COVID-19 effect on state finances

#GS3 #Economy

 

If the Reserve Bank of India’s study on state governments’ finances is any indication, gross fiscal deficits (GFDs) of state governments are set to double in 2020-21 as the Covid-19 pandemic has hit the financial position of states hard and the next few years are going to be challenging.

 

Where are the gross fiscal deficits of states headed?

  • In 2020-21, about half of the states have budgeted the GFD to gross state domestic product (GSDP) ratio at or above the 3 percent threshold although most of these budgets were presented prior to the onset of Covid-19, the RBI said.
  • The direction of possible revision is evident from the fact that the average for states presenting their budget before the outbreak of the pandemic is 2.4 percent, while the average for the balance number of states that made post-outbreak budget presentation is 4.6 percent of GSDP.
  • Thus, states are grappling with the pandemic with constrained fiscal space. In terms of primary balances, states are clearly in an unfavorable position, with most states incurring primary deficits in 2019-20, as against primary surpluses at the onset of the global financial crisis, the RBI study said.

 

Will it continue?

  • The crisis literature focuses on the operation of the scissor effects — loss of revenues due to demand slowdown, coupled with higher expenditure associated with the pandemic.
  • The duration of stress on state finances will likely be contingent upon factors like tenure of lockdown and risks of renewed waves of infections, all of which make traditional backward-looking tax buoyancy forecasting models unreliable, according to the RBI study on state finances.
  • The quality of spending and the credibility of state budgets will assume critical importance. The next few years are going to be challenging for the states, it said.

 

Past experiences 

  • An event study analysis using four pandemic outbreaks in India — the 1896 plague, the 1918 Spanish flu, the 1957 Asian flu, and the 1974 smallpox — shows that all episodes were associated with a contraction/ deceleration in GDP, with the 1918 flu registering the sharpest downturn of about 13 percent.
  • Interestingly, the recovery pattern is quite similar — a sharp rebound in the immediately subsequent year because of favorable base effects, followed by contraction again, with the GDP growth rate finally subsiding back to pre-pandemic years in about 3-4 years.
  • These severe disease outbreaks have also depressed per capita economic output in the economy, albeit with varying magnitudes. The recovery, however, is observed to be swift and complete within two years of the outbreak, except in the case of the 1918 flu when GDP per capita was restored to pre-outbreak levels only in 1922, the RBI said.
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