The COVID pandemic and Karnataka’s fiscal conundrum

COVID-19 pandemic has devastated economic activities across states. Our country is under lockdown since March 24, 2020 to till day. Presently, we are under the fifth phase of the lockdown where the majority of the restrictions are being removed with a measured and phased manner.

Now, along with controlling the spread of pandemic, the state governments are working on the revival of the economy. No doubt, there was slowdown even before the onset of Covid-19 pandemic. The GDP growth rate for the last quarter is 3.1% as announced by the Central Statistical Organisation (CSO).

The growth rates were 4.1%, 4.4% and 5.2% for third, second and first quarters of FY 2019-20, respectively. The provisional estimates of GDP growth rate for FY 2019-20 is estimated as 4.2% and it has declined from 6.1% in 2018-19. These figures indicate that economy was under slowdown even before the onset of Covid-19 pandemic.

The Centre and the Karnataka governments have taken many steps to address the economic slowdown which intensified due to Covid-19 pandemic. Many economic packages have been announced by the Union government. The state Karnataka also announced economic packages to needy including ASHA workers, construction workers, auto-rikshaw and taxi drivers, weavers, farmers, street vendors etc.

The government, in advance, has released ration to all ration card holders. In addition, more expenditure than budgeted towards heath sector through strengthening health infrastructure, cost of testing and treatment and cost of institutional quarantine are foreseeable.

Now comes the problem of financing these expenditures and also the committed expenditure as budgeted for FY 2020-21. As defined in the Medium-Term Fiscal Plan 2020-24 of Government of Karnataka, the committed expenditure consists of salaries and wages, pensions, interest payments, subsidies, administrative expenses, transfers to local bodies and grants-in-aid. These expenditures constitute nearly 85% of total expenditure of the government and hence reduction is difficult.

Karnataka’s fiscal position as per 2020-21 budget estimates was under distress. The reasons are as follows. State’s revenue source consists of three major items. First, state’s own revenue resources; second, state’s own non-tax revenues; and third, transfers from the Centre.

The Central transfers consist of tax shares of the states in the divisible pool and grants as recommended by the Finance Commission. We are under the Fifteenth Finance Commission (FFC) period. The FFC has submitted its report only for the year 2020-21 and the final report for remaining four years is still awaited. The FC recommends vertical devolution and horizontal devolution based on an adopted criterion where the former is the tax sharing between Centre and states and the latter on the distribution of this devolution among the states.

The FFC has reduced the states’ share in the divisible pool from 42% as laid down by Fourteenth Finance Commission to 41%. As per the criteria adopted by the FFC for horizontal devolution, Karnataka’s share has been reduced to 3.646% under the FFC period as against the Fourteenth Finance Commission’s recommendation of 4.713%. This accounts for a decline in tax devolution to Karnataka by around Rs 11,215 crores.

Generally, the Finance Commission also recommends several grants consisting of revenue deficit grants, local bodies grants, sector-specific grants, performance grants etc. Karnataka does not receive any revenue deficit grants from the Centre as its revenue account shows post-tax devolution revenue surplus.

The revenue deficit grants are given to states which show a deficit in the revenue account even after tax devolution from the Centre. Fortunately, FFC has noticed that the sum of devolution and revenue deficit grants are going to decline between 2019-20 and 2020-21 for three states - Karnataka, Mizoram and Telangana. The FFC has recommended Rs 5,495 crore as special grants to Karnataka.

Sectoral grants

Surprisingly, the FFC has not recommended any performance-based grants and sector-specific grants to states for the FY 2020-21 except for grants towards the improvement of nutrition. This would further reduce transfers from the Centre to states and accordingly to Karnataka.

Covid-19 and resultant lockdown in the state has severely affected its own revenue resources mobilisation. Own revenue consists of commercial taxes, state excise duties, motor vehicle taxes, stamps and registration duties etc. State excise duty realisation during April was almost nil. The GST collections are going to face a big dip as the economic activities were restricted.

Except for the pharmaceutical, FMCG and other essential activities, GST realisation in other sectors was negligible. For instance, e-Way bill generated during April 2020 was around Rs 90 lakh as against Rs 4.1 crore in March 2020 and around Rs 5.5 crore during February 2020. This indicates the intensity of decline in economic activity. Due to lockdown, motor vehicle taxes, stamps and registration duties have also not realised during April 2020.

During the month of April and May 2019, Karnataka realised 15% of budgeted revenue receipts. But during the present financial year, there will be a drastic decline. If there is a 20% shortfall in revenue mobilisation against what is budgeted for FY 2020-21 and assuming the given budgeted expenditure, the state would face a revenue deficit nearing to 2% of GSDP and fiscal deficit around 4.5% of GSDP.

This calculation has taken GSDP figures as given in 2020-21 budget. However, there will certainly be a reduction in economic growth rate this year as indicated in many studies. A recent report released by State Bank of India on May 26, 2020, estimated a GSDP loss of 11.4% to Karnataka amounting Rs 2 lakh crore. If this GSDP decline is incorporated in the calculation of the fiscal ratios, then the state’s revenue deficit crosses 2% of GSDP and fiscal deficit crosses 5% of GSDP.

This will be the highest deficit ratios for Karnataka since its landmark fiscal reforms through the enactment of Karnataka Fiscal Responsibility Act (KFRA) in 2002. As per the KFRA, the fiscal deficits to be less than 3% of GSDP and revenue deficits to be nil. Given the present fiscal distress, crossing these caps and more borrowings are inevitable for Karnataka this year. However, once the economic activities gear up, the state can reach its steady path of economic growth in the medium term.

(The writer is with Fiscal Policy Institute, Bengaluru)