Challenges of Sub-National Fiscal Reform

Recent concerns over excessive drooling free of cost It is often interpreted by the states as an intrusion into the federal powers of the states. The states lag behind on this issue on the basis of welfare provision and protection of weaker sections of the population. The central government’s alarm has been over the rising debt burden and deteriorating financial situation in some states. Since both the central government and the states are expected to work together in a cooperative federal structure, friction arising from these exchanges can have an impact on both resource sharing and expenditure prioritization. Therefore, it is important that the Center and the states are on the same page on these issues.

In recent times, three issues have emerged as key discussion points in India’s fiscal federalism, leading to back-and-forth exchanges between the Center and the states. The first is a set of issues related to the Goods and Services Tax (GST) such as rate structure, inclusion and exclusion of goods, revenue sharing from GST and related compensation. Second, the state level expenditure pattern is specifically related to the welfare schemes of the states. Third, the concept and implementation of central plans.

A forum for discussion on issues related to GST as they are usually the agenda of the meetings of the GST Council. However, the other two cases are generally flagged by the Finance Ministry based on 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 an exchange of shifting the blame, especially when different political parties are in power at the Center and in the state concerned.

discretionary spending

A major issue of recent debate between the states and the Center is the quantity and quality of public expenditure by the states. In this context, it is important to distinguish between the two types of public expenditure. Mandatory expenditure is expenditure that is governed by prescribed formulas or norms rather than by appropriation from time to time and as such, unless expressly changed, the previous year’s expenditure bill for these items of expenditure in the current year. applies to. Conversely, discretionary spending is expenditure that is moderated by annual or other periodic appropriations. While states demand more fiscal space to increase discretionary spending, the Center is pushing for greater fiscal discipline by reducing the scope of discretionary spending and limiting states to focus on mandated spending.

Generally, increased discretionary public spending is intended to stimulate the economy during periods of greater sluggishness, as the government spending multiplier will be higher and operate primarily through the consumption channel. Discretionary spending is, at the same time, more volatile than mandatory spending. Cross-country empirical evidence also shows that discretionary spending is not correlated contemporaneously with output growth and the correlation is less for the next immediate time period. Furthermore, once started, some discretionary spending, which is used to boost demand in the economy, continues for a long period of time causing fiscal stress. This is due to the fact that it is difficult to reduce government spending, especially on expenditure heads that spur private consumption, as it requires some balancing measures to deal with public resistance.

The current debate about freebies needs to be viewed in this larger context of sub-national financial consolidation. In a federal system, the fiscal stress of the states spills over to the centre, leading to overall fiscal slippage. As the economy recovers from the crisis, the path of fiscal reforms needs to be followed by both the Center and the states, as the crisis calls for more discretionary spending than in normal times. Such additional expenses need not and cannot be sustained over a long period of time. However, in the Indian context, many states indulge in high levels of expenditure to maintain their ‘model of welfare provision’. While these models claim to have their own merits, the effects of such expenditure on the growth of the economy and the well-being of the beneficiaries are unclear as credible evidence is lacking.

fiscal consolidation

The continued increase in welfare expenditure by the states leads to fiscal expansion, which requires mobilization of additional resources. When efforts to mobilize additional resources meet with limited success, as is the case with many states in India, states resort to borrowing. Fiscal expansion financed through debt and the resultant debt accumulation has a significant impact on the economy both in the short run and in the long run. Although the debt itself cannot be bad, the use of money raised through borrowing is significant, that is, if it is used for capital formation, it can contribute to the real income of future generations and help the government. Repayment capacity can also add up. , Conversely, if borrowing is used only to finance current expenditures, it poses the risk of debt rising to volatile levels.

Data published by the RBI shows that the outstanding loans of states have registered an increase in recent years. This can be partly attributed to the implementation of Ujjwal Discom Assurance Yojana (UDAY), farm loan waiver, continued growth in populist welfare measures and growth slowdown especially in 2019-20. A combination of increased expenditure and non-conforming revenue raising efforts has resulted in an increase in the debt-GSDP ratio (Gross State Domestic Product) between 2013 and 2022. The debt-GSDP ratio of the states increased from 22.6 in 2013 to 25.1 in 2018, and further to 31.2 in 2022 (Budget Estimates).

Given the current macroeconomic environment, the debt-GSDP ratio is expected to rise further. This rising trend in the debt-GSDP ratio has to be seen in the context of the revenue mobilization efforts of the states. Overall, the revenue receipts declined due to the decline in the states’ own tax revenues. With declining revenue receipts, many states had to opt for expenditure compression to comply with the fiscal responsibility law target.

This scenario underscores the importance of fiscal reforms at the state level. While there is a need to mobilize additional resources at sub-national levels, expenditure priority has to be met diligently. The discussion on freebies needs to be understood in the context of reducing development expenditure and capital expenditure on some important social and economic services. The Centre, on its part, also needs to demonstrate commitment to fiscal discipline by sticking to the announced fiscal glide path to ensure the stability of a frictionless cooperative federal structure.

M. Suresh Babu is an advisor to the Prime Minister’s Economic Advisory Council and Professor of Economics at IIT Madras. Views expressed are personal.