Challenges of sub-national fiscal correction

The Centre and States need to prioritise expenditure and adhere to fiscal discipline

August 30, 2022 12:25 am | Updated 01:57 pm IST

Recent concerns over excessive doling out of freebies by States are often interpreted as intrusion into the federal powers of the States. States push back on this issue on the grounds of welfare provisioning and protection of the vulnerable sections of the population. The Central government’s alarm has been on the mounting debt burden and the deteriorating fiscal situation in some States. As both the Union government and States are expected to work closely in a co-operative federal structure, frictions arising out of these exchanges might have repercussions on both resource sharing and expenditure prioritisation. Hence, it is important that the Centre and States are on the same page on these issues.

In recent times, three issues have emerged as major discussion points in India’s fiscal federalism, leading to back-and-forth exchanges between the Centre and States. First are a set of issues related to Goods and Services Tax (GST) such as the rate structure, inclusion and exclusion of commodities, revenue sharing from GST and associated compensation. Second, State-level expenditure patterns especially related to the welfare schemes of States. Third, the conception and the implementation of central schemes.

Issues related to GST have a forum for discussions as they are usually the agenda for GST council meetings. However, other two matters are generally flagged by the Finance Ministry based upon reports and studies done by the Reserve Bank of India (RBI) and the Comptroller and Auditor General of India. As States engage in clarifications on these reports and studies, it often ends up as exchanges of shifting the blame, especially when the Centre and the concerned State have different political parties in power.

Discretionary expenditure

A key issue of recent debates between the States and the Centre is the quantity and quality of public expenditure by the States. In this context, it is important to distinguish between two kinds of public expenditure. Mandatory spending is expenditure that is governed by formulas or criteria set forth, rather than by periodic appropriations and as such, unless explicitly changed, the previous year’s spending bill applies to the current year for these items of expenditure. By contrast, discretionary spending is expenditure that is governed by annual or other periodic appropriations. While States demand more fiscal space for increasing discretionary spending, the Centre is pushing for more fiscal discipline by reducing the scope for discretionary spending and limiting States to focus on mandatory expenditures.

Generally, the aim of enhanced discretionary public expenditure is to stimulate the economy during periods of excess slack, as government spending multipliers would be high and work primarily through consumption channel. Discretionary expenditure is, at the same time, more volatile than mandatory expenditure. Cross country empirical evidence also shows that discretionary expenditure is not contemporaneously correlated with output growth and the correlation is low for the next immediate time period. Further, once started, some of the discretionary expenditure, used to increase demand in the economy, continues for longer periods leading to fiscal stress. This is because of the fact that it is hard to decrease government spending, especially on expenditure heads that raise private consumption, as it requires some counter balancing measures to deal with the resistance from the public.

The current debate around freebies needs to be viewed in this larger context of sub-national fiscal consolidation. In a federal system, States’ fiscal stress gets spilled over to the Centre, leading to a situation of overall magnified fiscal slippages. As the economy is recovering from crisis, there exists a need to adhere to the path of fiscal correction both by the Centre and by the States, as a crisis demands more discretionary spending than normal times. Such additional expenditures need not be and cannot be sustained over longer periods. However, in the Indian context, many States indulge in higher levels of expenditures towards maintaining what they call as their ‘models of welfare provisioning’. While these models claim to have their own merits, the effects of such expenditures on growth of the economy and well-being of the beneficiaries are ambiguous as there is a lacuna of credible evidence.

Fiscal consolidation

Sustained increase in welfare expenditure by the States leads to fiscal expansion, which necessitates additional resource mobilisation. When efforts towards additional resource mobilisation yield limited success, as in the case of many States in India, the States resort to borrowings. Fiscal expansion financed through debt and the resultant debt accumulation have important impacts on the economy both in the short run as well as in the long run. While debt per se might not be bad, the utilisation of funds raised through borrowings is important, that is, if it is used for capital formation, it could contribute to the real income of future generations and add to repayment capacity of the government as well. On the contrary, if use of borrowings is to finance only the current expenditure, it poses the risk of debt rising to unsustainable levels.

Data published by the RBI show that in recent years, States’ outstanding debt has registered an upward movement. This could be partly attributed to the implementation of the Ujwal DISCOM Assurance Yojana (UDAY), farm loan waivers, sustained increase in populist welfare measures and growth slowdown especially in 2019-20. A combination of increased expenditure and non-commensurate revenue mobilisation efforts has resulted in increased debt-GSDP ratio (gross state domestic product) between 2013 and 2022. The debt-GSDP ratio of States increased from 22.6 in 2013 to 25.1 in 2018, and further to 31.2 in 2022 (budget estimates).

Given the prevailing macroeconomic environment, the debt-GSDP ratio is expected to increase further. This rising trend in debt-GSDP ratio needs to be seen in the context of revenue mobilisation efforts of the States. Overall, there is a decline in revenue receipts due to a fall in the States’ own tax revenue. With dwindling revenue receipts, many States had to opt for expenditure compression to adhere to the fiscal responsibility legislation target.

This scenario underscores the importance of fiscal correction at the State level. While there exists a need for raising additional resources at the sub-national levels, expenditure prioritisation has to be carried out diligently. Discussions on freebies need to be understood in this context of squeezing of development expenditure and capital expenditure on some important social and economic services. The Centre, too, on its part needs to demonstrate commitment to fiscal discipline by sticking to announced fiscal glide path to ensure the sustainability of a frictionless co-operative federal structure.

M. Suresh Babu is Adviser to the Prime Minister’s Economic Advisory Council and a Professor of Economics at IIT Madras. The views expressed are personal.

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