UDAY, Pay Revision Could Limit Fiscal Flexibility Window Centre Has Thrown Open

It is a pity that the central government took over a year to accept the Fourteenth Finance Commission’s recommendation on giving extra borrowing space to state governments by relaxing their fiscal deficit targets.

If it had done this while accepting the core recommendations of the Commission with regard to devolution of taxes in February 2015, perhaps the economy could have seen more capital expenditure in 2015-16 itself.

Sure, better late than never and all that, but this extra fiscal space may be available only for 2016-17; in the years following that, the condition of state finances may not allow many states to be eligible for this relaxation. Everything hinges on how the UDAY (Ujwal Discom Assurance Yojana) scheme for turning around ailing power distribution companies plays out and what states do about pay revisions.

A quick recap. The Fourteenth Finance Commission had set a 3 per cent of gross state domestic product (GSDP) target for the fiscal deficit of states through its award period (2015 to 2020). But recognising that this may constrain states’ ability to spend for development, it said they could get an additional borrowing limit of up to 0.5 per cent on fulfilling certain conditions.

First, states must have a revenue balance or revenue surplus in the preceding two years prior to year for which the borrowing limit is to be relaxed. So, say, for 2015-16, the revenue balance/surplus should reflect in the actual accounts of 2013-14 and revised estimates of 2014-15. But since the recommendation has been accepted only now, it cannot apply to 2015-16; the easing of fiscal space will be available only from 2016-17, which means only states that had a revenue balance/surplus in of 2014-15 (actual) and 2015-16 (revised estimates) will be eligible for the relaxation. This insistence on revenue balance/surplus ensures that the borrowing will be used for capital spending (though expenditures are fungible and creative accounting is always possible).

Once states qualify, they will then have to fulfil at least one of two criteria based on the actual figures of two years earlier – the debt has to be 25 per cent or less of GSDP (which will entitle them to an extra borrowing of 0.25 per cent of GSDP) and interest payments must be 10 per cent or less of total revenue receipts (which will give another 0.25 per cent borrowing headroom). States that make the mark on both will get 0.5 per cent borrowing headroom. So, for 2016-17, only states who met one or both of these conditions in 2014-15 (actual numbers, not revised estimates) can claim the relaxation.

Since UDAY was announced in November last year, it will not affect the 2016-17 borrowing limit (since this will be based on 2014-15 actual accounts). But it could affect borrowing limits starting from 2017-18 (that will be based on 2015-16 actual accounts). States signing up for UDAY have to take over 50 per cent of discom debt as on 30 September 2015 in 2015-16 and another 25 per cent in 2016-17. The state governments will repay lenders of this debt by issuing state development loans of 10-15 years tenure.

While this debt amount will not be included in the calculation of a state’s fiscal deficit in 2015-16 and 2016-17, it could make them unable to fulfil the two criteria for getting the extra fiscal space. A January study by rating agency ICRA on the likely impact of UDAY and pay revision on state budgets had noted that for the nine states in its sample, the interest burden on account of UDAY could go up by Rs 1,600-5,100 crore from 2016-17 onwards. That could see both interest payments-total revenue receipts and debt-GSDP ratios going askew. Remember, the actual accounts of 2015-16 and 2016-17 will determine the borrowing limits for 2017-18 and 2018-19 respectively. So it is possible that this capital expenditure spending window may be available for just a year.

But even in this financial year, not too many states will be able to get this extra fiscal space. Going by the revised estimates of state budgets for 2014-15 in the latest Reserve Bank of India annual study on state budgets, only nine of the 18 major states may be eligible for this headroom. So could seven of the 11 smaller (special category) states, but their spending share is small and may not have a major macro impact (though it will help them individually).

But even this can change, since the actual accounts for 2014-15 for all the states are not yet in the public domain. The 2013-14 revised estimates showed nine states with revenue surpluses; the number came down to eight in the actual accounts.

The nine major states with revenue balance/surpluses in the 2014-15 revised estimates are – Chhattisgarh, Goa, Gujarat, Jharkhand, Karnataka, Madhya Pradesh, Odisha, Tamil Nadu and Uttar Pradesh. This could change in the actual accounts; between 2013-14 revised estimates and actual accounts, some states slipped from revenue surpluses to deficits while others moved from revenue deficit to surpluses. Some of the big spending states – Maharashtra and Andhra Pradesh, for example – are out of this list.

Only five states (Chhattisgarh, Jharkhand, Karnataka, Madhya Pradesh and Odisha) could get a relaxation on both the interest payments and debt criteria (if they maintain the position showed by 2014-15 revised estimates), which means only they can get to borrow an extra 0.5 per cent for capital expenditure. Goa, which makes the cut on revenue position, fails on both these counts. Gujarat, Tamil Nadu and Uttar Pradesh will get the relaxation on only one count, so they can spend only up to 3.25 per cent of GSDP. Whether all the states who get this flexibility have the capacity to undertake massive capital expenditure is another imponderable. Nineteen states have signed up for UDAY as of now and going forward the number of states that could be eligible for extra fiscal space could get even smaller.

Delayed the government decision may be, but public finance experts have welcomed it.“It is a recognition of the fact that the centre wants the states to undertake more capital expenditure,” says Pinaki Chakraborty, professor at the National Institute of Public Finance and Policy who was economic adviser to the Fourteenth Finance Commission. D. K. Srivastava, chief policy advisor at Ernst & Young has been making this point for long – that states making use of the extra fiscal space given by the Fourteenth Finance Commission was one of the main ways to boost capital expenditure at a time when the centre’s finances were not in good shape.

Certainly, states now have greater fiscal flexibility – the UDAY commitments will not be counted in the fiscal deficit for two years and they get relaxation under the Fourteenth Finance Commission formula. It is now entirely up to them to use it responsibly. Many states are heading for elections next year, they will be tempted to offer over generous pay hikes or other subsidies/freebies/doles. If they choose the path of fiscal profligacy, they will run revenue deficits and not be eligible for fiscal flexibility. The Finance Commission and the central government have done their bit. The ball is entirely in the states court now.