Problem with state government finances

Source: The post problem with state government finances has been created, based on the article “Should states that spend irresponsibly be penalised?” published in “Indian Express” on 5th October is 2024

UPSC Syllabus Topic: GS Paper 2- Governance – issues related to federal structure

Context: The article discusses India’s state finances, highlighting how an implicit guarantee from the central government allows states to borrow without facing credit risks. It suggests that this arrangement encourages fiscal irresponsibility and questions whether stricter market pricing or new fiscal rules could improve the situation.

For detailed information on Fiscal Consolidation of state governments in India read this article here

How is state debt in India perceived?

1. Implicit Union Guarantee: State government borrowings in India are perceived to be backed by an implicit guarantee from the Union government, making default highly unlikely.
2. Auto-Debit Mechanism: This guarantee is executed through an auto-debit mechanism on state accounts (CAS Nagpur), ensuring timely payments.
3. Uniform Bond Yields: Despite differing fiscal conditions, state bond yields show little variation. For instance, Gujarat has a lower debt-to-GSDP ratio and a revenue surplus, while Punjab and Himachal Pradesh face fiscal strain, yet all states borrow at similar rates.
4. No Market Discipline: Stressed states don’t face higher interest rates, which would otherwise enforce fiscal discipline.

What is the problem with state government finances?

1. TIPS (Tariffs, Interest, Pensions, Subsidies): Tariffs for electricity and water are minimal in many states, not reflecting actual costs. This adds strain on state revenues.
2. Interest Payments: Interest on state debt consumes a significant share of state revenues. For many states, interest payments, pensions, and power subsidies account for over 70% of their own tax revenue.
3. Pension Obligations: Pension liabilities are rising as some states return to older schemes, adding fiscal pressure.
4. Subsidies: States frequently announce new subsidies. For example, Himachal Pradesh is reviewing its subsidies, while Punjab has sought a bailout.
5. Borrowing for Consumption: Many states borrow to fund consumption instead of capital expenditure, leading to poor financial management.

What should be done?

1. Introduce market-driven pricing for state debt: States like Himachal Pradesh, facing fiscal stress, should be subject to higher interest rates based on their financial position. This would incentivize fiscal discipline.
2. Reevaluate the Union government’s implicit guarantee: The current system, where all states, regardless of fiscal health, borrow at similar rates, encourages irresponsible borrowing.
3. Control expenditure: Many states, like Punjab and Himachal Pradesh, are borrowing not for capital investment but to cover consumption. States must reduce subsidies and control pension and interest costs, which consume over 70% of tax revenues.
4. Learn from past bailouts: Bailouts, like the Uday scheme for power discoms, did not resolve underlying issues. Repeated bailouts without structural reforms will not lead to sustainable solutions.
5. Adopt fiscal rules: The 16th Finance Commission should create differentiated fiscal rules to guide states based on their financial positions.

Question for practice:

Examine how the implicit guarantee from the Union government affects fiscal discipline and borrowing practices of state governments in India.