State finances on the mend as revenues, capex pick up

Recovering state finances
The past three years have been tough for state finances, but a smart recovery is on, led by the western and southern states.

The past three years have not been great for the state finances which went into disarray owing to geopolitical disruptions, macro-economic crises, and the coronavirus pandemic. The Union government’s decision to end the compensation scheme for possible losses from the switch to GST regime also aggravated the situation. However, there seems to be a reversal in the fortunes of states as they appear to come out of the shadows. Stable GST collections and a modest revenue growth seem to have fuelled the recovery.

There are several indicators that show a revival in state finances. In a bid to shrug off the effects of the coronavirus pandemic and a global economic downturn, the government has been making a major capital expenditure push and efforts to revive public sector growth. While the states have been lagging behind in this effort, the ongoing financial year seems to have brought happy tidings after three dismal years. The states are trying to match the Union government’s efforts to raise the capital expenditure.

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The government has budgeted a capital expenditure of nearly 3% of the GDP. For the state governments, this stood at 2.1% in 2022-23, but has risen to 2.8% in the current fiscal year. While this is quite close to the Union government’s budgeted amount, it still falls short of the pre-pandemic trend of the governments exceeding their capex goals. It is perceived that the amount spent by state governments on capex has a higher multiplier effect on the economy. Andhra Pradesh, Telangana, Haryana, Rajasthan and Madhya Pradesh are leading in capital expenditure in the first two months of the financial year.

An analysis by CRISIL Ratings show that the total revenue of 18 states with the biggest economies is likely to grow 6-8% in the current financial year. Eight states — Gujarat, Haryana, Karnataka, Kerala, Rajasthan, Telangana, Uttar Pradesh, and West Bengal — collectively account for 47% of the national GDP. In FY24, the collective nominal GSDP of these states is expected to grow 12.1% to Rs 143.7 trillion. Thanks to the robust indirect tax mop-up, revenues are expected to grow at a faster pace compared with other revenue streams.

An ICICI bank analysis shows that western and southern states have better fiscal health than the rest of India. Thanks to their strong economies, higher per capita incomes, better quality of expenditure, and lower liabilities and deficits, these states have managed to keep their balance sheets healthy. Analysts at the bank believe that this creates a virtuous cycle of faster economic growth and hence better financial health.

The northern and eastern states lag behind as they are more dependent on the Union government due to higher outstanding liabilities, higher deficits, lower per capita incomes, higher committed expenditure, and lower tax revenues. This results in a cycle of lower investments, lower potential growth, and lower economic prosperity. The states showing this trend include Bihar, Rajasthan, Punjab, Kerala and West Bengal.

The financial health of states is determined by broadly seven parameters — outstanding liabilities, primary deficit, fiscal deficit, quality of expenditure, own tax revenue, committed expenditure, and per capita GSDP.

Risks ahead for state finances

One of the major risks for state finances remains the volatile global economic outlook which is bound to negatively impact export-linked sectors. Moreover, the state finances will also see some impact from the end of the guaranteed compensation regime under the goods and services tax.

For several states, the fiscal deficit is likely to remain stretched for the current financial year. These include Madhya Pradesh with a fiscal deficit of 4% of GSDP, Rajasthan at 4%, West Bengal and Andhra Pradesh at 3.8%, Uttar Pradesh at 3.5%, and Tamil Nadu at 3.3%. The overall fiscal deficit for 24 states stood at 2.6% of their combined gross state domestic product last fiscal. This is the lowest since FY20.

In the latest Union budget, FM Sitharaman had announced that individual states are allowed to have a fiscal deficit of 3.5% of their individual GSDP with an additional 0.5% contingent on them understating power sector reforms. Usually, states are willing to partake in power sector reforms, but that comes at the cost of capital expenditure which may prove counterproductive to the states’ growth in the long run. Of the 10 biggest state economies, only Madhya Pradesh and Rajasthan have planned to exhaust the full target of 4%.

The revival in state finances could have several positive implications for the Indian economy such as higher economic growth, creation of more jobs, and better investment climate leading to better future growth prospects.

The Union government needs to take steps to support the state economies. These include ensuring stable GST collections through simplification of the GST tax structure and reducing the number of exemptions. It can also provide financial assistance to states that face financial hardships. This can be done through direct transfers or by providing loans at concessional interest rates. The Union government can also support investment in states by offering grants and loans for infrastructure projects.