State Governments and the Union Budget - Impact on Revenues and Expenditures

Context:

• State governments are crucial stakeholders in the Union Budget, as their fiscal health is significantly influenced by tax devolution, grants from the Centre, and interest-free loans for capital spending.
• These components form a substantial part of state revenues and shape their expenditure and deficit levels.

Tax Devolution Trends:

• Overview: Over 40% of several states' revenues come from tax devolution and grants. The actual tax devolution has fluctuated over the past five years, varying from initial budget estimates.
• 2024-25: Tax devolution was revised upwards to Rs 12.9 trillion from Rs 12.5 trillion, reflecting adjustments for previous payments and an increase in states' share of income tax revenues.
• 2025-26: Tax devolution is projected at Rs 14.2 trillion, an 11% increase over the previous year.
• Future projections: The impact of personal income tax modifications may lead to an optimistic revenue growth forecast, potentially affecting tax devolution.

Grants to States - Declining and Volatile Trends:

• Overview: Grants from the Centre have shown an uneven trajectory, influenced by factors such as:
  • End of GST compensation grants (2022-23).
  • Decline in Finance Commission-recommended grants, leading to a 13% drop in total grants (Rs 7.8 trillion in 2023-24).
• 2024-25: Further reduction of Rs 1 trillion in 2024-25 revised estimates due to lower allocations for centrally sponsored schemes and GST compensation.
• 2025-26 projections: Total grants set at Rs 8.9 trillion, marking a 14% growth, surpassing the increase in tax devolution.

Capital Expenditure Loans to States:

• Overview:
  • Interest-free loans for capital expenditure have emerged as a critical funding source since 2020-21.
  • To boost the resources of state governments, the Centre has been stepping up allocation under the special assistance scheme as loans to states for capital expenditure.
• 2024-25 revised estimates:
  • Allocation for the capex loan scheme was reduced to Rs 1.25 trillion from Rs 1.5 trillion.
  • By January-end 2025, actual disbursements reached Rs 1.1 trillion, indicating robust utilization.
  • All 28 states availed funds under this scheme, with major recipients including Bihar, MP, UP, and West Bengal (40% share).
• 2025-26 allocation: Rs 1.5 trillion, with disbursement influenced by the mix of tied and untied loans.

Conditional Borrowing and Power Sector Reforms:

• The Centre extended the 0.5% of gross state domestic product (GSDP) conditional borrowing linked to power sector reforms for 2025-26. In FY 2023-24, States borrowed Rs 1.2 trillion under this framework.
• Initially set to end as per the 15th Finance Commission's recommendations, this extension aims to drive critical reforms in the power sector.
• This move is expected to strengthen state finances and support economic growth.

Implications for State Capital Expenditure:

• Key provisions in the Union Budget positively impact state capex:
  • Higher tax devolution: Provides untied funds, offering fiscal flexibility.
  • Enhanced capex loan outlay: Encourages infrastructure development.
  • Extension of power sector reform-linked borrowing: Incentivizes critical sectoral reforms.

Future Outlook - 16th Finance Commission Recommendations:

• State governments will closely monitor the recommendations of the 16th Finance Commission (FY 2027-31).
• Key expectations include:
  • Deficit and debt targets for states.
  • Continuation of the capex loan scheme beyond the 16th FC award period.
  • Potential exclusion of capex loans from the net borrowing limit.
• The recommendations are expected before the Union Budget 2026-27 and will significantly shape state finances.

Conclusion:

• The Union Budget significantly influences state finances through tax devolution, grants, and loans.
• While tax devolution has seen an upward revision, the volatility in grants remains a concern.
• The capex loan scheme and conditional borrowing linked to power sector reforms play a crucial role in shaping state fiscal health.
• The upcoming 16th Finance Commission recommendations will be critical in determining future fiscal frameworks for states.

Q1. Discuss the significance of tax devolution in state finances and its impact on fiscal planning.

Ans. Tax devolution forms over 40% of several states' revenues, influencing their expenditure, deficit management, and fiscal autonomy.

Q2. How have grants to states evolved in recent years, and what are the key challenges associated with them?

Ans. Grants have shown volatility, declining after the end of GST compensation and Finance Commission-recommended transfers, leading to fiscal uncertainty for states.

Q3. What role does the capital expenditure loan scheme play in strengthening state finances?

Ans. The interest-free capex loan scheme supports infrastructure investment, with states like Bihar, MP, UP, and WB availing significant funds to boost development.

Q4. Explain the rationale behind extending the conditional borrowing linked to power sector reforms for states.

Ans. The extension aims to incentivize power sector reforms, ensuring states adopt sustainable fiscal policies while improving economic growth.

Q5. What key aspects of state finances are expected to be addressed by the 16th Finance Commission?

Ans. The 16th FC will likely focus on deficit and debt targets, the continuation of capex loans, and their inclusion or exclusion from borrowing limits. 

Source:IE