State finances improve, but reforms needed to address lingering issues

The Reserve Bank of India’s (RBI’s) latest study of state-government finances, released last week, showed significant progress at aggregate level. However, there is still ample scope for improvement and overall economic management depends, to a large extent, on how state-government finances are managed. At a broader level, since Union-government finances are typically the focus of public debate, reports like these help bridge an important gap. The latest RBI study showed that the adoption of fiscal-responsibility rules had helped states. The consolidated gross fiscal deficit for states declined from an average of 4.3 per cent of gross domestic product (GDP) between 1998-99 and 2003-04 to an average of 2.7 per cent between 2004-05 and 2023-24. The debt stock also declined, though at 28.5 per cent of GDP (March 2024), it is still way above the 20 per cent mark as recommended by the Fiscal Responsibility and Budget Management Review Committee in 2017.

 

More recently, the states contained their gross fiscal deficit at 2.9 per cent in 2023-24, lower than the prescribed limit of 3 per cent. This year, the aggregate fiscal deficit is budgeted at 3.2 per cent. However, as some analysts have pointed out, expenditure tends to undershoot for states as was the case also in 2023-24 — the states had budgeted for a fiscal deficit of 3.2 per cent. It is also worth noting that the quality of expenditure for states has improved. The capital outlay in 2023-24 was worth 2.6 per cent of GDP, compared to 2.2 per cent in 2022-23. Favourable fiscal outcomes in recent years have partly been driven by states’ revenue buoyancy, which has improved to 1.44 in the post-pandemic period, compared to the average of 0.86 between 2012-13 and 2019-20. Interestingly, an analytical study featured in the report showed inter-state disparity in the states’ tax revenue to gross state domestic product (GSDP) ratio declined after the implementation of goods and services tax.

 

However, despite the improvement, some issues need to be addressed on priority. First is the debt level as noted above. It is also worth highlighting that there are significant inter-state disparities. The outstanding liabilities of Himachal Pradesh, for instance, are above 45 per cent of GSDP and have increased significantly over the past decade. A mechanism will need to be put in place to address such outlying fiscal positions. Second, guarantees issued by state governments need to be addressed. It was worth 3.8 per cent of GDP in 2023 and could potentially emerge as a source of stress for state governments. Third, the competitive politics of providing subsidies and cash transfers by state governments can affect their capacity to make productive investment with long-term implications for growth and development.

 

In terms of future structural reforms, some suggestions in the RBI report are worth highlighting here and must be debated. First, a large number of central-government schemes affect the flexibility of state governments in spending. Rationalising such schemes can free budgetary space for state governments and allow them to spend as needed. Second, the timely transfer of resources to local bodies is important to enable them to fulfil their responsibilities. It will help improve growth outcomes. Overall, state finances have improved, but constant vigilance and reforms will be required to improve outcomes.