Number Theory: Why diversity is important in understanding state finances

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On Monday, Telangana chief minister Revanth Reddy admitted in the state assembly that the state cannot pay Dearness Allowance (DA) to its employees because of a fiscal crunch. Telangana is not the only state in country which is facing problems in finding funds for essential spending even as money is being spent on other things, including populist schemes that offer electoral dividends. What is the nature of crisis in state finances? What can be done to solve it?

Telangana chief minister Revanth Reddy at the World Economic Forum in Davos, Switzerland, on January 22. (Bloomberg)

Number Theory: Why diversity is important in understanding state finances

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  States are more fiscally prudent than the Centre

  Because state budgets follow a staggered calendar, their aggregated analysis usually takes place with a lag. RBI’s annual document on state finances is usually considered the most authoritative document on state finances. The latest document which was published in December 2024, gives data up to 2024-25 Budget Estimates (BE). A comparison of aggregated deficit indictors for all states and union territories with the 2024-25 Union Budget shows that the union government’s deficit was higher than that of the states on all three deficit measures: revenue deficit, primary deficit and fiscal deficit. Revenue deficit is the difference between revenue spending and revenue receipts, primary deficit is the difference between total spending excluding interest payments on past debt and fiscal deficit is the difference between spending including interest payments and total receipts.
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  But deficits and debt levels vary significantly across states

  This is the most important factor to keep in mind while looking at the state deficits. The headline number of state deficits discussed above masks significant differences within deficit levels of states. For example, Jharkhand was expected to have a revenue surplus of 3.7% of its GSDP in 2024-25 (BE) and a fiscal deficit of just 1.9%. This number was 2.9% and 2.8% for Punjab. Andhra Pradesh, despite having a relatively lower revenue deficit (2.1%), had a much higher fiscal deficit of 4.2%. That states such as Telangana are facing a fiscal crisis despite a negligible revenue deficit basically indicates diversion of spending from heads such as DA for employees to populist schemes. To be sure, not all states are equal when it comes to financing their deficits because some of them receive revenue deficit grants from the Centre under a special provision in the Finance Commission norms. The 15th Finance Commission recommended revenue deficit grants of Rs. 2,94,514 crore over 2021-22 to 2025-26 for seventeen states. “The revenue deficit grants are on a declining path and the number of qualifying states declines from seventeen in 2021-22, the first year of our award, to six in 2025-26, the last year of the award. The total revenue deficit grant amount is also on a declining path, from Rs. 118,452 crore in the first year to Rs. 13,705 crore in the last year”, the Finance Commission report said. The issue of revenue deficit grants will likely become a controversial aspect when the 16th Finance Commission’s recommendations are being finalised.
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  Fiscal deficit and debt levels of states show a strong positive correlation

  Logically speaking, a state can have a higher fiscal deficit despite being prudent in the present if it faces a high debt servicing burden as interest payments for previous debts will extract a fiscal cost. A comparison of fiscal deficit and debt-GSDP ratio of states proves this point as they show a strong positive correlation. As is to be expected, states with high debt-GSDP ratios are also more likely to have a low growth rate.
• Experts have been arguing for a more nuanced approach to state finances

  Experts have been arguing that the diversity in state finances requires a heterogeneous rather than one-size-fits-all approach to their fiscal issues. A September 2024 research note by JP Morgan Chief India Economist Sajjid Chinoy classified states into four clusters in order to have an effective debt-sustainability analysis. They were (i) states with high debt levels and relatively low growth rates which meant debt levels could remain sticky (ii) states with elevated debt levels but the problem being non-compliance of the fiscal rule which meant sticky or even rising debt levels (iii) states where debt levels are low and deficits have always averaged much below 3% of GDP leading to unused fiscal space and (iv) states in a healthy equilibrium where debt is close to the 30% of GDP average and expected to stay that way. The note went on to explain that ensuring a convergence among these categories will require an optimum balance of equity (perhaps with more horizontal transfers from the centre) with market discipline. As is obvious, these nuanced issues have been buried in the shrill discourse on populism and Centre-state battles.