The Union and the States

Currently, the fiscal management of the States in India is receiving unprecedented attention. Concerns relate to the growing freebie culture, a very high debt level, use of borrowing for unproductive purposes, use of off-budget borrowing to fund government schemes, and the failure of institutional checks and balances, such as FRBM, CAG and the market. There are suggestions for improvement “as the cost of fiscal profligacy at the state level is considered high”. Suggestions include conditionalities to be imposed on states borrowing using the draconian provision of financial emergency and improvements in the FRBM framework. However, the cost of fiscal profligacy at the Union Government can be higher.  

Growing Fiscal Activism  

On growing fiscal activism, both freebies and subsidies, a more nuanced approach is warranted. It is said that a dole  is called an incentive when it goes to the rich and a subsidy when it goes to poor. Also, some of the States well known for freebies have demonstrated improvements in both growth and welfare. Some of these ‘freebies’ such as Tamil Nadu’s mid-day meal scheme became a transformative national programme on nutrition. It is therefore inappropriate to generalise on such measures and their fiscal viability. It is also important to note that both the Union government and the State Government  are increasing the freebies and subsidies through the budget, and through public sector undertakings including banks. So an aggregate view on increasing fiscal activism and its impact on deficit, debt and fiscal sustainability is necessary.

Off-Budget Borrowing 

Off-budget borrowings in effect dilutes the integrity of the budget. Both the Union and State Governments are repeatedly guilty of this. The Union Government has to show the way forward. In brief, the fiscal profligacy of the States is a serious national concern. Exclusive attention to this factor may, however,amount to a diversionary tactic from a far more complex and frightening prospect of a persisting collusion between State Governments, the Union Government and the financial sector. 

As regards institutional mechanisms, the legal framework gives more manoeuvrability to the Union Government than to the States. The institutional mechanism of timely disclosure of non-transparent fiscal practice in the both the Union and State Governments is absent. There are suggestions for improvements in the institutional framework since the cost of fiscal profligacy at the State level can be too high. In fact, the cost of fiscal profligacy by the Union Government may be far higher.

It is inconceivable that the States could have indulged in off-budget borrowing without explicit knowledge or implicit approval of the Government of India. In particular, there is considerable evidence to show that a large part of the off-budget borrowing by the States is from leading public sector banks including the State Bank of India,  leading public sector financial institutions like Power Finance Corporation and Rural Electrification Corporation and development finance institutions like NABARD. It is also surprising that these enterprises, particularly banks, were supporting off-budget borrowing. It is also believed that these financial undertakings are profiteering by levying very high interest rates.

Finally, the off-budget borrowings, both by the Union and States, have only diluted the cap on borrowing imposed by the Fiscal Responsibility Legislations. This practice has also introduced a great deal of non-transparency to  fiscal operations.  It has also created a loop of intra-public sector transactions involving the Union Government, State Governments, Public Sector Banks and Financial Institutions. Unless this is delinked, the public sector’s exposure to the financial system will continue to increase and would enhance fiscal risks further.  

Fiscal Prudence: A Symmetric Approach  

There is no disagreement that fiscal prudence is a necessary condition for macroeconomic stability and its importance has increased many-fold due to the global headwinds created in recent years by the pandemic and the Russia-Ukraine war. In India, , the combined debt to GDP (Union+States) has reached a level close to 90 per cent of GDP. Given this increase, certainly there is a need to reduce the general government debt and deficit to ensure macro stability. Debt reduction is also critical to reduce interest costs and create more space for expenditures that are important and desirable. But the details are important.  If we compare the pre- and post-pandemic levels of deficit, the combined deficit to GDP ratio for the year 2019-20 was 8.3 per cent, and for the States, it was 3.6 per cent. In the year 2020-21, the deficit to GDP ratio of the Union government increased to 9.2 per cent. The States’ deficit for the same year was 4.1 per cent of GDP. In the year 2020-21, the revenue deficit of the Union government was as high as 7.3 per cent of GDP. The revenue deficit of the Union government started in 1979-80 and since then has continued and increased in volume. The quantum of revenue deficit in 1979-80 was Rs. 694 crores. As per the 2022-23 (BE), the revenue deficit of the Union government is estimated to be more than Rs. 10 lakh crores amounting to 3.8 per cent of GDP.

In the year 2020-21, States’ revenue deficit was to be 1.9 per cent of GDP.  It is important to note that States are also the major drivers of general government capital expenditure. Even during the peak of the pandemic, the share of states’ capital expenditure in combined capital spending remained around 56 per cent and at around 2 per cent of GDP. On fiscal management, post the Fiscal Responsibility Legislation (FRL) in 2005, aggregate state-level deficits remained well within the targets set by the FRL in most of the years. States combined revenue account also showed some surpluses that helped improve the fiscal space for higher capital spending during this period. However, due to the macroeconomic slowdown and the pandemic, many states have slipped into revenue deficits. In the year 2017-18, states’ revenue deficit was 0.2 per cent of GDP, which increased to 1.9 per cent of GDP in 2020-21 due to the pandemic and is expected to be 0.3 per cent of GDP in 2022-23 (BE). A quick reversal of this trend is important.

To conclude, the fiscal imbalance is asymmetric and it is higher for the Union government. Thus, consolidation can only be achieved if the fiscal challenges are viewed as the joint responsibility of both the Union  and States. After 2020-21, there have been significant fiscal corrections at the Union level evident from the fiscal deficit numbers provided in the latest 2023-24  Union Budget. The deficit of the Union government reduced sharply in the year 2021-22 and is 6.4 per cent of GDP in 2022-23 (RE) and expected to be 5.9 per cent in BE 2023-24. 

However, only a symmetric view in terms of approach and differentiated fiscal correction path at the Union Government and State Governments can  reduce the general government deficit to a sustainable level.