Challenges of sub-national fiscal correction

The RBI in its recently published paper has reported an upward trend in States’ outstanding debt.  An increase in the Debt-GSDP ratio between 2013 and 2022 has been reported in the paper.

What does the recent RBI report have to say about the situation?

• Increase in the States’ outstanding debt: The possible reasons given for this are 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.
• Increased debt-GSDP ratio: A combination of increased expenditure and out-of-proportion revenue mobilization efforts has resulted in the 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).

The debt-to-GDSP ratio is the ratio between a state’s debt and its gross domestic product. It is a reliable indicator of how capable a state is of paying its debts.

• Decline in revenue receipt: There is also a decline in revenue receipts due to a fall in the State's own tax revenue.

‘Poorly-directed freebies’ may adversely affect the country’s economy:

• Most of the time freebies are poorly directed and are a fiscal mistake with significant adverse consequences resulting from “political compulsions”.
• Freebies given by state governments can wreak havoc with state finances. We have seen in Sri Lanka’s case, that fiscal profligacy always leads to disaster.
• It could only accentuate the already worsening public debt situation in many states and create perverse incentives as well as intergenerational friction.

Two kinds of Public Expenditure:

1. Mandatory Spendings: Expenditure governed by formulas or criteria set forth, rather than by periodic appropriations and as such, unless explicitly changed.
2. Discretionary Spending: Expenditure governed by annual or other periodic appropriations.

• • Such expenditure is used to stimulate the economy during periods of low demand and declining jobs because of the higher multiplier effect of government spending.

Issues related to Discretionary spending by the state:

• No assured output: The evidence from the other countries shows that there is no direct correlation between the growth output and discretionary spending.
• Fiscal Stress: Once started, it is hard to decrease government spending later on, as it requires dealing with the resistance from the public.
• Spillover effect: In a federal system, States’ fiscal stress gets spilled over to the Centre, leading to a situation of overall magnified fiscal slippages.
• Unsustainable resource mobilization: To finance discretionary spending, state governments might resort to borrowing which may ultimately require additional resource mobilization which is not sustainable.

How should governments strike a balance between fiscal deficit and welfare spending?

• All government spending contributes to the fiscal deficit, so we need to scrutinize all spending. We need to understand “welfare as a redistributive mechanism”, intended to assist with the leftovers.
  • The fiscal deficit, arising out of it can be tackled by raising more revenue through taxation, not restricted to income tax.
  • There is also a widening gap between rich and poor states. Transferring resources from rich to poor states might be a solution but it should not bring another dimension of complexity.

States spending the most on subsidies: According to the Reserve Bank of India (RBI), Jharkhand, Kerala, Odisha, Telangana, and Uttar Pradesh are the top five states with the largest rise in subsidies over the last three years.

Fiscal Consolidation: Path of course of correction

• The funds raised through borrowings must be used for capital formation. This would contribute to the real income of future generations and add to the repayment capacity of the government as well.
• The centre needs to demonstrate its commitment to fiscal discipline by following to announced fiscal path to ensure the sustainability of a frictionless cooperative federal structure.
• It is necessary to have strict enforcement of provisions laid under Article 293(3) and (4) including a 'system of credit rating' being introduced for grant of credit facilities to the state government.