capital expenditure (capex) relative to that of the Centre. The changing political map of India has reignited fears that political capital could get compromised, which would worsen budgetary choices and economic efficiencies. This merits a review of the deficit profiles of the states through the lens of the current fiscal and political landscape.

 

Freebies-led cracks in the path: While the Centre’s consolidation journey has continued in FY25 with a fiscal deficit (FD) to gross domestic product (GDP) target of 4.9 per cent, our assessment of the budgets of 19 key states indicates that their consolidation appears to have hit a pause. States are budgeting a 0.2 percentage point (ppt) widening of FD/gross state domestic product (GSDP) at 3.0 per cent — the highest since FY21— after under-spending and achieving a 2.8 per cent deficit in FY24, compared to the 3.2 per cent budgeted.  Of the 10 major states to go to polls in 2023-24, nearly every state has introduced new freebie schemes, regardless of party lines. This is not a completely new phenomenon. Our analysis over the last 20 years shows that on average, states’ FD/GSDP is 0.5 ppt higher during election years compared to the previous year, with revenue expenditure/GSDP increasing by 0.4 ppt, whereas capex/GSDP declining by 0.1 ppt.

 

Interestingly, nearly seven states have announced modified FY25 budgets this year after the general elections, and have increased their FD/GDP targets by an average of 0.3 per cent of GSDP compared to initial estimates. This change has been primarily driven by an almost 0.8 per cent increase in revenue expenditure, while the revenue targets remain overly ambitious. Higher revenue expenditure has been driven by new populist schemes (1.5-1.7 per cent of GSDP). Financial assistance schemes for women have been very popular, followed by free electricity and farm loan waivers.

 

Revenue targets mask weakness in fiscal math: States’ revenue growth has been consistently slowing post-Covid. Despite increased spending, states FD/GSDP is still looking to track nearly 3 per cent — thanks to their optimistic FY25 budget estimate (BE) revenue growth at 19-20 per cent, compared with the Centre’s 15 per cent. This is likely to result in a miss, especially with segments like state goods and services tax (SGST) budgeted to grow as high as 18 per cent, compared to just 11 per cent for Central GST. Meanwhile, growth in own tax revenue, or OTR,  (19 per cent) and grants (41 per cent) has been set at ambitious levels. Additionally, several states have budgeted much higher growth estimates for volatile revenue sources, such as non-tax revenue (25 per cent) and non-debt capital receipts (159 per cent), to bridge revenue gaps. The increasing reliance on these sources creates higher chances of budget estimates being missed.

 

Innovative ways of revenue mobilisation:  States will have to look for innovative avenues to mobilise their revenues better without straining their balance sheet. There are certainly some low hanging fruits that can help increase revenues quickly. For instance, the alcohol beverage policies.

 

States' capex turning out to be a casualty? Amid a healthy revenue stream, the Centre has focused its spending on capex while controlling and better targeting revenue expenditure. In contrast, states have treated capex as residual spending, as committed revenue expenditure (interest, pensions, salaries, and freebies) continues to bite them. States tend to spend 75-80 per cent of their budgeted capex, with over 20 per cent of this spending done in March. However, helped by the Centre’s capex loan programme, states’ capex outturn has improved since Covid, with rising achievement rates. FY24 specifically saw states frontload their capex in line with the Centre, albeit led by a small number of states. This year, states have kept an ambitious target of a 2.5 per cent capex/GSDP ratio — the highest in a decade! Data till August shows that states’ aggregate capex is 7 per cent lower than last year, with significant variance across states so far in FY25. With states’ FY25 committed expenditure/GSDP rising to 7.6 per cent BE— the highest since Covid and much higher than pre-Covid levels, and with overoptimistic revenue receipts, their capex targets will be easily missed, especially on projects not funded by the Centre’s capex loan programme.

 

Centre’s fiscal gains offset by state spending? Overall, while states’ FY25BE FD/GSDP is widening to 3 per cent from 2.8 per cent in FY24 (provisional), fiscal/state development loan data for FY25 so far has not been too disturbing. However, we see reasonable risks of slippage and fiscal mix worsening in the second half, with revenue deficit widening further to 0.5 per cent (vs FY24P: 0.3 per cent). This will also imply that the total general government FD/GDP might consolidate slower in FY25 and may still stay above 8 per cent in FY25 (8.4 per cent in FY24P), assuming the Centre sticks to 4.9 per cent FD/GDP and states slip to 3.2 per cent.

 

On the whole, multiple fiscal risks remain from the states’ perspective, particularly due to falling grants, emerging stress on own tax revenue, and ongoing non-merit subsidies. These state-specific fiscal vulnerabilities need appropriate policy considerations to enable sustainable fiscal recovery and innovative ways to augment the revenue space.

 

The writer is the chief economist at Emkay Global Institutional Equities desk