The Covid-19 pandemic-induced lockdowns and consequent slump in economic activity will hit tax collections of states and result in a near 4x expansion in their revenue deficits this fiscal, on-year. This will not only expand states’ aggregate gross fiscal deficit (GFD) to an all-time high of Rs.8.7 lakh crore, or 4.7% of GSDP, but also skew its composition¹ towards revenue deficit which is relatively less value–accretive towards future tax potential.

Tax collections may slowly recover with improving economic outlook. However, higher interest burden because of high debt funding of this year’s GFD, coupled with sticky revenue expenditures, may keep revenue deficits high for states and GFD composition skewed over the next 2-3 years.

This will, in turn, increase the credit risk for states.

A CRISIL Ratings study of 18 states², which account for ~90% of aggregate gross state domestic product (GSDP), indicates as much (see annexure).

Says Manish Gupta, Senior Director, CRISIL Ratings Ltd, “Composition of GFD, apart from its level, is one of the critical indicators of credit quality of states. Higher contribution of capital expenditure (capex) in a state’s GFD composition is viewed positively as it supports capital formation, which improves the state’s tax potential. In this fiscal, revenue deficit of states would contribute ~70% of GFD, sharply higher than the average ~15% seen over the past five fiscals.”

That is because of 15% on-year decline in revenue this fiscal. Revenue expenditures may also remain sticky as these are either committed (related to salaries, pension and interest costs), making it difficult to cut, or have been necessitated by the pandemic (such as grants-in-aid, medical and labour welfare related expenses). High revenue deficit will also compel states to moderate their capex to remain within fiscal borrowing limits,³ thereby aggravating the GFD skew.

To fund this expanded and skewed GFD, states are likely to borrow more this year. This will increase their indebtedness, but not contribute much towards future tax potential. We expect revenue collections to – at best – reach close to pre-pandemic levels next fiscal, factoring in unlocking that began in July 2020⁴ and our forecast of real GDP growth of 10% for India next fiscal.

Says Ankit Hakhu, Director, CRISIL Ratings Ltd, “The rising interest obligations due to higher indebtedness coupled with modest revenue collections will weaken interest cover⁵ of the states to 5-6 times over the medium term from ~7.7 times in fiscal 2020. Further, while states’ capex is expected to rise next year within the available fiscal space, its impact on tax potential will only be visible in subsequent years.”

Meanwhile, high and sticky revenue expenditures will continue to skew the GFD composition, with revenue deficit contributing to 30-40% of GFD over next few years, higher that the average of fiscals 2016-20. This skewed GFD composition, along with weak interest cover, will constrain the credit outlook for the states.

A strong and sustained revival in tax collections going forward and ability of states to step up capex to rebalance the composition of GFD will remain key monitorables.

¹ GFD is primarily composed of capex, net lending and revenue deficit
² States analysed: Maharashtra, Gujarat, Karnataka, Tamil Nadu, Uttar Pradesh, Andhra Pradesh, Telangana, Rajasthan, West Bengal, Madhya Pradesh, Kerala, Haryana, Bihar, Punjab, Odisha, Chhattisgarh, Jharkhand and Goa
³ States are provided unconditional market borrowing limit of 4% of state GDP; additional 1% conditional limit is available on fulfilment of reforms pertaining to universalisation of One Nation-One Ration Card, ease of doing business, power distribution and urban local body revenues
⁴ As per Comptroller and Accountant General (CAG) data for 12 of the 18 states analysed, revenue collections witnessed a ~5% improvement on-year in October 2020 before remaining almost flat on-year in November 2020
⁵ Revenue receipts/interest obligations

Annexure

Key assumptions

• Analysis factors in provisional financials for fiscal 2020 (source: CAG) and actual financials for earlier fiscals; for some states, revised estimates were considered for fiscal 2020 as provisional financials were not available
• Actual decline in key revenue sources in first half of fiscal 2021 is based on CAG data. With economic activity picking up, substantial recovery is assumed in the second half
• Revenue expenditure to increase in fiscal 2021 due to high committed expenditures and elevated pandemic-related expenses