Cost of state, free gifts and fiscal negligence

During last year’s planning and campaigning ahead of the Punjab Assembly elections, the Aam Aadmi Party (AAP) had promised an amount of ₹1,000 per month to each woman in the state. To take home the generosity of the promise, AAP leader and Delhi Chief Minister Arvind Kejriwal insisted that under AAP’s ‘Mission Punjab’ for Punjab elections 2022, if three adult women (daughter-in-law, daughter-in-law, mother-in-law) in a household ), each of them will get ₹1,000. Asked how Punjab, already heavily in debt, could afford it, Mr Kejriwal said something like that if there is good political management, there will be no money problem.

Growing Freebie Culture

Such election promises raise many questions. Is it sustainable to borrow and spend for free? Is this the best possible use of public money? What is their opportunity cost – what is it that the public is collectively giving up so that the government can fund these payments? Shouldn’t there be some check on how much can be spent on them?

I am using Punjab to illustrate a point and in no way suggest that it is unique. In fact, many states are following 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 high growth and high revenues in the future so that debt can pay for itself. On the other hand, if governments spend debt money on populist gifts that generate no additional revenue, the growing debt burden will eventually explode and end in tears.

Concerned by the increasing number of states following this economically ruined path, senior bureaucrats reportedly flagged the issue in a meeting with the prime minister, saying that ‘some states may go down the Sri Lankan path’.

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 conclusion you will draw is that state finances are in good, if really strong, health, and all these are honest. Fiscal Responsibility and Budget Management (FRBM) targets.

This is a misleading picture. Beyond the scope of FRBM tracking, most of the lending that funds these freebies is out of budget. Typical modalities for states have been to borrow on the books of their public enterprises, in some cases by pledging the state’s future revenue as a guarantee. Effectively, the burden of debt is on the state exchequer, even if it is concealed. The Comptroller and Auditor General (CAG) of India had in fact pointed out that in respect of some states ‘if the extra-budgetary borrowing is taken into account, the liabilities of the government are much more than the amount admitted in the official books’.

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

The obvious motivation for expanding free facilities to states is to use the coffers to create vote banks. A certain amount of expenditure on transfer payments is not only desirable but also necessary to provide a safety net to the most vulnerable sections of the population. Problems arise when such transfer payments become a core issue of discretionary spending, spending is financed by debt, and debt is hidden to circumvent FRBM targets.

The more states spend on transfer payments, the less they have to spend on physical infrastructure such as, for example, electricity and roads, and social infrastructure such as education and health, which could potentially lead to development. improve and generate employment. The truth of the Chinese proverb, ‘Give a man a fish and you feed him for a day; Teach a man to fish and you feed him for life’ is self-evident to everyone including politicians. But electoral calculations tend to put short-term gains ahead of long-term stability.

Institutional Checking Balance

What is it about institutional checks and balances that should stop this downward spiral? Unfortunately, all of them have turned out to be ineffective. In theory, the first line of defense should be the legislature, especially the opposition, whose responsibility is to keep the government in line. But given the dangers of our vigorous democracy, the opposition does not dare to speak out for fear of forfeiting the vote bank that these freebies end up with.

Another constitutional check is the CAG audit which should introduce transparency and accountability. In practice, it has lost its teeth as audit reports inevitably come with a lag, when political interests typically shift to other hot button issues. Furthermore, our bureaucracy has mastered the fine art of converting audit paras into ‘files’ that run its course and die a quiet death.

The market is another potential check. It may indicate the health or otherwise of the state’s finances by separately pricing the loans issued by different state governments, reflecting their debt stability. But in practice this also fails as the market assumes all state borrowings to be centrally guaranteed, no matter the fact that in reality there is no such guarantee.

the cost can be huge

The cost of fiscal negligence at the state level can be huge. The amount that states collectively borrow every year is equal to the size of the Centre’s borrowing, which means their fiscal stance has the same impact on our macroeconomic stability as the Centre’s. Therefore, there is a need to establish more effective checks that can bring wayward states in line.

Here are two suggestions in that direction.

First, there is a need to amend the FRBM Acts of the Center as well as the States to enable more complete disclosure of liabilities on their exchequer. Even under the existing FRBM provisions, governments are required to disclose their contingent liabilities, but this disclosure is limited to those liabilities for which they have given an explicit guarantee. The provision should be expanded to cover all liabilities whose servicing obligations fall over budget, or could potentially fall over budget, regardless of any guarantees.

Second, under the Constitution, states are required to seek the permission of the Center while borrowing. The Center should not hesitate to impose conditions on independent states while granting such permission. States slapped with conditions will surely bow down and accuse them of political motives. The challenge for the Center will be to function transparently and in accordance with well-defined, objective and competitive norms.

Lastly, the Constitution of India has a stringent provision that allows the President to declare a financial emergency in any state if he is satisfied that financial stability is threatened. This Brahmastra has not been invoked so far for fear that it will become a political weapon of mass destruction. But the provision in the constitution is there for a reason. After all, the root cause of fiscal irresponsibility is the greed for electoral nirvana. This will stop only when the political leadership fears punishment. It is therefore important to ensure that the prospect of a financial emergency in terms of gross and persistent fiscal irresponsibility is not only an intangible threat but a realistic one.

Disappointingly, the Center itself has not been the epitome of virtue when it comes to financial accountability and transparency. To its credit, it has improved the curriculum over the years. To command the moral authority to enforce good financial behavior on the part of the states must fulfill that function.

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