Indian States: The New Fulcrum of India’s Growth Push

When the markets are talking of bottom lines and economists about the policy reforms in Delhi, there is a silent but substantial change happening in the background. The combined fiscal deficit of Indian states is expected to decline further in the fiscal years (FY) 2016 even as the country is all set to experience a significant spending push (by central and state governments) in the infrastructure sector. That is, a fiscally public prudent investment boom is under way that is expected to drive the growth momentum at a time when domestic corporate sector remains conservative in its investment plans.

States now account for more than 60% of total tax revenues and spending….

The states' share of taxes collected by the Union government has increased up to 42% from 32%, according to a new formula for fiscal transfer recommended by the Fourteenth Finance Commission (FFC). Consequently, this works out to roughly Rs. 1900 billion (or 1% of GDP) of windfall for states this fiscal year alone. Though budgetary support to state governments have been slashed simultaneously, still in net terms the Centre will transfer (via tax devolution and grants) amount equivalent to 60% of its gross tax revenues to states in the current year. As a percent of total tax revenue (i.e. total gross tax revenue of central and state governments combined), states now account for about 62% of all tax revenues and spending, and the Centre only 38%. And this figure still does not even include coal royalty that some states will receive from recently auctioned coal blocks and a corpus of Rs 285 billion that various municipalities and villages will get from New Delhi over five years. Since, political power hinges on spending ability, this renewed devolution formula has shifted the balance of spending power — and, hence, political power — to state governments.

Total public investment in FY16 equivalent to roughly 4% of nominal GDP, combined fiscal deficit of states to decline to roughly 2.1%....

Of 29 states and 2 union territories with legislatures, 10 (that account for about 42% of total expenditure by States) have presented budgets for FY2016 taking into account these increased transfers. For other states we make plausible assumptions about how the increased transfers will be used based on the expenditure pattern of 10 states that have internalized the FFC's recommendations.

Our estimation shows that on average capital outlay by state governments will be up by roughly one-fifth this year. When combined with Rs 1250 billion worth of infrastructure investment by the central government, the country will experience a burst in public infrastructure investment to the tune of Rs. 5,300 billion, or 4% of nominal GDP this fiscal, up from approximately 3% in FY15.  Further, the figures also show that many states have budgeted to pay down debts which means that with a minimal nominal growth of 11% (i.e. 7.5-8% in real terms), the combined fiscal deficit of all states put together will decline from 2.3% to 2.1% in FY16.

Passing additional string-free resources to states will provide much-needed fiscal stimulus to the economy….

Investments in the economy had been consistently slowing, from 34.7% in the first quarter of FY12 to 30.1% at the end of the second quarter of FY15. The lack of investments was largely on account of stalled projects amounting to Rs 8800 billion or 7% of GDP, of which 80% belonged to the private sector. Since then, the government has undertaken a slew of policy initiatives and two rounds of rate cuts to turn the investment cycle.

To provide a fillip to the economy, the central authorities have already only ratcheted up spending on rail, roads, power and defense in the current budget. But considering the Constitution makes the states responsible for executing everything from power and irrigation to education and healthcare – passing additional string-free resources to states has opened up the possibility for a much-needed fiscal boost to the economy which otherwise was constrained by central government’s fiscal deficit target of 3.9%.

Boost in public infrastructure investment will have multiplier effect and drive economic growth….

The “multiplier” is the ratio of a change in output (ΔY) to changes in government spending (ΔG). The concept of multiplier comes from the fact that when people receive additional income they consume a part and save the remaining. Suppose, people spend 80% of every additional Rs 100 of income they receive, than when the government increases expenditure by Rs 100 on goods produced by agent A, it becomes A's income, of which 80% (or Rs 80) he/she consumes on goods produced by agent B. This means agent B has an extra income of Rs 80, of which Rs 64 (i.e. 80%) is spent on something else (i.e. it becomes someone else’s income) and the process repeats itself. Since, GDP is the sum of all expenditure in the economy (i.e. 80+64+……), every incremental investment has a larger impact than the original amount. In other words, the government spending gets “multiplied”.

Studies have found that multiplier effect is highest and more prolonged for capital expenditure as compared to all other categories of expenditure. For India, estimates of capital expenditure multiplier ranges between 2.45 (NIPFP) to 2.10 (RBI). This means that an increased capital expenditure of Rs 1 by central government would raise the GDP by Rs 2.45 (by NIPFP estimates) or Rs 2.13 (by RBI estimates) in one years’ time. This multiplier effect is as high as 3.84 over a period of three years (i.e. an additional capital investment of Rs 1 generates Rs 3.84 in three years). Considering that the capital investment outlay in the current general budget is Rs 1250 billion, this investment, if fructifies, may generate an additional amount equivalent to 2% of GDP in FY16, and accordingly will have multiplier effect in the succeeding years.

The multiplier effect is also one of the primary reason behind increased resource devolution and hence spending powers to states. According to the RBI study, greater decentralization of government expenditure is expected to have more output effects as compared to the Centre. The study suggests that while capital expenditure multiplier for Centre and states is identical after the first year, it stands at 3.84 for Centre and a whopping 7.61 for states over a period of three years. That is to say, while capital investment multiplies approximately four times for the Centre, the same investment by states multiplies almost eight times over a period of three years. The primary reason for this difference is that while central funds are thinly spread across a range of schemes, state investments are concentrated into few projects thereby generating larger multiplier effect.

Despite the high value of capital expenditure multiplier, infrastructure investments by governments at all levels in recent past have been sluggish. In this regard, increased resource transfers to states together with policy thrust to boost infrastructure spending by governments at all levels is a welcome step that will put India on higher growth trajectory. The financial muscle has been created, the sooner states join the spending race, better it will be for India's economy.