Incentivising fiscal prudence for states

Source: The post is based on an article “Incentivising fiscal prudence for states” published in Business Standard on 31^st July 2023.

Syllabus: GS 3 – Indian Economy – Public Finance

Relevance: measures needed to reduce debt of states.

News: The article explains the increasing debt of state governments and measures needed to reduce it.

What is the present situation of debt?

States, at 28 percent of GDP, account for nearly a third of the total debt of Indian governments. The central government accounts for the rest.

There is also variation among states holding debts. For example, debts of Gujarat and Maharashtra remain below 25 per cent of their respective GDP.

Whereas, debts of Punjab, Rajasthan, and Kerala as a proportion of their state GDP have exceeded 40 per cent at the end of 2020-21.

What is the predicted situation for states’ debt?

The debt-to-GDP ratio of the states is projected to increase on average. The states with the highest levels of debt now are also those where debt is expected to rise the greatest.

For example, Punjab’s debt is expected to rise sharply from its present level of about 48% of state GDP to almost 55% in 2027-28.

What are the differences between states with high levels of debt and states with low burdens of public debt?

The primary budget deficits and contingent liabilities of more indebted states are more than twice as high as those of less indebted states. Higher indebted states also show slower GDP growth.

However, one thing that doesn’t vary across high- and low-debt states is borrowing costs.  Gujarat and Punjab, despite differences in the level of debts, issue debt at the same interest rate.

What are the concerns with the same borrowing cost for all the states?

Due to the absence of interest rate variation, there is absence of market discipline because states with higher debts are not prohibited from borrowing by paying higher interest rates.

Even though the RBI implements measures to keep interest rates stable, it grants some flexibility to states with higher debt to avoid the perception of debt distress spreading to other states. This, in turn, leads to a loosening of market discipline.

Further, the horizontal devolution of taxes among states, awarded by the Finance Commission, mandates to allocate more resources to states with larger revenue deficits.  This again gives an advantage to states that have higher debts.

What can be done to strengthen state finances?

First, states could increase revenue mobilization through expanding digitization, widening the tax base, raising property taxes, implementing new taxes, and increasing privatization receipts.

Second, states should redirect their spending towards capacity- and infrastructure-building investments, which promise to improve state GDP and income.

Third, states should pursue fiscal-management reforms to reduce the dangers that contingent liabilities pose to their public finances.

Fourth, the RBI should oblige states that vary with their present and future debt levels to pay market interest rates.

Fifth, there is a need to strengthen the finance commission. The commission gets dissolved after they submit the report and there is no parallel institution or body to monitor states’ finances. Hence, there is a need to establish a permanent fiscal or expenditure council to monitor state finances.

Sixth, fiscal experts and the media need to scrutinize the budgetary processes of the states.