Fiscal weakness – State finances can impede growth

News: State governments indulge in most of the general government spending (including the central government). According to a recent Reserve Bank of India(RBI) study, five states namely, Bihar, Kerala, Punjab, Rajasthan, and West Bengal figure among the most stressed states fiscally.

The study has highlighted 10 vulnerable states based on their debt stock in 2020-21. These 10 states account for around half of the total expenditure by all state governments in India.

What are the reasons for distressed state government finances?

Impact of Pandemic: Before the pandemic, the average gross fiscal deficit (GFD) to gross domestic product (GDP) ratio was at 2.5%, though some states ran fiscal deficits above 3.5%. But the pandemic significantly affected government finances.

During the pandemic State’s revenues were hit. Despite that, States continuously provided medical care and supported the vulnerable sections of the population.

Decline in revenue collection: Revenue expenditure constitutes about 80-90% of total expenditure in these (10 vulnerable) states, which clearly affects their ability to spend on growth-enhancing asset creation.

What are the risks highlighted by RBI to state government finances?

The RBI study also underlines several risks to state government finances. Due to that, the RBI projections suggest that most states would have a debt-GSDP ratio of over 30 per cent by 2026-27. These risks are,

a) Growing preference for distribution, b) Some states reverting to the old pension scheme is also a cause for concern, c) The guarantees extended to state-owned enterprises and the mounting debt of power distribution companies, d) According to estimates, the off-budget borrowings of state governments have increased to about 4.5% of GDP and e) The end of the compensation regime under the goods and services tax would further weaken the fiscal position of the states.

What should be done to improve the state government finances?

An unsustainable level of debt in some of the large states would not only affect growth prospects, but could also pose risks to macroeconomic stability. Hence, India needs an overall medium-term consolidation road map.

Source: The post is based on the article “Fiscal weakness – State finances can impede growth” published in “Business Standard” on 23^rd June 2022.