Government Budgets

States, freebies and the costs of fiscal profligacy

Note4Students

From UPSC perspective, the following things are important :

Prelims level : FRBM Act provisions

Mains level : Paper 3- Freebies and finances of the States

Context

Many states are pursuing the freebie culture, which raises several questions.

About freebies

  • Why do governments give freebies? The obvious motivation for States in expanding freebies is to use the exchequer to build vote banks.
  • Electoral calculations tempt them to place short-term gains ahead of long-term sustainability.
  • Case in which it is necessary? A certain amount of spending on transfer payments to provide safety nets to the most vulnerable segments of the population is not only desirable but even necessary.
  • What is the problem? The problem arises when such transfer payments become the main plank of discretionary expenditure, the spending is financed by debt, and the debt is concealed to circumvent the FRBM targets.
  • Opportunity cost: The more States spend on transfer payments, the less they have for spending on physical infrastructure such as, for example, power and roads, and on social infrastructure such as education and health, which can potentially improve growth and generate jobs.

Questioning the logic of freebie culture

  • Sustainability: Is borrowing and spending on freebies sustainable?
  • Best use: Is this the best possible use of public money?
  • Opportunity cost: What is their opportunity cost — what is it that the public are collectively giving up so that the government can fund these payments?
  • Checks and balances: Should not there be some checks on how much can be spent on them?

Where should government spend the borrowed money?

  • Ideally, governments should use borrowed money to invest in physical and social infrastructure that will generate higher growth, and thereby higher revenues in the future so that the debt pays for itself.
  • On the other hand, if governments spend the loan money on populist giveaways that generate no additional revenue, the growing debt burden will eventually implode.

But what is the problem with freebies if states are confirming to the FRBM targets?

  • Any analysis of State Budgets by the Reserve Bank of India shows that State finances are in good health and that all of them are conforming to the Fiscal Responsibility and Budget Management (FRBM) targets.
  • This is a misleading picture.
  • Off budget borrowing: Much of the borrowing that funds these freebies happens off budget, beyond the pale of FRBM tracking.
  • The typical modus operandi for States has been to borrow on the books of their public enterprises, in some cases by pledging future revenues of the State as guarantee.
  • Effectively, the burden of debt is on the State exchequer, albeit well concealed.
  • The Comptroller and Auditor General of India (CAG) had in fact pointed out that in respect of some States.
  • Huget cost: The costs of fiscal profligacy at the State level can be huge.
  • The amount States borrow collectively every year is comparable in size to the Centre’s borrowing which implies that their fiscal stance has as much impact on our macroeconomic stability as does that of the Centre.
  • The need, therefore, for instituting more effective checks that can make wayward States fall in line is compelling.

What are the institutional checks and balances? What are the reasons of their failure?

  • 1] Legislature and opposition: In theory, the first line of defence has to be the legislature, in particular the Opposition, whose responsibility it is to keep the Government in line.
  • But the Opposition does not dare speak up for fear of forfeiting vote banks that are at the end of these freebies.
  • 2] Lag in CAG reports: Another constitutional check is the CAG audit which should enforce transparency and accountability.
  • In practice, it has lost its teeth since audit reports necessarily come with a lag, by when political interest has typically shifted to other hot button issues.
  • 3] The market: The market is another potential check.
  • It can signal the health or otherwise of State finances by pricing the loans floated by different State governments differently, reflecting their debt sustainability.
  • But in practice this too fails since the market perceives all State borrowing as implicitly guaranteed by the Centre, never mind that there is no such guarantee in reality.

Suggestions

  • 1] Amend FRBM Act for complete disclosure: First, the FRBM Acts of the Centre as well as States need to be amended to enforce a more complete disclosure of the liabilities on their exchequers.
  • Even under the current FRBM provisions, governments are mandated to disclose their contingent liabilities, but that disclosure is restricted to liabilities for which they have extended an explicit guarantee.
  • The provision should be expanded to cover all liabilities whose servicing obligation falls on the Budget, or could potentially fall on the Budget, regardless of any guarantee.
  • 2] Centre should impose conditionalities: Under the Constitution, States are required to take the Centre’s permission when they borrow.
  • The Centre should not hesitate to impose conditionalities on wayward States when it accords such permission.
  • 3] Use of financial emergency provision: There is a provision in the Constitution of India which allows the President to declare a financial emergency in any State if s/he is satisfied that financial stability is threatened.
  • This provision has never been invoked so far for fear that this will turn into a political weapon.
  • But the provision is there in the Constitution for a reason.
  • After all, the root cause of fiscal irresponsibility is the lure of electoral nirvana. It will stop only if the political leadership fears punishment.
  • 4] Course correction by the Centre: The Centre itself has not been a beacon of virtue when it comes to fiscal responsibility and transparency.
  • To its credit, it has embarked on course correction over the last few years.
  • It should complete that task in order to command the moral authority to enforce good fiscal behaviour on the part of States.

Conclusion

The state governments, as well as the Central government, need to avoid the freebies that harm financial health and cause long-term harm. For that, there is a need to implement the suggestions mentioned above.

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Back2Basics: FRBM Act

  • The FRBM is an act of the parliament that set targets for the Government of India to establish financial discipline, improve the management of public funds, strengthen fiscal prudence and reduce its fiscal deficits.
  • It was first introduced in the parliament of India in the year 2000 by Vajpayee Government for providing legal backing to the fiscal discipline to be institutionalized in the country.
  • Subsequently, the FRBM Act was passed in the year 2003.
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