The fiscal gridlock

India’s overall response to the outbreak of Covid-19 depends to a large extent on the state of state government finances, which usually do not get the attention they deserve. State governments are at the forefront of fighting the pandemic, which will materially add to their expenditure at a time when revenues are likely to decline significantly. For instance, goods and services tax (GST) collection in March slipped below the Rs 1 trillion mark and is likely to remain under pressure in the coming months. Further, states have not received the compensation for the shortfall in GST collection for several months now. The Central government is of the view that it can compensate only through the cess collected on luxury and sin goods. This will have a major impact on state Budgets in the current fiscal year because the economy is projected to weaken significantly. Revenue collection from items outside GST such as alcohol, petroleum products, and stamp duty will also suffer.

Facing serious Budget constraints, several state governments have decided to either cut or defer salaries of their employees. However, given the scale of the challenge, it will not take them too far. Some state governments, apart from asking for additional funds to deal with the pandemic, have suggested raising the fiscal deficit limit by 1 percentage point to 4 per cent of state gross domestic product. While the Central government released about Rs 17,287 crore to augment state government finances and the Reserve Bank of India (RBI) has raised the limit under the ways and means advances, fiscal problems should be addressed more systematically.

It is clear that neither the Central government nor the states are in a position to fight this pandemic with the given budgetary constraints, and an increase in government expenditure is unavoidable. Perhaps the easiest thing to do at this stage is to increase the budget deficit limit for state governments by 1 percentage point. However, this will also have repercussions and it is not clear if that would be enough. Bond yields have inched up, anticipating the supply of government bonds. Further, while the demand is thin, the supply of bonds has also gone up because of heavy selling by foreign portfolio investors. Additionally, while it is clear that the Central government will not be able to attain fiscal targets in the current year, it has kept the borrowing plan unchanged, creating confusion in financial markets.

It is critical, therefore, to address the fiscal constraints more transparently. First, it is important to ascertain the magnitude of intervention required. Only then can the government contemplate mobilising resources and possible distribution between the Central and state governments. The government will also need to consult the central bank. A number of commentators have suggested selling government bonds directly to the RBI. Although it may look like an easy way out at the moment, the government would do well to consider its longer-term implications. But an increase in government expenditure is inevitable, so it is important for the Central government to act swiftly and transparently. This will not only help ease financial pressure on states but also provide clarity to financial markets. The nature of government intervention at this stage will meaningfully determine how quickly India is able to contain the pandemic and bring the economy back on track.

Business Standard is now on Telegram.
For insightful reports and views on business, markets, politics and other issues, subscribe to our official Telegram channel