A bigger fiscal worry

Reining in states' fiscal deficit must be priority

In the last four years, the Union government has done reasonably well with regard to fiscal consolidation. In each of these years, the Centre’s fiscal deficit has declined over that in the previous year, and in the current year as well it is set to decline to 3.5 per cent of gross domestic product, or GDP. The target set for 2017-18 is still lower at 3.2 per cent. While this is commendable in itself — even though it could be argued that the quality and pace of fiscal consolidation in the Union government’s finances could have been better — a concern that is growing almost alarmingly is the widening fiscal deficit of the states. In contrast to the Centre, the states have seen their combined fiscal deficit rise from 1.93 per cent of GDP in 2011-12 to 2.46 per cent in 2015-16, and is likely to rise to 2.8 per cent in 2016-17.

While this is within the 3 per cent target set by the Finance Commission, analysts point out that the current year’s deficit figure could be an underestimate as it was arrived at without taking into account the impact of higher borrowings by states as a consequence of their participation in the Ujwal Discom Assurance Yojana, a financial turnaround and revival package for state-owned power distribution companies. A sharp rise in the combined fiscal deficit of the states can easily undermine the Indian economy’s overall macroeconomic performance and neutralise the gains that would have otherwise accrued from the Centre’s attempts at shrinking its deficit. The concern about the states’ fiscal deficit has gained more importance because the combined size of the states’ budgets today is much bigger than that of the Centre and, as such, the slippages in fiscal consolidation by states deserve urgent attention. 

Three factors are likely to make the threat to the health of state finances even more serious. One, the key reasons for an increase in the fiscal deficit at the state level are lower growth in revenue and a faster rise in expenditure. These, in turn, make the task of bridging the gap more onerous. Two, the impact of the Seventh Central Pay Commission’s recommendations on the states is not yet fully evident. Only a few state governments have decided to increase the wages of their employees in tune with the recommendations of the commission. More states will follow suit in the coming months. Consequently, the states’ fiscal deficit for the next couple of years is likely to worsen. Finally, the launch of the goods and services tax, or GST, from July this year will introduce an element of uncertainty to the flow of tax revenue to state government coffers. Until the new tax regime is fully rolled out and clarity emerges on the anticipated revenue loss as a consequence, the combined fiscal deficit of the states is likely to take a hit. The consequent rise in the demand for higher borrowings by states will thus be a tough, new challenge and the Centre and the Reserve Bank of India will have to tackle it without allowing it to do more damage to the Indian economy’s macroeconomic performance.