Are State Government Finances In For A Double Whammy?
At a time when state finances are under pressure, could Fifteenth Finance Commissions’ recommendations act as a double whammy?
State government finances have been stretched for the last two years as a spate of expenses ranging from farm loan waivers to costs incurred on account of a power sector restructuring scheme have reduced the headroom available for spending.
A recent report by the Reserve Bank of India cautioned that while states have been trying to keep fiscal deficit in check, the prudence has come at the cost of capital expenditure, which in turn, is hurting growth in the broader economy.
“Fiscal consolidation and pressures to increase current spending have led to an overall decline in capital spending to the tune of about 0.3 to 0.5 percent of GDP during 2017-19,” the RBI said in its review of State Finances earlier this month. “Arresting this trend is crucial to avoid adverse effects on long-term growth and welfare,” the central bank added.
Yet state finances may actually worsen in the near term hit by a recent cut in corporate tax rates announced by the central government and continued losses at power distribution companies, cautioned M Govinda Rao, economist and member of the Fourteenth Finance Commission. Against this backdrop, the recommendations of the Fifteenth Finance Commission, due over the next few months, will be crucial in determining the future trajectory of state finances, Rao said.
The Near-Term Pressures
The most recent concern for state finances has emerged from the central government’s announcement of a cut in effective corporate tax rate. The government estimates a revenue loss of Rs 1.45 lakh crore from the cuts, even though economists and analysts peg it lower.
Rao said that going by the central government’s estimates the loss to state governments would be to the tune of Rs 60,000 crore. He added that unlike the central government which can recoup some of this loss via increased dividends from public sector enterprises and by other means such as divestment, states have much lesser flexibility.
As a result, whatever capital expenditure they were doing, which is about 3 percent of GDP, that is going to be impacted. They can’t reduce wages and salaries or subsidies and transfers because these are all broadly fixed. So revenue expenditure remains, interest payments will continue but capital expenditure will have to be cut or they will have to be allowed to borrow more. But since the Government of India will not allow them to borrow more, it will be capital expenditure that will be squeezed.M Govinda Rao, Member, Fourteenth Finance Commission
The cut in state level capital expenditure could hurt growth in the Indian economy, which fell to 5 percent in the first quarter of 2019-20. The RBI, in its report, had noted that states must front-load capital spending, “as it has strong multiplier and welfare enhancing effects.”
Pressure on revenue generation will prevent such support from capital spending at the state level.
States may also see increased debt and interest outgo on account of the UDAY scheme, implemented in 2015.
States had signed an agreement to take on a larger share of power distribution companies’ losses with each passing year. As per the agreement, states would take on 10 percent of DISCOM losses of the previous year in 2018-19, 25 percent in 2019-20, and 50 percent in 2020-21.
Rao said the UDAY scheme is proving to be burden for states.
This is one of those diseases for which we haven’t found a cure....States have taken over 75 percent of the debt, which is leading to higher interest payments? The expected improvement in DISCOM operations has also not come. So you have a huge problem.M Govinda Rao, Member, Fourteenth Finance Commission
Awaiting The Fifteenth Finance Commission Recommendations
The backdrop of emerging weakness in state finances will bring an added dimension to the recommendations of the Fifteen Finance Commission. The term of the commission has been extended till the end of November.
The recommendations will take a view on whether the 42 percent share of divisible taxes assigned to states needs to be reviewed. It will also look into whether a separate mechanism is needed for funding defence and internal security.
Rao said that the Finance Commission is an independent body and the expectation is that it would take a fair view keeping all needs of the economy in mind. He, however, questioned the government’s decision to add a new ‘term of reference’ related to defence funding just months before the commission was to complete its work.
This is one of the ways in which the Government of India is nudging the Finance Commission and asking for more space for centrally sponsored schemes. The original terms of reference already said that the Fifteenth Finance Commission should examine the devolution assigned by the previous finance commission in light of ‘New India 2022’. Nobody knows what ‘New India 2022’ but they are basically saying that we need to have more centrally sponsored schemes for which you should reserve money.M Govinda Rao, Member, Fourteenth Finance Commission
Rao added that the Finance Commission has a constitutional mandate to adopt the methodology that it deems fit. “So my suggestion to the commission has been that they should simply ignore all these things and make a balanced judgement on sharing of taxes between the union and the state,” Rao said, adding that sharing of taxes with states is not “charity” but a constitutional mandate.
Watch the full interview below: