States’ Fiscal Deficit To Widen Past 4% Of GDP, Says RBI Report

The Covid-19 outbreak has posed risk to finances of Indian states by pushing up their gross fiscal deficit and causing a rise in debt and guarantees.

That’s according to the Reserve Bank of India’s report on state finances, which said gross fiscal deficit of state governments is projected to widen beyond 4% of the GDP in 2020-21 in the RBI’s baseline scenario, compared with the budgeted 2.8%.

The states will be constrained by their borrowing limits that finance about 90% of the deficit on an average, according to the report which was published on Tuesday. Despite higher borrowing limits this year, states may be able to utilise only half of the additional borrowing given to them considering the terms and conditions they’ll have to meet to be eligible for the increased limits.

While tax revenues are likely to be reduced for the next few years, pandemic-related spending, particularly on health and other support measures for households and firms are likely to keep these expenditures high, prolonging the ‘scissor effect’—loss of revenue accompanied with higher expenditure—the RBI said.

While state governments may want to put investment projects on hold, this will inevitably entail growth losses given the multiplier associated with capital spending, the report said. As such, states will see a a rise in indebtedness. If that’s not accompanied by an acceleration in growth, “fiscal sustainability will become the casualty, overwhelming the modest gains of the prudence in recent years”, the central bank cautioned.

The report urged state governments to reprioritise expenditure and improve revenue mobilisation.

Key Recommendations:

• Reprioritising expenditure towards more productive high multiplier capital projects has to be made centre-stage. States with limited fiscal space can focus on low gestation and high labour intensity projects that also crowd in private business.
• States must expand spending on health to achieve the universal health coverage goal of 2.5% of GDP at the aggregate level.
• States must improve revenue mobilisation by improving tax compliance, and greater digitalisation of administration to expand the tax base.
• Digitalisation can help states lower cash dependence and need for physical access to banking infrastructure and can foster improvements in direct benefit transfer systems, including through e-governance initiatives.
• Inter-state coordination with special emphasis on urban local bodies. Setting up uniform and timely database collection systems across states could help identify and prioritise associated service gaps.
• Like the central government, states may also consider revising their fiscal legislations by bringing in the desired counter-cyclicality and incorporate debt as a medium-term anchor.