States, freebies and the costs of fiscal profligacy

News: In recent years, many states are pursuing the freebie culture. Such freebies are announced ahead of the assembly election. For example, the one of the contesting political parties in Punjab election, promised a sum of Rs. 1,000 per month to every woman in the State.

Read How are freebies different to free essential services and production-related incentives?

The state-governments are expanding freebies mostly to build vote banks through transfer payments to provide safety nets to the most vulnerable segments of the population.

What are the implications of freebies?

The state governments are facing heavy debt. It is difficult to afford such freebies.

The costs of fiscal profligacy can be huge. It can have an adverse impact on India’s macroeconomic stability.

The more States spend on transfer payments, the less they have for spending on physical infrastructure and social infrastructure, which are vital to improve growth and generate jobs. If governments spend the loan money on freebies, then it generates no additional revenue. It will lead to the growth of debt burden which will eventually implode in future.

There are discussions indicating that ‘some States might go down the Sri Lankan way’ due to freebies.

What are the causes of such problems?

The institutional checks and balances that could prevent this downward spiral have become ineffective. These are:

(1) Legislature/Parliament has failed. For example, the Opposition in legislature does not dare speak up against the populist schemes for fear of forfeiting vote banks that are at the end of these freebies.

The state governments are mandated to conform to the Fiscal Responsibility and Budget Management (FRBM) targets. But the law has failed. The current FRBM provisions mandates that the governments disclose their contingent liabilities, but that disclosure is restricted to liabilities for which they have extended an explicit guarantee.

In reality, the state governments resort to extra-budgetary borrowings to finance these populist measures. This debt is concealed to circumvent the FRBM targets. Further, there is no comprehensive information in the public domain to assess the size of this off-budget debt.

(2) The CAG Audit is another constitutional check to enforce transparency and accountability. However, it has lost its teeth because the audit reports come with a lag.

(3) The market, which could signal the health of State finances, has also failed. It could price the loans floated by different State governments differently which could reflect their debt sustainability.

What should be done?

There is a need for instituting more effective checks that can push States to fall in line with prudent fiscal policy making. Various suggestions towards that end are:

First, the FRBM Acts need to be amended. Its provisions should be expanded to cover all liabilities of the government whether budget borrowing or off-budget borrowing, regardless of any guarantee.

Second, at present, the States are required to take the Centre’s permission when they borrow, under the Constitution. Therefore, the Centre should not hesitate to impose conditionalities while giving permission. While doing so, the Centre must act transparently and in accordance with well-defined, objective, and contestable criteria.

Third, the President can invoke the provision of the financial emergency enshrined in the Constitution. If s/he is satisfied that financial stability is threatened.

Fourth, the politicians should aim for long-term and sustainable gains instead of short-term gains. There is a Chinese saying, ‘give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime’.

Source: The post is based on an article “States, freebies and the costs of fiscal profligacy” published in the “The Hindu” on 28th June 2022.

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