Union and state budgets need to commit to more capital spending

Union and state budgets need to commit to more capital spending

Pranjul Bhandari writes: For the states, the tax revenue bounty has so far been used for fiscal consolidation and current expenditure. The capex track record over the last few years has been weak. With the budget season upon us, there is a hope that fiscal consolidation can coexist with high capex.

The budget season is upon us. The 2023-24 Union budget will be announced on February 1, followed by the states’ respective budgets. These budgets will set the policy tone for the rest of the year and, as such, are followed closely.

Much has changed during the pandemic. Most importantly, the overall fiscal deficit of the government has soared and we believe the next few years will be all about getting it back on track. This is important because interest payments on past debt make up a whopping 50 per cent of net tax revenues for the central government, leaving very little room for other spending. Given the needs of the economy on various fronts like health, education and capex, it is important to lower the interest burden over time. That can only be achieved by fiscal consolidation.

But what does the path for fiscal consolidation look like for the central and state governments? Can it be done easily? What is the main challenge? It is clear to us that the performance of central and state finances has been different for at least four reasons. This is an important point because many wrongly assume that performance levels have been similar.

One, central government tax revenues have risen faster than state revenues. Both benefitted as small and informal firms struggled with the lockdowns and lost market share to large firms, which tend to pay more taxes. But the reason for the disparity is simple. A large chunk of the tax revenues in the early part of the pandemic period came from the “special” duty and surcharge on oil, which went primarily to the central government. To be fair, the central government subsequently cut the duty on oil (in both 2021-22 and 2022-23) and the tax share that went to the states rose somewhat.

Two, the Centre has committed to more current expenditure than the states. While it increased across the board during the pandemic, current expenditure rose more for the central government. This was led by higher social welfare spending (for instance, on the free food distribution scheme) and, more recently, higher subsidies (for example, fertilisers) in the face of rising commodity prices. The common perception is that states have gone all out on unsustainable current expenditure. But the data shows that it’s just a few states which have spent heavily (for example, Telangana, Assam, West Bengal and Punjab).

Three, the central government capex has risen but state capex has contracted. Making a commendable choice, the central government used both its tax bounty as well as its ability to borrow more at a time when banking sector liquidity was loose to raise capex spending, which rose by 1.2 per cent of GDP between 2019-20 and 2021-22.

On the other hand, the states cut back on capex, which has fallen as a percentage of GDP over the last few years, and continues to be on a weak footing in the current year. In fact, putting the central government’s capex alongside the state and public sector capex shows that the overall public sector thrust is not any stronger than it was back in 2018-19.

Four, the central government’s fiscal deficit has overshot targets while the state deficit is relatively contained. At a budgeted 6.4 per cent of GDP in 2022-23, the central government’s fiscal deficit has risen above the pre-pandemic level of 3.4 per cent in 2018-19, and is well above the 3 per cent medium-term target.

On the other hand, even though the state fiscal deficit rose in the first year of the pandemic (from 2.5 per cent of GDP in 2018-19 to 3.8 per cent in 2020-21), it has fallen sharply since (to 2.7 per cent in 2021-22). In fact, state government borrowing is rather low in the current year so far. If this continues, the fiscal deficit could be even lower in 2022-23 (around 2.5 per cent of GDP), which is well under the 3 per cent medium-term target, and bang in line with pre-pandemic levels.

In fact, the debt metrics show that even though the debt-to-GDP ratio of the states has risen on a consolidated basis, it remains below the Finance Commission’s recommended level for 2022-23.

All said, the states have less fiscal consolidation to do than the central government. Having said that, both have a common challenge — to commit to more capex, which is considered high quality spending as it “crowds in” private investment if done responsibly. And we believe investment is the only sustainable way to increase the capacity of the economy to grow and create jobs.

For the central government, the challenge is to hold on to its capex push at a time of fiscal consolidation. For the states, the challenge is to start doing more.

The central government’s aim is to lower the fiscal deficit by about 2 per cent of GDP over the next three years. About half of this consolidation can come from lowering current expenditure to pre-pandemic levels. But the balance must come from one of the following: Continued formalisation of the economy that raises tax revenues (though “organic” formalisation will likely be more sustainable than “forced” formalisation), a bigger push for disinvestment by selling stakes in public-owned companies, and further tax reforms (in terms of direct taxes and the GST). If these don’t work, the default option will be to cut capex, which is a concern as it has implications for medium-term growth.

For the states, the tax revenue bounty has so far been used for fiscal consolidation and current expenditure. The capex track record over the last few years has been weak.

All said, with the budget season upon us, there is a hope that fiscal consolidation can coexist with high capex. And that is what we will be watching out for on February 1 and beyond.