How will the GST and UDAY affect state budgets? | Part 1

Friday, April 22nd, 2016

This post, which is divided into three parts, will look at the implications of reforms such as UDAY and GST on state budgets. In the first part, we will examine why it is important to look at this data as well as give an overview of the current trends in state budgets. In part 2 and part 3, we will take a closer look at the proposed UDAY scheme and the GST.


Why does this matter?

The central government has a lot of reforms on the table. Of these, there are 3 reforms which affect the states in a major way:

  1. the Goods and Service Tax (GST),
  2. promoting cooperative  and competitive federalism between states, and
  3. financially restructuring of state-owned discoms to increase efficiency in power generation, transmission and distribution

The first reform, the GST, would simplify and standardise the tax system across states and improve the ease of doing business in India.

The second reform aims to increase competition between states, which will promote development, whilst freeing states from centre-defined subsidies. The logic behind this reform is that the states are the ones that are best positioned to understand their unique local economies and hence should be given freedom to implement reforms that would be more tailored to their constituents. The government has already increased the states share of tax devolution from 32% to 42% and has simultaneously cut the number of centrally sponsored schemes to compensate for revenue loss.

The third reform has an impact on the medium term fiscal position of states because it transfers liabilities from the discoms to the books of state governments while incentivising discoms to become more operationally efficient.

All these three reforms will have a major impact on state revenues and expenditures. Empirical evidence confirms that the composition of government expenditure can have perceptible implications not only for growth, but also for social welfare. Additionally, private investment is currently weak in the Indian economy and growth will rely heavily on government spending. Bringing all these facts together tells us that increasingly, it is the states that will drive growth for the Indian economy. Analysing the trends in their spending, particularly on social and physical infrastructure can give us an idea of growth looking forward.


What are the trends in state spending?

For this part of the post, we refer to the latest RBI report on state finances.

  • Over the last few years, states have been undergoing fiscal consolidation because of the implementation of a rule-based framework under Fiscal Responsibility and Budget Management (FRBM) legislations. These legislations were passed by each state at different points in time and hence it is difficult to analyse their effect uniformly. What is clear however, is that on an overall level, the non-developmental expenditure has come down as a percent of state GDP. Thus, fiscal consolidation at the state level over the last few years has been accompanied by improvement in their quality of public expenditure after the implementation of FRBM.


State budgets and the GST

  • Interest payments, administrative services and pensions, which are in the nature of committed expenditure, account for a dominant portion of non-development revenue expenditure of states. The pension liabilities of states has more that doubled from 1997 – 2015 (see chart above) and with the governments implementation of One Rank One Pension (OROP), the trend in pensions and salary expenditure is likely to continue and is likely to exacerbate the fiscal strain on the states.

State budget expenditure quality

  • There has only been marginal improvement in the average development expenditure of states as a proportion of GDP. In recent years, resource constraints have forced cutbacks in state spending on development due to commitments towards subsidies, pensions and other liabilities. We can see how different states have been spending on social and physical infrastructure in chart II.3 above. Spending on social infrastructure, such as education and health, tends to be similar across all states and is relatively dominated by education. On the other hand spending on physical infrastructure like roads and energy varies greatly between states. 

III 1 Trends in Central TransfersIII 2 Social Sector Expenditure

  • Even though states now get an increase in the share of taxes now, the reduction in central schemes has actually led to a decline in central  transfers to states by 0.3 percent of GDP (see chart III.1  and III-2 above). As a result, capital and social expenditure is budgeted to decline in 2015-2016 which raises concerns about the quality of development in our country.
  • Finally, the central governments initiative to turnaround discoms under the Ujjwal Discom Assurance Yojana (UDAY) scheme will likely increase the liabilities of participating states and constrain their capacity to spend.

In summary, things do not look good for state-led development. According to the RBI report, the fiscal health of states deteriorated in 2013-14 with their consolidated revenue account turning into a deficit after a gap of three years and the states’ fiscal situation further weakened in 2014-15 with the fiscal deficit growing as a proportion of GDP. It is critical that states increase their focus on creating additional fiscal space by mobilising more revenue and giving priority to development expenditure while economising on non-essential spending. Only then would it be possible to have higher and better quality of growth

In the next post we will look at  the proposed implementation of the UDAY scheme and its bearing on the quality of states’ expenditure in the medium- term.

About the author

Rishad is the founder of Kairos Capital. He started his career with Standard Chartered Wealth Management and has extensive experience in markets, particularly in terms of mutual funds and stocks.

View all author posts →