States, freebies and the costs of fiscal profligacy

The need for instituting more effective checks that can make wayward States fall in line is compelling

Published - June 28, 2022 12:16 am IST

‘The amount States borrow collectively every year is comparable in size to the Centre’s borrowing’

‘The amount States borrow collectively every year is comparable in size to the Centre’s borrowing’ | Photo Credit: Getty Images/iStockphoto

During the planning last year and the campaign ahead of the Punjab Assembly election, the Aam Aadmi Party (AAP) promised a sum of ₹1,000 per month to every woman in the State. To drive home the generosity of the promise, the AAP leader and Delhi Chief Minister, Arvind Kejriwal, emphasised that under AAP’s ‘Mission Punjab’ for the Punjab polls 2022, if there were three adult women in a household (daughter-in-law, daughter, mother-in-law), each of them would get ₹1,000. When questioned how Punjab, already reeling under heavy debt, could afford this, Mr. Kejriwal said something to the effect that if there is good political management, money would not be a problem.

Growing freebie culture

Electoral promises of this kind raise several questions. Is borrowing and spending on freebies sustainable? Is this the best possible use of public money? What is their opportunity cost — what is it that the public are collectively giving up so that the government can fund these payments? Should not there be some checks on how much can be spent on them?

I am using Punjab to illustrate a point and by no means to suggest that it is unique. In fact, many States are pursuing the freebie culture, some even more aggressively than Punjab.

Ideally, governments should use borrowed money to invest in physical and social infrastructure that will generate higher growth, and thereby higher revenues in the future so that the debt pays for itself. On the other hand, if governments spend the loan money on populist giveaways that generate no additional revenue, the growing debt burden will eventually implode and end in tears.

Concerned by an increasing number of States that are embarking on this financially ruinous path, senior bureaucrats reportedly flagged the issue at a meeting with the Prime Minister, telling him that ‘some States might go down the Sri Lankan way’.

There is an argument that this concern is being exaggerated. After all, if you look at any analysis of State Budgets by the Reserve Bank of India or any think tank, the inference you will draw is that State finances are in good, if indeed robust, health, and that all of them are scrupulously conforming to the Fiscal Responsibility and Budget Management (FRBM) targets.

This is a misleading picture. Much of the borrowing that funds these freebies happens off budget, beyond the pale of FRBM tracking. The typical modus operandi for States has been to borrow on the books of their public enterprises, in some cases by pledging future revenues of the State as guarantee. Effectively, the burden of debt is on the State exchequer, albeit well concealed. The Comptroller and Auditor General of India (CAG) had in fact pointed out that in respect of some States ‘if extra-budgetary borrowings are taken into account, the liabilities of the government are way above what is acknowledged in the official books’.

How big is the problem? There is no comprehensive information in the public domain to assess the size of this off-budget debt, but anecdotal evidence suggests that it is comparable in size to the debt admitted in the Budget books.

The obvious motivation for States in expanding freebies is to use the exchequer to build vote banks. A certain amount of spending on transfer payments to provide safety nets to the most vulnerable segments of the population is not only desirable but even necessary. The problem arises when such transfer payments become the main plank of discretionary expenditure, the spending is financed by debt, and the debt is concealed to circumvent the FRBM targets.

The more States spend on transfer payments, the less they have for spending on physical infrastructure such as, for example, power and roads, and on social infrastructure such as education and health, which can potentially improve growth and generate jobs. The truth of the Chinese saying, ‘give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime’ is self-evident to everyone, including politicians. But electoral calculations tempt them to place short-term gains ahead of long-term sustainability.

Institutional checks, balances

What about the institutional checks and balances that should prevent this downward spiral? Unfortunately, all of them have become ineffective. In theory, the first line of defence has to be the legislature, in particular the Opposition, whose responsibility it is to keep the Government in line. But given the perils of our vigorous democracy, the Opposition does not dare speak up for fear of forfeiting vote banks that are at the end of these freebies.

Another constitutional check is the CAG audit which should enforce transparency and accountability. In practice, it has lost its teeth since audit reports necessarily come with a lag, by when political interest has typically shifted to other hot button issues. Besides, our bureaucracy has mastered the fine art of turning audit paras into ‘files’ which run their course and die a quiet death.

The market is another potential check. It can signal the health or otherwise of State finances by pricing the loans floated by different State governments differently, reflecting their debt sustainability. But in practice this too fails since the market perceives all State borrowing as implicitly guaranteed by the Centre, never mind that there is no such guarantee in reality.

The costs can be huge

The costs of fiscal profligacy at the State level can be huge. The amount States borrow collectively every year is comparable in size to the Centre’s borrowing which implies that their fiscal stance has as much impact on our macroeconomic stability as does that of the Centre. The need, therefore, for instituting more effective checks that can make wayward States fall in line is compelling.

Here are two suggestions towards that end.

First, the FRBM Acts of the Centre as well as States need to be amended to enforce a more complete disclosure of the liabilities on their exchequers. Even under the current FRBM provisions, governments are mandated to disclose their contingent liabilities, but that disclosure is restricted to liabilities for which they have extended an explicit guarantee. The provision should be expanded to cover all liabilities whose servicing obligation falls on the Budget, or could potentially fall on the Budget, regardless of any guarantee.

Second, under the Constitution, States are required to take the Centre’s permission when they borrow. The Centre should not hesitate to impose conditionalities on wayward States when it accords such a permission. States slapped with conditionalities will of course baulk and allege political motives. The challenge for the Centre will be to act transparently and in accordance with well-defined, objective and contestable criteria.

Finally, there is the draconian provision in the Constitution of India which allows the President to declare financial emergency in any State if s/he is satisfied that financial stability is threatened. This Brahmastra has never been invoked so far for fear that this will turn into a political weapon of mass destruction. But the provision is there in the Constitution for a reason. After all, the root cause of fiscal irresponsibility is the lure of electoral nirvana. It will stop only if the political leadership fears punishment. It is therefore important to ensure that the prospect of a financial emergency in case of gross and continuing fiscal irresponsibility is not just an abstract threat but a realistic one.

Disappointingly, the Centre itself has not been a beacon of virtue when it comes to fiscal responsibility and transparency. To its credit, it has embarked on course correction over the last few years. It should complete that task in order to command the moral authority to enforce good fiscal behaviour on the part of States.

Duvvuri Subbarao was Finance Secretary to the Government of India and Governor, Reserve Bank of India

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