It Is Time For States To Turn Away From Populism And Focus On Capex

The Covid-19 pandemic dragged the global economy to an unprecedented lull, and the Indian economy was no exception. After multiple bouts of vaccination against the transmission of an economic slowdown, India is finally on a road to recovery. For the country to steady itself on a trajectory of growth, its states have to wise up financially as well. 

Over the course of the past few years, since the pandemic brought state economies to a standstill, several financially imprudent decisions were made. Perhaps, the time has arrived to rectify this, as a recent Reserve Bank of India (RBI) report suggests. The report, titled State Finances: A Study of Budgets, has found that state finances are finally improving after sticking to better fiscal management in financial year (FY) 2022-23 as seen in budget estimates (BE). 

The states play a crucial role in India’s gross fixed capital. This because the government expenditure’s share in the total gross fixed capital of the country is 11 per cent, of which 60 per cent is borne by states. This is significantly higher compared to the global average for sub-national spending which is at 30 per cent. 

With such an important role to play, the states were tied down by the impact of the pandemic, aptly described as the ‘scissor effect’ by the National Institute of Public Finance and Policy (NIPFP). This two-prong effect consisted of revenue loss and the urgency to spend so that economic activities could be revived.  

While revenue loss led to increased borrowing and deepening of state fiscal deficits, the sudden expenditure took a populist line that served political purposes. In the view of upcoming state elections, the states’ fiscal management deserve a closer scrutiny. 

Populism At Play 

The pandemic arrived without any warning and pulled the states into impromptu lockdowns. In order to provide a social safety net for the vast majority of the population, the government, at central and state levels, had to increase its subsidy spending. In FY 2020-21, most states recorded a substantial jump in subsidy expenditure.  

Data from the Comptroller and Auditor General of India (CAG) show that state’s expenditure on subsidies grew 12.9 per cent and 11.2 per cent during in FY 2020-21 and 2021-22, respectively. Notably, this came after the states recorded a contraction in FY 2019-20, when the lockdowns were yet to strike.  

In the last three FYs, Uttar Pradesh, Jharkhand, Telangana, Kerala, and Odisha saw the largest rise in subsidy outgo, while Punjab, Chhattisgarh, and Gujarat spent over 10 per cent of their revenue expenditure on subsidies. When subsidy measures are not well-targetted, they lighten the government purse without causing any noteworthy improvement to the welfare of the state’s people. 

Such measures negatively impact credit culture, discourage private investment by distorting prices through cross-subsidisation, and lead to falling labour force participation by disincentivising work at the prevailing wage rate. However, these measures can be made popular among the masses, giving rise to electoral benefits for the governments at work. 

State governments reportedly announced subsidies and populist schemes over Rs 1 lakh crore in 2022. Economists and experts have pointed out often that states, in order to safeguard their electoral interest, resort to spending that do little to augment growth but adversely impact state finances.  

The recent flip-flop by states on the Old Pension Scheme (OPS) is a good example of governments pursuing populist agendas that can have grave tax burdens on upcoming generations. After years of debate and discussions, many states decided to opt for the newer pension regime as the OPS was agreed to be unsustainable in the long run by most states. But Rajasthan, Himachal Pradesh, Punjab, and Chhattisgarh have brought back the old system.   

The unfunded nature of most populist schemes pushes the government to borrow more, causing grave slips in fiscal deficits and a piling up of debt. 

Deepening Of Debt, Deficits 

In the pandemic year, states resorted to additional borrowings to ensure a 4.9 per cent growth in states’ expenditure, despite a fall in revenue. The states’ lending jumped by close to 56 per cent, a four-time growth over the pre-pandemic year. Borrowing, as a means to fund current expenditure, is not an ideal situation. 

Just as in the household level, a loan is an instrument to invest in long-term benefits and not to fund one's daily expenses. In FY 2020-21, expenditure grew by 14-17 per cent in states like Tamil Nadu, Andhra Pradesh, Kerala, Uttarakhand, Bihar, and Punjab.  

In 2020-21, the states’ consolidated gross fiscal deficit (GFD) rose to 4.1 per cent of gross domestic product (GDP), the highest level since 2004-05. According to data compiled by the CAG, between FY20 and FY21, fiscal deficit increased by 1 per cent of gross state domestic product (GSDP).  

A state-wise disaggregation suggests that fiscal deficit and borrowings were among the highest in the States of Uttar Pradesh, Bihar, Jharkhand and Rajasthan. The case of Uttar Pradesh was particularly acute. Aggregate receipts declined by 20 per cent in the pandemic year, which resulted in an increase of fiscal deficit of about 3.9 per cent of GSDP, the highest among the 26 states studied. 

While the pandemic was an exigency, several states have generally had a high debt burden owing to untargeted schemes announced during election campaigns. An RBI report titled State Finances: A Risk Analysis that was published last year highlighted that finances of states like West Bengal, Kerala, Punjab, Rajasthan and Andhra Pradesh showed warning signs of building stress.  

Based on the debt-GSDP ratio in 2020-21, Punjab, Rajasthan, Kerala, West Bengal, Bihar, Andhra Pradesh, Jharkhand, Madhya Pradesh, Uttar Pradesh and Haryana had the highest debt burden, accounting for around half of the total expenditure by all state governments in India. The report said that Kerala, Jharkhand and West Bengal exceeded the debt target for 2020-21 set by the 15th Finance Commission.  

It also indicated that the debt stock was no longer sustainable for Punjab, Rajasthan, Bihar, Kerala and West Bengal, as the debt growth outpaced their gross state domestic product growth in the last five years. Such unsustainable models, that combine injudicious spending and reckless borrowing, leaves very little room to spend on capital expenditure (capex). 

Case For Capex 

Now that the states are experiencing relief from the economic strain caused by the pandemic, there is a good case for capex receiving more attention. Provision for capital outlay by states saw a robust growth of 32 per cent in 2021-22, aided in part by the Centre’s allocation for states through Scheme for Financial Assistance to the States for Capital Investment. Further, states have budgeted a 38 per cent increase in capital outlay in FY2022-23.    

However, the latest CAG data on state accounts for the first eight months of the ongoing financial year shows that states may not be in sync with the Centre’s policy focus towards capex as growth multiplier. A study of India’s 10 largest states by gross domestic product (GSDP) shows that only Gujarat, Karnataka, and West Bengal’s capex increased in FY23 April-November compared to the same period a year ago.  

Gujarat spent 57 per cent of its budget target on capex, up from 46 per cent a year ago, Karnataka spent 52 per cent, up from 43 per cent a year ago, and West Bengal spent 32 per cent, up from 25 per cent in the same period a year ago. 

While Uttar Pradesh’s capex in absolute term went up to Rs 35,658 core in FY23 April-November from Rs 33,457.14 crore in the same period a year ago, there was no change in terms of percentage of budget target, which was 29 per cent for both years. Maharashtra, Tamil Nadu, Rajasthan, Andhra Pradesh, Telangana, and Madhya Pradesh have all spent less on capex in FY23 April-November compared to the same period a year ago. 

The Way Out 

Since finances have always remained a bone of contention between the Centre and states, the lack of funds for capex have often turned into a political blame game. Opposition-ruled states are quick to point to the acute centralisation of funds and lower devolution by the Centre for them being cash-strapped, while the Centre retorts that electoral needs make them opt for populism over growth, thus draining resources. 

Indeed, political compulsions, and aspirations of electoral gains, have resulted in state governments following a populist path. But the centralised nature of Goods and Services Tax (GST) have impacted the states’ revenue mobilisation abilities as well. 

The way out might be in augmenting new revenue streams as several states have been attempting. Kerala and Rajasthan announced amnesty schemes to clear pending tax disputes and mobilise revenue, and Maharashtra has opted for this as well. Punjab proposed forming a tax intelligence unit to achieve better tax compliance under GST while Chhattisgarh is planning to raise revenue through data-based review of taxation rules and tax rates.  

Assam has introduced a liquidation scheme for settling of arrears whereas Haryana has a one-time scheme for settling old VAT dues, in addition to phased monetisation of assets. Both Assam and Kerala have green tax to discourage old vehicles.   

By snapping away from populist policies, generating new revenue streams and streamlining its welfare measures, states can now finally hit the gas on capex. This will ensure sustainable growth and prevent undue tax pressure on future generations.