State Spending is Ballooning. What Does it Mean for India’s Fiscal Position?

The issue of India’s fiscal deficit assumes contextual significance in light of the reversion to the old pension scheme (OPS) by some states and the likelihood of others adopting this move, together with extensive recourse to freebies. Such measures exacerbate the pressure on state finances and constrain their capacity to undertake growth-enhancing capital expenditure. 

India’s revenue and fiscal deficits raise the interest burden, crowd out expenditure in productive sectors, increase borrowing cost and financially crowd out private investments. This causes an inflationary spiral, weakens the balance of payments and makes financial sector reform more protracted. It also damages the ability of future generations to meet their needs and leads to downgrading by rating agencies, raising the cost of foreign borrowing by the private sector. 

In other words, larger government debt deficits, high debt levels and higher interest rates result in a vicious circle of rising interest expenditure that adversely impact more productive programmes like infrastructure investment or social expenditure. Deteriorating debt dynamics also raise borrowing costs for the private sector, hit business activity, financial markets and broader macroeconomic prospects.  

India has had a fiscal deficit for over 40 years, with the last year of fiscal surplus being FY69, when the fiscal surplus was $3.2bn, constituting 0.3% of gross domestic product (GDP). The Fiscal Responsibility and Budget Management (FRBM) Act mandates limiting fiscal deficit to 3% of GDP by March 31, 2021 and central government debt to 40% of GDP by 2024-25. However, the Act permits deviations because of calamity and national security.  

Public finance metrics have been a persisting weakness in India’s credit profile: its fiscal deficit, interest-to-revenue and debt ratios are still relatively high. Over the last ten years, the government has been straddling the requirements of economic growth and the need to promote the welfare of disadvantaged sections. The government has largely been fiscally prudent barring the once-in-a-century Covid-19 pandemic that necessitated countercyclical fiscal measures and a more active fiscal policy for macroeconomic stabilisation.  

Surging Expenditure of States 

The ability of the states to incur expenditure is a function of tax devolution by the government. It includes a prescribed share of the “net proceeds” (gross tax revenue of the Union less surcharges, cess and costs of collection), grants to states in need of assistance under Article 275 and the amount under Article 282 of the Constitution on subjects in the state and concurrent lists through centrally sponsored schemes and central sector schemes. Given the pressure on state finances and the competing claims by multiple state governments, the Union government incentivises states to promote internal resource generation. 

Structural Revenue and Expenditure Mismatch 

Higher welfare within the fiscal framework requires realigned revenue and expenditure management because of the compelling debt deficit and financing dynamics. This can be done through the level and types of taxes, the extent and composition of spending and the degree and form of borrowing. There cannot be an across-the-board increase in welfare programmes because of pressure on the fiscal and the need for scarce investible resources for schemes and programmes.  

A protracted debt overhang will have profound consequences, for example, the agriculture and rural debt relief scheme (ARDRS), 1990 and the Rs 60,000 crore farm loan waiver schemes of 2008 are unsustainable, apart from the moral hazard of incentivising loan defaulters, vitiating the recovery ecosystem and choking the flow of credit. Such consequences constrain the fiscal space and restrict government spending on more productive activities and programmes, exacerbating fiscal slippage and denting growth.  

Coexistent growth and welfare require focused and carefully targeted programmes with clear identification of beneficiaries and well-defined programme objectives to slash leakages in the overarching context of the pressure on fiscal sustainability.  

All welfare schemes are not bad and some well-conceived ones, such as the midday meals in Tamil Nadu and some other states and bicycles for girl students in Bihar had a salutary impact on broad-based economic development. Hence there is a compelling need to separate the wheat from the chaff without resorting to a broad generalisation or a one-size-fits-all approach. 

Ensuring effective and fiscally responsible welfare schemes is a delicate task and requires a sharper focus on public expenditure efficiency by central and state governments, slashing time and cost overruns, targeted welfare programmes and the government’s ability to service its debts. 

State Finances 

Data available in the Reserve Bank of India’s (RBI) RBI Study on State Finances 2023-24 points to some key takeaways: 

States’ consolidated gross fiscal deficit (GFD) to gross state domestic product (GSDP) ratio declined from 4.1% in 2020-21 to 2.8% in 2021-22 because of moderating revenue expenditure and increasing revenue collection. Some states have budgeted for fiscal deficits exceeding 4% of GSDP in 2023-24 vis-a-vis the all-India average of 3.1%. They also have debt levels exceeding 35% of GSDP as against the all-India average of 27.6%. 

The strong growth in state goods and services tax (SGST) has been instrumental in reducing the vertical fiscal imbalance between the Centre and the states in recent years. The support received from the Centre in the form of 50-year interest-free capex loans has helped in reducing states’ interest burden. 

The Dominant Paradigm   

Going ahead, maintaining the fiscal glide path by generating adequate fiscal resources without curbing welfare programmes will be a policy dilemma because of the vulnerability of the economy, transforming the structure of the deficit and debt and its sustainability. Fiscal deficit is financed by borrowing from banks, financial institutions and public and overseas investors. 

All revenue streams, that is, direct and indirect taxes, disinvestment, dividends from public sector undertakings (PSUs) and the RBI and public borrowings must be explored and examined for revenue generation. Budget management reforms and a fiscal council to monitor the implementation of rule-based fiscal policy could be helpful in managing trade-offs and policy dilemmas.  

A judicious policy mix must factor in taxes, borrowings, disinvestments, dividends and appropriate pricing by public undertakings. Revenue expenditure must be eliminated with targeted improvement in tax buoyancy and refocused public expenditure management on actual outcomes and a paradigm shift from outlay to outcome.  

C Rangarajan and D K Srivastava highlight issues of sustainability of fiscal deficits of the central and state governments, as well as the solvency of these governments, given their debt and deficit levels and high structural fiscal deficits that constrain the use of fiscal policy as a tool of stabilisation for output and prices. There are also aspects of asymmetry between accumulation of fiscal liabilities by the central and state governments. These include the potential for additional seigniorage for financing fiscal deficits, formulating rules and targets to stabilise debt and deficits and the derivation of these targets. Other concerns are the quality of fiscal deficit, “crowding out” of private investment by fiscal deficits, “crowding out” of government capital expenditure by growing interest payments and “crowding in” of private investment by public investment.  

These interdependent issues in the context of a fiscal deficit overhang require a multi-layered examination. It must address the peculiar debt and deficit profile and fiscal risk across states for sustainable fiscal recovery and containing the fiscal deficit within manageable proportions. In the ultimate analysis, fiscal policy and monetary policy must move in tandem. Growth and fiscal deficit are not contradictory but complementary.  

The writer is chief economist, Infomerics Ratings. Views expressed are personal.