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Importance of State budgets in overall economy (Relevant for GS Prelims & Mains Paper III; Economics)

Last week, the Reserve Bank of India released its annual study of state-level budgets. With each passing year, understanding about state government finances is becoming more and more important. That’s because of two broad reasons.

One, states now spend one-and-a-half times more than the Union government and, in doing so, they employ five times more people than the Centre. What these two trends mean is that not only do states have a greater role to play in determining India’s GDP than the Centre, they are also the bigger employment generators. As such, it is crucial to understand their spending pattern. If, for example, their combined expenditure contracts from one year to the other, then it will bring down India’s GDP.

Two, since 2014-15, states have increasingly borrowed money from the market — a trend captured in the fiscal deficit figure. In fact, their total borrowing almost rivals the borrowing by the Union government. This trend, too, has serious implications on the interest rates charged in the economy, the availability of funds for businesses to invest in new factories, and the ability of the private sector to employ new labour.

Why fiscal deficit matters
Suppose there is only Rs 100 in the economy that is available in the form of investible savings. This money could be borrowed either by private businesses (to invest in a new or existing venture) or by the government (to make roads, pay salaries etc.). Suppose again that initially, businesses borrow Rs 50 and the central government borrows Rs 50. If, however, state governments also start borrowing, say Rs 20, then private businesses will have only Rs 30 left to borrow and invest. Worse, this Rs 30 would come at a higher interest rate because the same number of people would be now vying for less money. That is why economy observers and businesses fuss over the fiscal deficit number the most.

There is another reason why states borrowing more and more should raise concerns especially when they borrow to meet unexpected policy goals such as farm loan waivers. Each year’s borrowing (or deficit) adds to the total debt. Paying back this debt depends on a state’s ability to raise revenues. If a state, or all the states in aggregate, find it difficult to raise revenues, a rising mountain of debt — captured in the debt-to-GDP ratio — could start a vicious cycle wherein states end up paying more and more towards interest payments instead of spending their revenues on creating new assets that provide better education, health and welfare for their residents.

In short, with each passing year, state government finances have become more and more important not only for India’s GDP growth and job creation but also for its macroeconomic stability. That is why, the 14th Finance Commission had mandated prudent levels of both fiscal deficit (3% of state GDP) and debt-to-GDP (25%) that must not be breached.

What RBI found
The first thing of note that the RBI report has found is that, except during 2016-17, state governments have regularly met their fiscal deficit target of 3% of GDP. On the face of it, this should allay a lot of apprehensions about state-level finances, especially in the wake of extensive farm loan waivers that many states announced as well as the extra burden that was put on state budgets after the UDAY scheme for the power sector was introduced in 2014-15. Under UDAY, state governments had to take over the debts of power distribution companies (discoms).

However, any relief on the fiscal deficit front is of limited value because most states ended up meeting the fiscal deficit target not by increasing their revenues but by reducing their expenditure, mostly capital expenditure and increasingly borrowing from the market.

Source: The Indian Express

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