The difficulty in spending

Tax receipts are surging and markets are primed for higher state government deficits, but states are struggling to spend

Neelkanth Mishra | Last Updated at January 11, 2022 00:13 IST

This appeared in the Business Standard on January 11, 2022 (link).

One can easily spend a few thousand rupees, maybe even a few lakhs, but it is not easy to spend a few thousand crores. More so, if one is a government not geared up for work-from-home, and a raging pandemic keeps most of its staff from attending office for months. This has had consequences: Government consumption in the September 2021 quarter, as measured in gross domestic product (GDP) accounting, was 17 per cent lower than in September 2019 (in real terms). If it had instead grown at the pace seen pre-Covid, the overall GDP would have been 4 per cent higher than in September 2019, versus being nearly equal as was reported.

The instinctive “explanation” for this — fiscal constraints— is incorrect. A measure of unspent funds is the government cash balance with the Reserve Bank of India: Now at a substantial Rs 4.7 trillion, or 2 per cent of GDP. Not only have tax receipts been much better than budgeted, bond markets are also primed for a higher level of fiscal deficit for both the Centre and the states. In fact, state governments have been borrowing less than they were expected to for the last two years. It is thus a problem of execution, a difficulty in spending, also visible in actual deficits turning out to be much lower than planned.

Revised estimates (RE) for the fiscal deficit last year (FY21) were at 4.7 per cent of GDP. The RE is prepared with nine months of actual data and estimates for the remaining three. The final FY21 deficit will only be published when states present their budgets for FY23, but we can estimate broadly on the basis of states’ market borrowings and the cash they had at the end of the year, both of which we now know. This gives a deficit ratio close to 3 per cent, substantially lower than the RE, and not far from the 2.5 per cent to 3 per cent levels seen pre-Covid.

On current trends, even though the RE for FY22 published by states in the coming months will be higher than the budgeted numbers (3.6 per cent of GDP), as it always is, the final FY22 deficit is also likely to end up close to 3 per cent or possibly lower.

Put simply, states are missing spending targets: Expenditure was to rise to a record 19 per cent of GDP in FY21 and FY22, substantially above the 15 per cent to 16 per cent ratio seen pre-Covid. However, it may fall short of the target by 1.5 per cent of GDP despite the extra spending on health and subsidy-related spending during the pandemic, as well as a substantial increase in interest costs due to a higher debt-to-GDP burden. States have a long history of missing expenditure targets, and of final deficits being lower than the RE, but the gap has widened substantially in the last two years, just when governments had to step in to support aggregate demand. By signalling higher deficits, governments have primed markets for “crowding out” and thus pushed up interest rates, but as they have struggled to spend, the necessary economic support has not transpired. The costs have been borne, but the benefits are missing.

While it is widely believed that capex sees the most significant shortfall versus budget, revenue expenditure falls short too, even on accounts like salaries and pensions. The bulk of state spending continues to be revenue expenditure, with education, social welfare, pensions and interest adding up to nearly half of total spending; capital expenditure (capex) is only around a sixth of total.

The underlying reasons for the misses are not hard to imagine. Economic volatility exacerbated the normal budgeting inaccuracies and lockdowns aggravated project management challenges. Government processes are not geared for remote work: Not only are physical files hard to move across desks when staff is not in office, employees lack the hardware and software to execute processes that can work remotely. This is, of course, over and above the person hours lost due to the ravages of the disease.

It is, therefore, reasonable to assume that resumption of normal functioning in state governments can be a significant growth catalyst. Capex in FY22 was budgeted to be 60 per cent higher than in FY20, an increase of almost 1 per cent of GDP. This expenditure (on roads, bridges, irrigation and water supply) has a high growth multiplier, meaning that GDP could get boosted by meaningfully more than 1 per cent. The onset of the third Covid wave is inopportune from the perspective of resumption of state spending, given how much activity occurs in the last quarter of the fiscal year, but one hopes that this wave is shorter in duration than the earlier ones, as it has been in South Africa and the UK.

For the Centre, the mid-year increase in expenditure has been largely on food subsidy, fertiliser subsidy, MGNREGA and vaccinations. Of these, only vaccinations required a rapid scaling up of a new channel; others were pipes that Aadhaar-linkage had cleaned up in prior years, and larger funds could be pushed down without much fear of leakage or distortion. Nearly all of these are also not permanent (at least for now), and can be dialled back as necessary. Execution on capex on roads, railways and drinking water has also been largely on target, though several departments have struggled to meet expenditure targets.

For governments in general and state governments in particular, these disruptions are a wake-up call for business-continuity planning. From a macroeconomic perspective, in order to get the elevated debt-to-GDP ratios to fall back to safer levels, it is important to grow the denominator (that is, the GDP) through productive expenditure rather than try to shrink government spending to reduce the numerator, which is the fiscal deficit. Such high cash balances also raise the risk of governments getting tempted into spending inefficiently, which can cause economic distortions, or create permanent liabilities (like salary increases) that eat up fiscal space for many years. Like on nearly every metric, the fiscal health of states also varies widely: For states like Punjab, Haryana and Kerala, for example, interest costs are already more than a sixth of the total budgeted expenditure (actuals may be higher as total spending may be less than budgeted).

As states and the Centre prepare the next year’s Budgets, for a change, the focus has shifted from the availability of fiscal space to the ability to spend productively. If India’s tax-to-GDP ratio continues to rise, this may be one of the most important questions for policymakers in the coming years.