New Delhi: India's states are trapped in a fiscal system where recurring costs rise automatically, while investment remains discretionary. This is why even though state budgets are seen expanding every year, the services and infrastrucutre that people can actually use are not keeping pace.

States have rigid spending requirements – on salaries, pensions, interest – and rising debt on top of it all. This is squeezing their fiscal flexibility as well as investment capacity, despite their having collected more money in FY24. Put differently, revenue expenditure is crowding out capital spending across Indian states, even as the capex is rising in absolute terms.

These are some of the findings in the latest edition of the Comptroller and Auditor General's (CAG) "State Finances, 2023-24: Decadal Analysis" report, released on December 25 last year.

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The findings help explain why ever-growing state budgets – and higher tax collections – do not always translate into more or better classrooms, lecture theatres, hospital rooms or other public services across the country. Revenue expenditure is 83.25% of the total expenditure, CAG finds, and capital expenditure is 16.75%. In value terms, the capex is Rs 7.84 lakh crore, while the revenue expenditure is Rs 38.96 lakh crore.

This 80:20 split, where revenue expenditure dominates total spending by a wide margin, has been a consistent trend in India. The bottomline of this trend is that states end up spending more to run the government and meet their obligations, but just do not have enough left to build future growth capacity.

Salaries and wages, pensions, interest payments on debt, subsidies, grants-in-aid for state-supported bodies and day-to-day operations and maintenance are hard to cut quickly and must be paid regularly. But they generate little in terms of long-term assets. These revenue expenditures take up 83.25% of state budgets.

Roads, bridges, power, water, sanitation infrastructure, schools, hospitals and equity for state-owned enterprises are, therefore, pushed down the priority list in states. They languish at lower shares of the total expenditure even though they are meant to create assets that are badly needed.

The situation is such that states are forced to borrow more to fulfil their immediate obligations. And this, again, does not help create matching assets. What the CAG report essentially highlights is that the stress in Indian states is not just over a lack of finances but over what it is being poured into.

Under the constitutional scheme, majority of capex – including the asset-building kind, which is meant to last generations such as state highways, district roads, irrigation projects, water supply and sanitation, equity for state PSUs and state-level infrastructure loans – are primarily the states' responsibility.

At the same time, schools, hospitals, electricity, power generation and other social and economic infrastructure are often based on cost-sharing between the Union government and the states. And then there are projects in which there is very little state capex directly, such as airports, ports and interstate power transmission networks.

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But most of the productive capex already lies squarely in the constitutional domain of states. That is why they can find resources to invest in growth only if they have fiscal flexbility. And, as the CAG report highlights, they do not have this flexibility.

Take, as an example, education. It was on the State List until 1976, when it was moved to the Concurrent List by the 42nd Constitutional Amendment. Now, both the state and the Union can legislate on education, but in practice, states run schools, hire teachers and fund day-to-day education spending. Meanwhile, the Union government sets the broad policy objectives and standards for education.

So, while education capex – building schools, colleges and so on – is on the Concurrent List, the revenue expenditure, such as on teacher salaries, though also on the same list, is largely borne by states.

The CAG report does not identify individual projects in each area, but it does identify what sectors are absorbing most of capex at the state level. Roughly 63% of the capital outlay went into the economic sector, it finds, where roads, irrigation, power and transport projects fall, alongside irrigation-related expenditure, including flood control.

Then followed the social sector, i.e., schools, hospitals, etc., which could get 31.5% of the total capital expenditure.

Seen carefully, this means that a few cost-heavy infrastructure projects and the entire social sector are forced to rely on just 17% of the total expenditure at the state level. Meanwhile, a lion's share of the money goes into meeting regular, unavoidable committments – with interest repayment at the top of that list.

That is why citizens don't see the new roads, clinics or schools, but they do experience the interest costs later.

To be fair, social sector expenditure has been rising in absolute terms in Indian states. However, its share has not risen meaningfully. Further, when committed costs absorb most of the funds, borrowing increasingly funds consumption, not assets. This means that states are using their resources to run the wheels of governance, but not to build them better or maintain them. Capex is rising in rupees – but shrinking in priority.

Central schemes push this tendency further. Centrally sponsored schemes require states to hire staff, run programmes and maintain assets. These costs show up as revenue expenditure, even when policy originates at the Union. The result is that recurring costs rise faster than capex in the states. Not just that. Even pay commission hikes set back states, by setting the benchmarks for staff pay and pensions.

The Goods and Services Tax (GST) regime has also played a role in this. It has stabilised revenue, the CAG report finds, but it has also reduced the freedom of states to raise revenues independently (such as by raising rates). That is why many states remain dependent on the Union government for transfers and there are continuing demands of the Union to compensate states for GST-related revenue losses.

Also read: States Drove Rise in Social Spending Despite Shrinking Transfers From Union Government

Besides, fiscal deficit limits apply to all states, even when revenue expenditure is unavoidable. In this scenario, the first steps states must take to comply is cutting capital expenditure. Union government policies have thus locked states into higher recurring costs while limiting fiscal room. In other words, it has made capex the adjustment variable.

From a citizen perspective, people are paying more – since tax collections are up – but it is just to try an keep things from collapsing, rather than expanding them. Governments don't (cannot) cut pensions or salaries, but they do move people to contract-based work, de-prioritise public companies, let schools get overcrowded, stop hiring regular teachers and health workers, delay irrigation works and slow hospital expansion.

Some states are far more exposed than others to this tendency, such as Manipur, Meghalaya, Arunachal Pradesh, Tripura, Mizoram, Sikkim, Assam, Himachal Pradesh and Bihar, which raise below 40% of their own revenues as a percentage of total revenue. In the middle are states like West Bengal, Uttar Pradesh, Punjab, Odisha, Rajasthan and Madhya Pradesh, which raise roughly 45% to 60% of their own revenues to fund expenditure.

And then come the better-off states, such as Haryana, Tamil Nadu, Gujarat, Telangana, Maharashtra and Karnataka, which fund most of their spending from taxes they raise themselves (70% to 80%). In general, these states are able to generate large fuel and excise revenues and have stronger property markets that yield stamp duties, as well as better non-tax revenues, such as from royalties, VAT/fuel taxes, excise on alcohol sales, motor vehicle taxes, etc. These states are structurally strong – not just GST dependent.

In Financial Year 2023-24, fifteen states together received 81.49% of total grants and central assistance. These were Uttar Pradesh in the lead (11.81%), Maharashtra, Madhya Pradesh and Andhra Pradesh (7.34%), followed by Bihar, Gujarat, Tamil Nadu (5.36%), Rajasthan, Assam, West Bengal, Odisha, Karnataka, Himachal Pradesh, Uttarakhand and Punjab (3.03%). The remaining 13 states received the rest.

Out of the total grants and central assistance to the states, from FY 2014-15 to FY 2023-24, a similar pattern was observed, where about 80.56% of the total grants and central assistance went to the same 15 states, the CAG report says.

However, once State GST is stripped out for several states, they considerably weaken fiscally, such as Kerala, Punjab, Rajasthan, West Bengal and Andhra Pradesh. This is purely on account of their limited flexibility outside the GST. And then come the chronically weaker states such as Bihar, Uttar Pradesh and in the Northeastern Region, which depend on transfers regardless of tax design.

The impact of capex becoming the sole adjustable variable is therefore not felt equally by everybody across the country, which is also something the CAG report highlights. States that rely heavily on GST and have weak non-GST taxes are also the ones struggling most with debt, leaving them little choice but to cut investment first whenever a crisis – or election – arrives.

Perhaps the exception to this is Tamil Nadu, where own revenues remain strong and where, despite high debt, the interest remains manageable and market access remains strong. Tamil Nadu does invest in infrastructure, but capex is increasingly squeezed by pension, salary and subsidies (power and transport, mostly). This shows that even fiscally strong states can struggle to invest if salaries, pensions and subsidies grow faster than revenues.

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