States’ fiscal deficits swell as welfare spending trumps financial prudence

Indian states are slipping into fiscal indiscipline after years of shrinking their budgets to recover from the financial impact of Covid-19. Welfare expenditures are growing, and revenue projections are overly optimistic.

The fiscal deficit — what states earn minus what they spend — is likely to swell to Rs 12.6 lakh-crore in financial year 2024-25 (FY25) from Rs 11.2 lakh-crore in FY24, widening to 3 per cent of their GSDP (Gross State Domestic Product, which represents the value of all goods and services produced within the state’s boundaries and is a vital indicator of the state's economic health) from 2.8 per cent.

This signals a pause in the post-Covid fiscal consolidation that states had so meticulously maintained over the last couple of years.

Growing revenue deficit

Even a year ago, this was not the case. According to PRS Research, states had managed to bring down their aggregate fiscal deficit from 4.1 per cent of GDP in FY21 to an estimated 2.8 per cent in FY24. However, much of this improvement has come from better GST collections and increased tax devolution from the Union government.

Despite efforts to bring them down, most states experienced sizeable revenue deficits. In FY24, 11 of 17 major states had budgeted revenue deficits, meaning that their revenue expenditure was more than their income. Big states like Andhra Pradesh, Kerala, Punjab, Rajasthan and West Bengal have been under persistent revenue deficits.

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Analysts and certain news reports attribute it to states banking on overly optimistic revenue growth and ramping up spending on populist welfare schemes, especially around election time.

Surge in subsidy

One of the biggest drivers of this shift is a surge in subsidy spending, which is projected to rise by 26 per cent year-on-year in FY25, reaching Rs 3.7 lakh-crore (or 8.7 per cent of their total revenue). This sharp increase indicates that states focus more on immediate voter-pleasing measures to retain power rather than long-term financial health.

Much of this extra spending is on power subsidies, which has caused substantial fiscal distress.

States in the wrong

States like Rajasthan, Punjab and Uttar Pradesh are using a sizeable chunk of their subsidy budget to lower consumers' electricity tariffs. Not only does this increase their aggregate expenditures, but it also undermines their efforts to stay fiscally prudent, which they had managed to achieve during the post-Covid years.

According to PRS, the 15th Finance Commission provided revenue deficit grants to some states from FY22 to FY26. These grants were so conceived that they tapered off in successive years.

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However, many states have continued to budget for revenue deficits. Given the quantum of grant reduction, the states must increase their revenues or reduce expenses to maintain revenue balance.

Revenue mobilisation concerns

Revenue growth remains a significant challenge for states. While states are projecting an 18 per cent growth in their own tax revenue (OTR) for FY25, this estimate is overly optimistic, given the slowing economic growth.

Sluggish GST collections: States’ GST (SGST) collections, which comprise 43 per cent of their total OTR, are growing slower than expected. States heavily dependent on GST and VAT, such as Bihar and Gujarat, will likely face revenue shortfalls, putting pressure on their budgets. However, the states' fiscal health remains vulnerable due to their dependence on tax devolution from the Union government and the uncertainties surrounding GST revenue. The erosion of fiscal autonomy due to GST implementation has limited states' ability to generate non-tax revenues effectively.

Volatility in non-tax revenue: Many states have turned to non-tax revenue sources, such as excise and stamp duties, to fill the revenue gap. However, these are highly volatile and could lead to further fiscal stress if the projected growth is not realised.

Capital expenditure trends

The brokerage firm Emkay Research report points out a significant divergence in capex growth across states. While states have budgeted an 18 per cent increase in capex for FY25, actual spending has been subdued due to delayed disbursements and political uncertainty.

Capex achievement below par: By August 2024, the states had achieved only 22 per cent of their FY25 capex targets, compared to 28 per cent in the previous fiscal. States like Uttar Pradesh and Odisha, which have budgeted high capex growth, need to catch up, raising concerns about meeting their full-year targets.

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Inter-state disparities: There is a clear pattern of higher capex growth in less industrialised states, such as Odisha and Madhya Pradesh, while industrialised states like Tamil Nadu and Karnataka are lagging in terms of capex as a share of GSDP.

Borrowing and debt risks

With rising deficits and optimistic revenue projections, states will likely turn to higher borrowing to meet their expenditure needs. The report highlights that medium-sized states have been driving overall state borrowing in recent years, and this trend is expected to continue in FY25.

SDL spreads widening: The spread of state development loans (SDLs) has increased, indicating a higher risk premium for states with weaker fiscal health. This could raise borrowing costs, further exacerbating the budgetary stress.

Contingent liabilities are a looming threat: The financial health of state-owned power distribution companies (discoms) remains a significant concern. Discoms' outstanding debt is around 2.5 per cent of GDP, with states like Tamil Nadu and Rajasthan facing exceptionally high exposure. If states are forced to take on these liabilities, it could lead to a further deterioration of their debt position.

According to Emkay Research, states must reassess their fiscal strategies with revenue growth slowing and rising expenditure pressures. Key recommendations include:

Revisiting revenue assumptions: States should adopt more realistic revenue estimates and reduce reliance on volatile non-tax sources.

Curbing populist spending: Limiting the scope of new welfare schemes, especially in election years, is crucial to maintaining fiscal discipline.

Focus on capex: States must prioritise capital expenditures to support long-term growth rather than cutting capex to accommodate higher revenue expenditures.

Strengthening fiscal coordination: The Centre and states must work together to ensure that fiscal consolidation does not become a casualty of political compulsions.

The Centre, too, is guilty of not spending enough where it matters. Asmi Sharma, a researcher who works with Financial Accountability Network among others, writing for India Development Review, has said that despite Union Finance Minister Nirmala Sitharaman’s announcement to focus on the poor, Budget 2024-25 continues with a decade-long trend of reduced allocations, further weakening the government’s stance as a welfare advocate.

Rising fiscal risks driven by populist spending, unrealistic revenue projections, and increasing debt levels could further deteriorate states' fiscal health, posing a risk to overall economic stability.