The role of state fiscal capacities in national growth

India’s economic progress is a composite reflection of the growth trajectories of its states. Given the federal structure of the country, each state operates with a degree of autonomy in implementing policies that drive their individual economies. This results in a broad spectrum of growth rates across states, highlighting significant disparities. For the nation to achieve holistic growth, it is imperative for all states to experience economic advancement.

Despite this, there is a notable discrepancy in the attention paid to fiscal matters at different levels of government. The Union Budget, detailing the central government’s finances, often garners substantial scrutiny and debate for its potential impacts on the nation’s economic direction. In contrast, state budgets, which are crucial for addressing local needs and fostering regional development, do not attract a similar level of public and analytical scrutiny.

Fiscal capacity, the government’s ability to generate revenue from available tax and non-tax bases, is crucial for several reasons. First, it underpins a government’s ability to provide essential public goods and services. These range from healthcare and education to infrastructure and defense, which are fundamental for the welfare of the citizenry and the smooth functioning of the economy. Without adequate fiscal capacity, governments may struggle to maintain these services at levels that meet public demand and expectations, potentially leading to social unrest or a decline in the quality of life.

Second, fiscal capacity is vital for economic development and growth. Governments need resources to invest in infrastructure projects like roads, bridges, and digital networks, which are critical for enhancing productivity and competitiveness. Such investments not only improve current living standards but also set the stage for future economic expansion. The Asian Development Bank Institute (ADBI) in 2017 and the World Bank in 2015 highlighted the risk of economies falling into a ‘middle-income trap’ where they are unable to transition to high-income status due to inadequate fiscal capacity among other factors.

Moreover, fiscal capacity is essential for macroeconomic stability. It allows governments to manage economic cycles more effectively, applying fiscal stimulus in downturns and restraint in booms to maintain economic stability. The Covid-19 pandemic’s impact on Indian states underscored this point, as reduced fiscal capacities constrained their ability to respond effectively to the crisis and its economic repercussions.

Finally, a robust fiscal capacity enables equitable social development. It allows for redistributive policies that can mitigate income inequality and fund social safety nets for the vulnerable. Studies have shown that factors such as high per capita income, education levels, and low corruption contribute to higher fiscal capacity, which in turn can be used to foster a more inclusive society.

Given that state governments account for over 60 per cent of general government expenditure in India, enhancing their revenue-generating capacity is imperative for the needed investment in areas such as education, research and development, and skill development.

The Reserve Bank of India recently released a report on state finances, which gives an insight into the state budgets of 2023-24. It has some important findings. First, revenue mobilisation in Indian states comprises both tax and non-tax revenues, with a significant portion coming from state’s own tax revenues (SOTR). Over the years, there has been a noticeable increase in SOTR, growing from 5.7 per cent of GDP in 2003-04 to 6.9 per cent in 2022-23. This growth, particularly in the post-GST era, reflects a shift in the composition of tax revenues with the State Goods and Services Tax (SGST) becoming a predominant source. The reliance on SGST, along with other taxes like sales tax/VAT, excise duty, and stamp duty, signifies the evolving nature of state revenue sources.

Second, the variation in fiscal capacity across states is pronounced, with SOTR constituting over 70 per cent of total tax revenue in economically better-off states like Haryana, Maharashtra, and Gujarat, but less than 50 per cent in less affluent states such as Bihar and Jharkhand. This disparity highlights the uneven economic development and the potential for fiscal capacity across the country. For instance, if one looks at the recent budget of Bihar, SOTR is merely 27 per cent. Resources from the Centre will be in the form of state’s share in central taxes will constitute 50 per cent of revenue receipts and grants will comprise of 23 per cent of revenue receipts. Thus, there seems an incentive for some states to keep their SOTR low, due to political compulsions and depend on the center. No wonder, states with low SOTR can decide to forgo the excise duty on liquor which is usually a significant chunk of the SOTR.

Fortunately, the improvement in tax buoyancy, especially post-2021-22, underscores the positive impact of economic revival and better tax compliance on revenue collection. Several states have also brought in reforms in last few years to augment their own tax capacity. Andhra Pradesh, Telangana, Karnataka, Kerala & Goa have brought in reforms around stamp duty and land registration fees. All these states have also brought incremental reforms in Motor Vehicle Tax. AP, Sikkim, Tamil Nadu, Karnataka and Kerala have brought in reforms around excise duty.

In response to the need to enhance revenue generation, states have undertaken various measures to reform their tax and non-tax revenue systems. Efforts in the stamp duty sector include recalibrating rates, updating the assessed value of land, and implementing electronic stamping for certain documents. Liquor-related revenues have seen an overhaul with adjusted excise duties, higher license fees, and the introduction of a social security cess.

Additionally, establishments selling alcohol are now equipped with digital payment options to streamline revenue collection. Motor vehicle taxation has evolved through the adjustment of lifetime taxes, the introduction of eco-friendly levies, and stricter penalties for non-compliance. States are encouraged to refine this tax structure further, drawing from global practices.

Addressing the shortfall in GST revenues, states have deployed sophisticated tools like AI-ML and data analytics, established dedicated tax intelligence units, enforced electronic governance, and mandated e-invoicing for select taxpayers. These efforts are designed to enhance GST compliance and minimize revenue leakage.

RBI report has also pointed that due to the increased demand for public services and constrained by the limited capacity to broaden the tax base under the uniform GST framework, states have turned to non-tax avenues to bolster their fiscal resources. This includes leveraging charges for state-provided services and goods. Revenue-enhancing reforms from non-tax sources comprise methods such as electronic auctioning of mining rights, adjusting royalty rates on mined materials, enforcing stricter penalties to deter illegal mining, monetising land assets, revising industrial water tariffs, and elevating the financial governance of state-owned enterprises.

Electricity tariffs have been revised across various states, significantly reducing under-recovery rates. Enhanced billing and collection efficiency through innovative metering solutions are anticipated to further curtail technical and commercial losses, strengthening the states’ fiscal position.

In passing, it’s worth highlighting that a fascinating pattern emerges where states boasting higher SOTR are actively pursuing further enhancements, while those with lower SOTR remain in the doldrums. This trend is mirrored in the sphere of the states’ own non-tax revenue (SONTR) as well, creating a self-perpetuating loop. This cycle is fuelled by the lackluster fiscal performance of certain states, which show little interest in initiating reforms, banking on the expectation that the Finance Commission will bail them out. States should listen to RBI and bring in reforms to augment both SOTR & SONTR as this in turn will augment their fiscal capacity.

The author (X: @adityasinha004) is OSD, Research, Economic Advisory Council to the Prime Minister. Views expressed in the above piece are personal and solely those of the author. They do not necessarily reflect Firstpost_’s views._