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The struggle of state finances

* The Centre’s finances look fairly manageable, despite the considerable capex push, led by strong growth in tax revenue, while non-tax revenue has expectedly declined. This, however, is not the case for the states, where healthy revenue growth has been met by increased focus on revenue expenditure, with capex actually down 3% YoY – with state borrowings being lower as a result (down 27% FYTD).

* While the Centre has largely taken the baton to lead public sector capex (mostly in road and railways), state capex as per FY23BE shows there is increased allocation to agriculture, irrigation, education, health, and urban development – all of which are important for the quality of development.

* States usually lag in terms of capex in the first half of the year, before accelerating in H2. However, they also regularly fail to meet their capex BE – averaging just 80% of the budget estimate over the past seven years. This trend is likely to continue this year as well, which, in addition to lower capex from CPSEs, means that public sector capex will likely decline as a percentage of GDP to ~6.5% in FY23, down from 6.9% in the previous two years and ~6.7% on average between FY15-FY20.

* The overarching need is for fiscal consolidation, but not at the cost of the capex. Increased formalization, improved tax reform, and higher divestment are all needed to continue to increase revenue, which can then help maintain the capex push at both the Centre and state level.

Centre’s finances look manageable as of now…

Coming towards the end of FY23, a quick check shows that the Centre’s finances look quite manageable, with steady growth in receipts, especially tax revenue – which has grown much faster than the budget estimate (18% YoY FYTD vs. 10% budgeted). Non-tax revenue, however, has been lower (as expected), with higher dividends from the likes of Coal India and ONGC, along with PSU banks, being offset by the expected lower RBI surplus, as well as far lower dividends from oil marketing companies (IOCL and BPCL) and lower divestments. On the expenditure side, the government’s firm capex push has continued, with 55% of the capex BE having been met by October, with roads and railways seeing the bulk of the outlay so far. In terms of revenue expenditure, higher spending on fertilizer subsidies has driven a large part of the increase. Overall, the government is in line to hit its fiscal deficit target (6.4% of GDP) even with increased level of spending.

…while states have lot of capex catching up to do despite healthy revenue

Our analysis of 26 states has shown that revenue has grown at a strong pace, with both tax and non-tax revenue up by over 25% YoY. Despite this, states have focused on revenue expenditure so far – revex is up 11% YoY, having hit 49% of the BE, while capex is actually down 3% YoY, at only 30% of the BE. With capex growth budgeted at ~36% over FY22RE, there is a significant amount of catch-up left for states in the second part of the year. Some hope arrives in the fact that this slow pace is usually the case, with states hitting just ~34% of their capex BE in the first seven months of the year, on average, over the past seven years. Nevertheless, we have also seen that states regularly underestimate their capex spending, managing to fulfil just ~80% of the budgeted capex during the same time. The likes of Gujarat, MP, Kerala, and HP are leading in terms of meeting their respective capex BE for FY23, while some of the northeastern states, along with UP, are lagging. States have also committed to higher spending on agriculture, irrigation, health, education, and urban development – which is a welcome sign.

With the slow pace of capex spending, state borrowing is also far lower (down 27% YoY). While this is a return to prepandemic normalcy after two years of high borrowing, the overall situation warrants concern on a medium to long-term basis – with states that are spending the most as a percentage of their GDP also having the highest outstanding liabilities.

Public sector capex to decline to ~6.5% of GDP despite Centre’s capex push

Thus, even with the Centre’s capex push, total public sector capex is likely to decline as a percentage of GDP. The Centre is likely to spend ~2.6% of GDP on capex, far higher than pre-pandemic levels of 1.5-1.9%. State capex is likely to remain stable; however, as mentioned earlier, states are unlikely to achieve the budget estimate of ~Rs6.9trn, which would have accounted for 2.6% of GDP. Instead, even with the expected ramp-up in capex in H2FY23, states will likely only hit ~Rs5.9trn in capex, which would be 2.1% of GDP, a similar level to that seen in the past few years. Additionally, capex spending by CPSEs is likely to decline for the third consecutive year, implying that total public sector capex is likely to come in at ~6.5% of GDP in FY23, declining from 6.9% in the two previous years, and ~6.7% on average between FY15-FY20. It is quite clear that the overall capex push has shifted away from states to the Centre over the past two decades, which makes it even more important that state finances are stable and overall fiscal consolidation takes place alongside capital spending. Increased formalization of the economy, tax reform, and higher divestment are all needed to continue increasing revenue, which can then help maintain the capex push.

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