After a four-year period of an improving trajectory of state government finances, CRISIL expects state governments' key fiscal indicators - revenue deficit and gross fiscal deficit - to start deteriorating from 2009.

The improvement in the fiscal profile of state governments is reflected in India's 28 states reporting an aggregate revenue surplus of Rs22,500 crore in 2007-08 (refers to financial year, 1 April to 31 March), from a deficit of Rs63,400 billion in 2003-04. This is now set to change, as the growth in state governments' own tax revenues, as well as in devolution of taxes from the centre, is expected to slow down.

The adverse effect of lower revenue growth will be accentuated by higher development and non-development expenditure. The general elections, and elections in some major states, will create pressure to increase populist expenditure, subsidies, and tax waivers and concessions.
''A shortfall of even 4 per cent in aggregate budgeted revenues for 2008-09 can wipe out the state governments' entire revenue surplus and push them back into revenue deficits," says Roopa Kudva, managing director & CEO, CRISIL."

"While the impact will begin to be felt in 2008-09, the full effect of these trends will manifest in 2009-10 and thereafter. CRISIL expects that many states will borrow beyond the fiscal Responsibility and Budget Management (FRBM) Act targets, resulting in higher debt levels,'' Kudva added.

The deterioration in fiscal indicators would adversely impact the states' debt protection measures and overall credit risk profiles.

According to Akash Deep Jyoti, head, corporate and government Ratings, CRISIL, ''The improvement in state finances between 2003-04 and 2007-08 was underpinned by strong annualised growth of 18 per cent in value-added tax (VAT) collections, 16 per cent in state excise duty, 23 per cent in stamp duty and registration charges, and 22 per cent in devolution of central taxes, over this period. All four are now expected to show lower growth.''

Revenue from VAT, contributing 42 per cent of tax receipts, is expected to slow down because of slower economic growth and deceleration in consumption demand. Growth in state excise revenue is expected to decelerate because of the decline in industrial growth; excise contributes 8 per cent of tax receipts. Revenue from stamp duty and registration charges, comprising 9 per cent of states' revenues, will suffer from the real estate slowdown, which has affected both the volume and value of property transactions.

The slowdown in this sector would also reduce government revenue from sale and lease of land. Finally, slower growth in the centre's income tax and excise duty collections will affect the devolution of central taxes, which contribute 31 per cent of states' revenue receipts.

On the other hand, expenditure will continue to grow. The expected increase in non-development expenditure will be accentuated by higher establishment expenditure because of implementation of Pay Commission recommendations. The commitments on these expenditures were made in anticipation of continued revenue buoyancy, and may not be rolled back now even though revenue expectations have been revised downwards. Similarly, high levels of infrastructure spending will drive an increase in development expenditure.