RBI’s fuzzy focus on State finances

The RBI annual State finances study, released this year on Oct. 27, comes with the special theme it has titled: “Covid-19 and its spatial dimension in India”. The 89-page analysis is a document that could have helped policy makers understand the impact of the pandemic and how this will play out in places it matters probably the most – the various States. This is an opportunity that the report has not fully built upon, given the many avoidable mistakes and erroneous conceptual underpinnings that stand out glaringly in the report this year. This comes with the introduction of terminology that is in many cases inexact and does not help build a view on how State finances will pan out.

The report offers an analysis of the fiscal position of State governments taking in to account the budget estimates for 2020-21, revised estimates for 2019-20 and accounts for 2018-19.  It is important to mention that most of the State budgets were presented before the onset of the pandemic. Therefore, a true picture of a State’s budgetary position is difficult to arrive at by looking at budget documents alone.  The RBI study has made an attempt to release a broad picture of the likely shape of the fiscal deficit relative to GDP for all States, which is estimated at 5 per cent as against the budgetary figure of 2.8 per cent. Thus, there is a large slippage due to the impact of the pandemic.

The report talks of the “scissor effect”, which implies a fiscal trend where expenditure surges and revenue collapses. It is important to mention that democratic governments have a deficit bias and therefore there is a self-imposed discipline of fiscal legislation for State governments.

The analysis of the fiscal position of the State governments in the RBI study has focused on the following aspects: (i) systematic bias in the revised estimates vis-a vis the provisional accounts, (ii) fiscal impact of farm loan waivers, (iii) State-wise pattern of  cutbacks in capital expenditure, (iv) determinants in the discretionary spending of States, (v)scissor effects in State finances, (vi) utilisation of rainy funds, (vii) market borrowings, debt and contingent liabilities and (ix) contingent labilities. Most of the conclusions in the above issues are well known to researchers, practitioners and policy makers. However, the RBI study has made some effort on the technical side of the analysis on the presumption that the technical analysis would make some value addition. But the impact of the technical analysis has been lost in some erroneous conceptual underpinnings, which could have been avoided.

The report talks of the “scissor effect”, which implies a fiscal trend where expenditure surges and revenue collapses. It is important to mention that democratic governments have a deficit bias and therefore there is a self-imposed discipline of fiscal legislation for State governments. Further, as the data reveal, in respect of budget estimates for 2020-21, the revenue deficit has been contained and is zero and the fiscal deficit has been around the FRL (Fiscal Responsibility Legislation) level of 2.8 per cent in the consolidated position of all States taken together. Covid-19 has not compelled the State governments to increase spending, as the RBI study itself has stated, quoting the Controller General of Accounts (CAG) data, which says the expenditure in April- June 2020 has been maintained at the previous year’s level for the corresponding period. It is true, however, that the pandemic has contributed to the collapse of the revenue. Hence the analogy of the scissor effect, which is borrowed from Western literature and force-applied in the Study, is erroneous and could have been avoided.

Secondly, and more importantly, treating the concept of primary expenditure (non- interest expenditure) as the discretionary expenditure is conceptually erroneous as this includes other committed expenditures such as pension, wages and salaries and administrative expenditure. This mis-application will skew many readings.

Treating the concept of primary expenditure (non- interest expenditure) as the discretionary expenditure is conceptually erroneous as this includes other committed expenditures such as pension, wages and salaries and administrative expenditure.

Thirdly, the conclusions drawn from the analysis of discretionary expenditure i.e. “debt plays an important role in States’ spending decisions” does not hold much water. The spending decisions in a democracy critically hinge upon political decisions. To some extent, fiscal legislation is a constraint. But debt-GDP ratio has not been included in the extant fiscal rule of State governments even though the 15th Finance Commission has recommended it at 20 per cent of GDP. The spending decisions are contextual to revenue deficit and fiscal deficit relative to GDP as per FRL, given the revenue raising capacity of the States and tax devolution from the Center. 

Fourthly, avoidable mistakes in the study are (a) use of GSDP (Gross State Domestic Product) and output gap in the consolidated position analysis of the States. Sometimes the study takes GDP and sometimes GSDP. The RBI should be clear which concepts should be used in the analysis of the consolidated position of State finances. Besides, the RBI study uses the term “tax transfers” in the analysis. Actually, this is tax devolution as defined in the fiscal federalism literature under the provisions of the Constitution. RBI ought to be particular about this and not lead in laxity.

The RBI study makes a reference to an innovative funding arrangement called “rainy day fund”. One is not clear whether this term has been coined by the RBI itself or by the State governments. What is the accounting head and how is this fund financed? The lack of conceptual clarity questions the quality of RBI analysis.

The study of the State budget would have been more relevant if it had given a State-wise analysis of the revenue and expenditure pattern, particularly own tax revenue and health expenditure and the likely shape of the revenue deficit and fiscal deficit taking into account the effects of the pandemic.

Now let us turn to the special theme of the report: “Covid-19 and Its Spatial Dimension in India”. The content of this section includes: (i) history of the pandemic in India, (ii)structural health factors such as demography and etymology, (iii) impact on migrants, employment and MSME, (iv) digitisation and (v) local government. The presentation and discussion in the special theme is well documented. And the content and conclusions are widely known, discussed and debated in various fora. In that sense, the RBI study has not made any substantial contribution. It may be equally argued that the advantage for the user of the report is that all the available information has been put in place in one document.

In the context of health care and fiscal implication for the States, the RBI study has analysed the health expenditure as a share of revenue expenditure. But analytically, total expenditure would have been more appropriate. This is because health expenditures have capital and revenue sides to it. Desirably, the health expenditure should have been broken into both revenue and capital and then the respective relative shares could be used for a more meaningful reading to know it takes to set up health infrastructure and what it entails to maintain and run it.

The study of the State budget would have been more relevant to researchers, academics, practitioners and policy makers if it had given a State-wise analysis of the revenue and expenditure pattern, particularly own tax revenue and health expenditure and the likely shape of the revenue deficit and fiscal deficit taking into account the effects of the pandemic. Surprisingly, the study is completely silent on zero revenue deficit budgeted for 2020-21. Since the root cause of the fiscal malaise is the persistence of revenue deficit, it would have been more relevant to the users of the analysis if it had included the sustainability of zero revenue deficit and the impact of this in creating fiscal space.

(Dr. R K Pattnaik is a former Central banker and a faculty member at SPJIMR. Views are personal)