Fiscal consolidation

Both Centre and states need to reduce deficit

Union Finance Minister Nirmala Sitharaman will present the first Budget of the third Narendra Modi government next week. There are expectations around issues such as tax rationalisation, increased capital expenditure, and efforts to generate employment. Although it is likely that this Budget will be closely aligned with the Interim Budget, stakeholders will expect a medium-term road map from the government. In terms of overall fiscal management, as things stand, after facing a shock during the pandemic, the central government is on a steady path of fiscal consolidation. The fiscal deficit for 2023-24 was 5.6 per cent of gross domestic product (GDP), lower than the Budget Estimate of 5.9 per cent. According to the Interim Budget, the government is expected to contain the fiscal deficit at 5.1 per cent of GDP this financial year. 

While most of the attention is on the Union government, what matters for macroeconomic management is the general government finances. To be fair, most of the expansion happened at the Union level, but states also needed to put their house in order. In this regard, a new working paper by the National Institute of Public Finance and Policy, which examined the fiscal performance of the states after the pandemic, noted that while the pandemic’s impact on state finances was less severe than on the Union government, their commitment to fiscal consolidation is insufficient. Despite a slight decline during the pandemic, states’ own tax revenue rebounded to 7.8 per cent of GDP in 2023-24. Meanwhile, state capital expenditure surged and witnessed a 36 per cent increase within a single year. However, the rise in capex was primarily financed through additional borrowing, including from the central government’s 50-year interest-free loans. Interest payments have become a large component of committed expenditure, potentially crowding out other spending.

From a broader economic-management point of view, it is worth noting that research shows a correlation between economic development and states’ own revenue receipts. In states with high or balanced economic development, like Karnataka, Kerala, and Maharashtra, the share of their own tax revenue accounts for two-thirds of the total revenue. Conversely, laggard states show mixed trends and raised only 44 per cent of their revenue in 2022-23, indicating greater reliance on borrowing and external finance. However, the relationship between capex and development outcomes is not very straightforward. Evidence suggests that capex and social spending have little impact on development outcomes. It is possible that spending in these areas is not enough to make a significant impact. Thus, states need to spend in the right areas to improve outcomes. This would also help increase revenue collection and reduce their dependence on central support.

The data shows states have budgeted for a higher fiscal deficit this financial year than the Revised Estimate of last financial year. It’s worth highlighting that the central government has made significant efforts toward fiscal consolidation without reducing capex. States must also aim to reduce the fiscal deficit by improving revenue collection. Government finances — both at the Centre and in the states — must be brought in order at the earliest. Efforts will be needed to boost revenue and contain wasteful spending. This is necessary to bring down public debt, which is hovering above 80 per cent of GDP.