A stress test for Karnataka’s finances

The Fiscal Health Index underlines strain from debt concerns and a rise in welfare and committed expenditure.

The NITI Aayog’s Fiscal Health Index serves as a framework to assess and compare the fiscal performance of Indian states. Conceived primarily to evaluate the fiscal soundness of the states, the Index also guides reforms and encourages evidence-based policymaking.

Major sub-indices considered are the quality of expenditure, revenue mobilisation, fiscal prudence, debt index, and debt sustainability.

The indices are constructed separately for major states, north-eastern states, and Himalayan states. States are ranked and categorised as aspirants, performers, frontrunners, and achievers.

The Index for 2023-24, released recently, places Karnataka in 9th place among 18 major states, with a score of 41.7 out of 100. It is classified under the category of frontrunners. Uttar Pradesh, Gujarat, Maharashtra, and Telangana are the other states in this category.

Odisha was ranked 1st in the Index, with a score of 73.1. It held the top spot in the previous year (2022-23) as well.

Among the major states, Punjab, with a score of 12.4, is at the bottom of the list. Joining Punjab in the aspirant category, among the major states, are Kerala, Andhra Pradesh, and West Bengal.

Karnataka’s rank has improved from 10th in 2022-23.

However, this position could be seen as surprising, considering its stature as a fiscally disciplined state. Karnataka was the first state to enact and implement a fiscal responsibility act of its own in 2002, even before the Union government enacted its Fiscal Responsibility and Budget Management (FRBM) Act in 2003.

The fiscal responsibility legislation for the states mandates the states to keep their fiscal deficit below 3% of the Gross State Domestic Product (GSDP), to eliminate revenue deficit, and to maintain their public debt below 25% of the GSDP.

Fiscal deficit is the difference between total expenditure and total revenue, while revenue deficit denotes the difference between revenue expenditure and revenue receipts. Laws governing the fiscal policies of states affirm the golden rule of public finance – borrowings shall be spent on the formation of capital.

Karnataka has been a frontrunner in adhering to the fiscal consolidation roadmap since 2005-06. The state has reported a surplus in the revenue account for many years after it enacted the fiscal responsibility act, until the Covid-19 outbreak in 2019-20.

So what, really, is pushing down Karnataka’s rank in the Fiscal Health Index? Of the sub-indices the NITI Aayog considered, public debt sustainability is a parameter that has dragged down the state’s scores. Debt sustainability evaluates a state’s long-term ability to service debt without creating fiscal stress. 

The indicator the NITI Aayog used to measure debt sustainability is the difference between the growth rate of GSDP and the growth rate of interest payments. If the growth rate of the economy is higher than the growth rate of the interest payments, the debt is seen as sustainable.

Funding the guarantees

Another crucial metric is fiscal prudence, which is measured by the fiscal deficit-GSDP ratio and the revenue deficit-GSDP ratio. States with lower ratios are considered fiscally prudent. The NITI Aayog reports that though Karnataka has shown gradual consolidation by successfully reducing the deficit post-pandemic, it has also been constrained by the rising welfare and committed expenditure.

Added to this, a decline in the share of resources to the state, as per the recommendation of the 15th Finance Commission, when compared with the previous Finance Commission allocations, has also hindered efforts towards fiscal prudence.

Given recent trends of increased government expenditure owing to the guarantee programmes, the decline in Finance Commission transfers, reduction in GST revenue, etc., the state’s Fiscal Health Index may show a downward trend for 2024-25 and 2025-26. However, there is a positive takeaway from the marginally higher devolution from 2026-27, as per the 16th Finance Commission recommendations.

The state government’s efforts to improve mobilisation of excise duty through structural reforms, such as the introduction of Alcohol-in-Beverage (AIB)-based taxation from April 2026, may prove crucial on the road to improved fiscal health.

In addition, as presented in the State Budget 2026-27, Karnataka is set to pursue what it calls the ‘11G Economic Model’, which envisions a balance between public expenditure on welfare programmes and the formation of capital. This model balances allocations between social and economic sectors.

Karnataka cannot afford to compromise its overall fiscal health. Given the pressure from rising expenditure, the state must mobilise concerted efforts to optimise its revenue potential.

The writer is an assistant professor in the School of Social Sciences, MS
Ramaiah University of Applied Sciences.

(Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.)