Incentivising fiscal prudence for states

31 Jul 2023
Incentivising fiscal prudence for states

Opinion: Barry Eichengreen and Poonam Gupta.

Debt is projected to increase by the largest amount in the same states that are currently the most heavily indebted.

At 28 per cent of gross domestic product (GDP), states account for nearly a third of the total debt of Indian governments. (The central government accounts for the rest.) In coming years, the share of the states will almost certainly increase still further. The question is, by how much and — if the answer is “too much”, what can be done about it.

In fact, one can imagine different scenarios for the future evolution of the public debt of the central and state governments. As our baseline scenario, we assume that for the next five years, the GDP growth, real interest rate, and the primary budget deficit of each state will remain the same as their respective averages during the last decade. Other scenarios assume faster GDP growth, a lower primary deficit, and larger contingent liabilities.

The Centre’s debt is projected to stabilise in the baseline as well as other scenarios alike. In contrast, the debt-to GDP ratio of the states is projected to increase on average. By implication, the projected increase in the general government debt in the coming years will be primarily attributable to the increase in debts of states.

There is considerable heterogeneity across states, with some of them contributing disproportionately to the level and rise in debt. States such as Gujarat and Maharashtra have managed their public finances well. Their debts have increased the least since 2014-15, remaining below 25 per cent of their respective state GDP. At the other end of the spectrum are Punjab, Rajasthan, and Kerala, whose debts as a proportion of their state GDP have increased on average by 12 percentage points since 2014-15 and exceeded 40 per cent at the end of 2020-21.

Debt is projected to increase by the largest amount in the same states that are currently the most heavily indebted. Punjab and Gujarat, for example, exhibit starkly diverging debt trajectories. Debt is likely to increase strongly in Punjab from its current level of nearly 48 per cent of state GDP to almost 55 per cent in 2027-28. In Gujarat, on the other hand, it is projected to decline from 20 per cent of state GDP to 18 per cent in 2027-28.

There are other notable differences across states with high versus low burdens of public debt. More indebted states have primary budget deficits and contingent liabilities more than twice those of less indebted states. They exhibit slower GDP growth.

One thing that doesn’t vary across high- and low-debt states, however, is borrowing costs. There is a notable absence of interest rate differentials across the two categories of states. Interest rates do not vary with the level of indebtedness, the primary deficit, or the rate of economic growth. Gujarat and Punjab, our two extreme examples, issue debt at the same interest rate.

This absence of interest rate variation translates into an absence of market discipline. Profligate states are not deterred from borrowing by the need to pay higher interest rates when placing additional debt with investors.

The absence of market discipline reflects an implicit guarantee from the central government, and the fact that the largest investors in government bonds (public-sector banks, insurance companies and provident funds) are themselves owned by the central government, and as such are passive investors. In addition, these institutional investors are required to hold government bonds to meet statutory regulatory requirements.

The Reserve Bank of India (RBI) carefully schedules the calendar of borrowing and coaxing government-owned investors to hold the bonds of the states, ensuring that interest rates on state debt remain in a tight range. Evidently, the RBI does not want perceptions of debt distress or unsustainability of the debts of some states to infect the others. De facto, this results in states in better fiscal health subsidising those whose health is worse. It thus ends up relaxing market discipline on the errant states.

The horizontal devolution of taxes among states, awarded by the Finance Commission every five years, also does not provide incentives for fiscal rectitude. To the contrary, Fiscal Commissions mandated to allocate more resources to states with larger revenue deficits, which is an obvious source of moral hazard, and yet another mechanism through which errant states are subsidised.

The 15th Finance Commission was asked to recommend performance incentives for states in areas like the power sector and solid waste management. However, Finance Commissions have not been asked to consider overall fiscal prudence when recommending allocations. Neither the Finance Commission nor another agency of the government has the data, mechanisms, and a clear mandate needed to estimate the contingent liabilities of states.

So what can be done to strengthen state finances?

First, states should improve revenue mobilisation through additional digitisation and administrative streamlining, broadening the tax base, raising property tax, adopting new taxes, and increasing privatisation receipts.

Second, states should re-orient spending towards capacity- and infrastructure-enhancing investment that promises to further boost state GDP and revenue.

Third, contingent liabilities pose risks to the public finances of states and should be minimised by the adoption of fiscal-management reforms.

Fourth, the RBI, as debt manager, should require states to pay market interest rates that vary with current and projected debt levels.

Fifth, Fiscal Commissions should be strengthened so as to provide incentives for prudence. Fiscal Commissions are dissolved after they submit their report to the President. There is no parallel institution or body to monitor states’ finances subsequently; to assess whether states have departed from the course laid down by the Fiscal Commission. It would be desirable to establish a permanent fiscal or expenditure council to monitor state finances, assess the quality of data and forecasts, measure and track their contingent liabilities, and inform the public of the fiscal stance and debt sustainability of the different states.

Finally, fiscal experts and the media, which subject central government Budgets to a disproportionately high level of scrutiny, need to devote at least a fraction of this scrutiny to the budgetary processes of the states.

Together, these steps would strengthen the finances of state governments and put their debts on a sustainable footing. In turn, this would do much to enhance the fiscal stability of the Indian public sector overall.

Eichengreen and Gupta are, respectively, with University of California, Berkeley, and National Council of Applied Economic Research

Published in: Business Standard, 31 Jul 2023