Augmenting fiscal capabilities

Quality of expenditure should sway fiscal transfers

The latest annual study of state government finances by the Reserve Bank of India (RBI) has made some valid recommendations to the 16th Finance Commission (FC XVI), while outlining the fiscal capacities and revenue dynamics of the states. The Union Cabinet recently approved the terms of reference for FC XVI, though the names of its members and chairperson are still awaited. As a measure to augment states’ tax collection and improve the institutional strength of their revenue departments, the central bank has advised that the Finance Commission examine and reinstate some of the fiscal efficiency parameters. The RBI has also called for a need to review the current system of grants from the Centre to states. For instance, revenue-deficit grants are disbursed to states with high revenue deficits post-tax devolution, which can act as a disincentive in fiscal consolidation. In this regard, the RBI has argued that the Finance Commission can consider recommending an increased share of conditional transfers based on the extent of reforms and quality of expenditure. This could go a long way in harnessing healthy competition and strengthening the fiscal sustainability of states.

Notably, the RBI has also emphasised the need to encourage states to play a pivotal role in customising climate action to meet local needs. This calls for integrating climate finance with fiscal planning. Accordingly, it calls for grants linked to climate action for states. For instance, the states that control emission levels and encourage renewable energy generation may be considered for the disbursement of additional grants. Climate-related investment projects may be given special attention. However, aside from devolution and central grants, the states will themselves have to work to make their fiscal future more sustainable. In this regard, the RBI has rightly cautioned against reverting to the old pension scheme because it will impose a huge fiscal burden on states in coming years, amounting to 4.5 times that of the National Pension System. It has also advised against running fiscally imprudent schemes and subsidies.

While different states will have to make corrections at different levels, it is worth noting that state finances have improved remarkably in the past two financial years. Despite pandemic-induced economic difficulties, states’ consolidated gross fiscal deficit to gross domestic product (GFD-GDP) ratio declined from 4.1 per cent in 2020-21 to 2.8 per cent in 2021-22, following the relaxation of lockdown measures and rebound in economic activities. As the numbers put out by the RBI showed, fiscal consolidation was led primarily by a moderation in revenue expenditure, coupled with an increase in revenue receipts. According to projections, the states are expected to have a GFD-GDP ratio of 3.1 per cent in 2023-24, below the Centre’s limit of 3.5 per cent for the year. This will allow the capital outlay of states to exhibit a robust growth rate of 42.6 per cent and create adequate fiscal space for undertaking higher capex. However, the pace of correction and level of availability of fiscal space differ significantly among states. The states’ own tax revenue, for example, ranges from more than 70 per cent of the total tax revenue in states such as Haryana and Maharashtra to less than 50 per cent in Bihar and Jharkhand. Given the state of the overall political economy, the pressure to perform will increase on laggards.