Context: Recently, RBI released its annual study of state-level budgets.

Key findings:

• Except during 2016-17, state governments have regularly met their fiscal deficit target of 3% of GDP. 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.
• Concern: However, most states ended up meeting the fiscal deficit target not by increasing their revenues but by reducing their expenditure and increasingly borrowing from the market.
• There has been a reduction in the overall size of the state budget in 2017-19. This retarding fiscal impulse has coincided with a cyclical downswing in domestic economic activity and may have inadvertently deepened it.
• Also worrisome is that while states have met their fiscal deficits, the overall level of debt-to-GDP (Chart 4) has reached the 25% of GDP prudential mark. A slightly stringent criterion as prescribed by the FRBM Review Committee and in line with the revised FRBM implied debt target of 20 per cent will put most of the states above the threshold.
• States have found it difficult to raise revenues: States revenue prospects are confronted with low tax buoyancies, shrinking revenue autonomy under the GST framework and unpredictability associated with transfers of IGST and grants.
• Unrealistic revenue forecasts in budget estimates thereby leave no option for states than expenditure compression in even the most productive and employment-generating heads.

Why understanding about state government finances is becoming more and more important?

1. States now have a greater role to play in determining India’s GDP than the Centre. States now spend one-and-a-half times more than the Union government.
2. They are the bigger employment generators. They employ five times more people than the Centre.
3. Since 2014-15, states have increasingly borrowed money from the market.

Thus, this overall trend 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? What happens if the debt-to-GDP ratio widens?

• 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.
• Then, 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.
• 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.