How Much Financial Flexibility Do States Have To Deal With Covid-19 Strain?

Both the central and state governments have had to commit to upfront expenditure to deal with the immediate fallout of the crisis. They have to spend on healthcare systems and provide relief to those who have lost their income as a consequence of the restrictions placed on business. Revenues, meantime, are uncertain given the sudden stop in business activity and the lack of clarity on when business activity will revive.

While the central government has greater flexibility in raising resources if it chooses to do so, most Indian states have large committed expenditure, few independent sources of revenue, a modest amount of disaster relief funds and limited access to emergency borrowings.

States With Highest Projected Fiscal Deficit

One way to look at this is to simply consider the expected gap between revenues and expenditure even before the Covid-19 outbreak. This would get captured in the fiscal deficit and tell you whether finances were in good shape to manage an emergency.

Among larger states, the deficit position weakened in 2019-20 but most states projected an improvement in FY21. Still, of the ten largest states, Uttar Pradesh, Rajasthan, Telangana and Kerala were projecting a fiscal deficit of 3 percent, which is the limit set under the Fiscal Responsibility and Budget Management Act.

But this indicator holds little value at this stage when both revenues and expenditure have been thrown off-track. The only thing it tells is that the states with higher projected deficits were already stretched. This stress now worsens considerably.

States Where Proportion Of Committed Expenditure Is Highest

A disaggregated look at the spending and revenue data could give a slightly better understanding of the flexibility a state has within its own budget.

Two spending items where states have relatively lower flexibility is interest costs and salaries and pension. Interest costs must be paid. With a few exceptions, notably Maharashtra and Telangana, states have not touched salaries either. Doing so is not even advisable at a time when demand conditions in the economy are so weak.

States for which these components make up a larger share of projected revenue will have lesser flexibility in reorganising spending to meet emergency needs. Using this metric, Tamil Nadu and Kerala have lesser flexibility. Telangana, where committed expenditure also include allocations towards subsidies, also has limited flexibility within its current budget.

Sources Of Tax Revenue

Now imagine a scenario in which not only do these expenditures continue to go out, but additional spending related to the spread of Covid-19 builds. This spending happens here and now.

Yet, revenues needed to fund it come to a near standstill. While it is tough to pin down the extent of the revenue hit over the course of the year, a glance at the sources of states’ ‘own tax revenue’ gives a reasonably clear view of the near-term slowdown in revenues.

For most states, state goods and services tax, value added tax and sales tax, excise duties and stamp duties form the largest components of ‘own tax revenue’. Since many of the business activities through which states get their own revenues, such as real estate transactions, sales of petroleum products and alcohol, are at a near standstill, tax earnings for the states will also plunge.

Moreover, as the centre’s collections drop due to weaker economic growth, tax transfers and the ability of the government to generate compensation cess to compensate states will reduce.

According to estimates put out by rating agency ICRA:

• The gross tax collections of the central government are likely to undershoot the FY20 revised estimate of Rs 21.6 lakh crore by around Rs 1.2-1.3 lakh crore.
• This would entail lower tax devolution to states of Rs 42,000 - Rs 55,000 crore, which would be adjusted in FY21.
• Additionally, the FY21 gross tax revenues of the central government of Rs 24.2 lakh crore are likely to be sharply revised at a later stage. Therefore, the actual central tax devolution to the state governments in FY21 is expected to be appreciably lower than the budget estimate of Rs 7.8 lakh crore.

Disaster Relief Funds

While the full impact on revenue collections and the ability of states to manage expenditure will play out during the course of this year, the immediate need for states is cash to spend on relief measures.

The first emergency fund available is the disaster relief fund, both at the state and the central levels.

Under the current structure, the responsibility of disaster relief is shared between the states and the centre, with the former holding primary responsibility and the centre stepping in as the second line of defence. “The State Governments incur most of the disaster-related expenditure through their State Disaster Response Funds (SDRF) and these funds could be augmented and replenished through the National Disaster Response Fund (NDRF) when disasters of rare severity necessitate it,” according to the Fifteenth Finance Commission’s report.

The central and state governments make contributions in the ratio of 75:25 to fund the total disaster relief corpus.

According the Fifteen Finance Commission’s recommendations for 2020-21, the total amount allocated to the states for disaster relief management is Rs 28,983 crore. Out of this, the central government’s share is Rs 22,184 crore. This total quantum works out to just about 0.1 percent of nominal GDP and is clearly inadequate in the current circumstances.

The national corpus is smaller at Rs 12,390 crore.

The state-wise allocation of these funds was decided by the Finance Commission on the basis of a combination of the following factors:

• Capacity (as reflected through past expenditure).
• Risk exposure (area and population).
• Susceptibility to hazard and vulnerability (disaster risk index).

This allocation, which doesn’t account for pandemics of the nature of Covid-19, could also prove to a concern since some of the states which saw an early outbreak like Kerala have limited allocations.

Ways And Means Advances Or Borrowings

To cover the gap, states can consider borrowing from the market. However, the first state government bond auction of the year saw a spike in interest rates. Kerala, for instance, had to pay nearly 9 percent to borrow 15-year funds.

One way to avoid costly market borrowings but access credit is to use the ‘Ways and Means’ advances offered by the RBI. These are short term borrowings to be repaid within 90 days, offered to states at the benchmark policy rates.

Until last year, Rs 32,225 crore was available to states via this window. This has been revised upwards by 30 percent to Rs 41,893, the RBI said. The central bank has also allowed states a longer period of overdraft.

These measures may provide some respite, albeit temporarily.

States are struggling with serious cash flow problems due to the lower revenue realisations from their own taxes, as well as from the central tax devolution, said M Govinda Rao, chief economic advisor to Brickwork Ratings. The cash crunch has posed a severe challenge for a number of states at a time when they need all the resources to fight the Covid-19 pandemic.

The increase could not have come a day too soon, Rao said.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.