Sri Lankan Shadow on Indian Federalism

How to Avoid Becoming Sri Lanka. With the current economic crisis unraveling in the emerald island after it defaulted on its foreign debt payment in April this year following years of fiscal mismanagement by successive governments, a book with this title will certainly do well in India today as apprehensions are running wild.

Newspapers and journals have already published reams of commentaries elucidating how India could face a similar fate in the coming years. Add to that the ongoing Ukraine-Russia war, inflation hitting a record high and rupee being battered to an all-time low against the US dollar and a glum picture emerges.

As experts dissect the predicament and analyse all the players involved, a recent article published by the Reserve Bank of India (RBI) seems to have found the culprit: finances of the state governments.

“The recent economic crisis in neighbouring Sri Lanka is a reminder of the critical importance of public debt sustainability. The fiscal conditions among states in India are showing warning signs of building stress,” reads the article titled State Finances: A Risk Analysis written by a host of authors from the RBI’s Department of Economic and Policy Research and published in the RBI bulletin in June.

The piece inadvertently throws light on the financial challenges Indian states are facing in the post-GST and post-Covid-19 world and puts the blame of India’s weak economic situation on the states’ policies on subsidies and freebies.

The RBI’s culprit also matched the sketch drawn up by several top bureaucrats who had reportedly pointed out to the Prime Minister in April that the populist schemes in several states were not viable economically and could lead to a Sri Lanka-like situation.

More recently, an all-party meeting held in July saw external affairs minister S. Jaishankar highlight that the lessons from the Sri Lankan crisis were that of fiscal prudence and responsible governance as he called for the end to a culture of freebies. During the same meeting, the government also pointed to the debt and fiscal condition of states like Andhra Pradesh and Telangana while giving a presentation. This, naturally, has not gone down well with the states with leaders from Andhra Pradesh’s ruling YSR Congress taking on the Centre by spotlighting its own burgeoning debt and asking it to look after its financial position.

This has ignited the latest state-versus-Centre debate centred around one pertinent question: why should states take all the blame?

State of Affairs

Drawing attention to the deteriorating finances of a large number of Indian states, the RBI article pointed out that state governments had breached the 3% mark for fiscal deficit in FY22.

Interestingly, not once did the article talk about the challenges that the Centre’s finances face even as its fiscal deficit has never been under control over the last decade. During Covid-19 (FY21), it touched a high of 9.3% of the country’s GDP, dipped to 6.7% in FY22 and has been pegged at 6.4% for FY23.

The article named Punjab, Rajasthan, Kerala, West Bengal, Bihar, Andhra Pradesh, Jharkhand, Madhya Pradesh, Uttar Pradesh and Haryana as the 10 states with the highest debt burden “taking into account the warning signs flashing from all the indicators”. This core subset of highly stressed states was identified by the debt/gross state domestic product (GSDP) ratio with Bihar, Kerala, Punjab, Rajasthan and West Bengal topping the chart as the five most indebted states.

“The rate of growth of public debt turns out to be higher than GSDP growth most of the time in the last five years, which has resulted in mounting debt-GSDP ratio in these states,” the RBI pointed out.

Calling fears of a Sri Lanka-like situation in India unfounded in the context of borrowings and debt of states alone, Suranjali Tandon, professor of economics at the National Institute of Public Finance and Policy, Delhi, explains: “The article uses the Sri Lankan crisis as context to carry out a risk analysis for state finances in India. However, the fears that a similar situation will play out in India is exaggerated. I say this since the ability of a state to borrow is constrained not just by the fiscal  rules but also by the constitutional powers of the Centre to consent to fresh loans. In addition, states cannot borrow externally.”

Article 293 (3) of the Constitution, which clearly outlines that no state can borrow additional funds without the permission of the Centre, reads, “A State may not without the consent of the Government of India raise any loan if there is still outstanding any part of a loan which has been made to the State by the Government of India or by its predecessor Government, or in respect of which a guarantee has been given by the Government of India or by its predecessor Government.”

For states to become bankrupt, it would require an unprecedented expansion in expenditure and decline in revenues, recognition of unexpected liabilities coupled with high levels of debt that require Centre’s approval, says Tandon.

In that aspect, the economics professor warns of further strain in Centre-state relations in the coming years. “The priority area for state and Centre are delineated and it is expected that each contributes to its mandates through the available fiscal means. In the event where the Centre is in breach of its fiscal target and continues to borrow, the states will demand similar flexibility,” she says.

The result? “Either inequities in expenditure and exacerbated strains in Centre-state relations where such flexibility is not afforded to the states or fiscal rules may become redundant,” adds Tandon.

But, as of today, given the centralised structure of the Indian polity, it is unlikely that any state will ever be allowed to cross the borrowing threshold to a level that it becomes a problem for the nation.

When Welfare is a Woe

The RBI article also quoted Comptroller and Auditor General (CAG) of India data to make a case against subsidies and freebies provided by states, especially when the pandemic broke out. “The state governments’ expenditure on subsidies has grown at 12.9 per cent and 11.2 per cent during 2020-21 and 2021-22, respectively, after contracting in 2019-20. Commensurately, the share of subsidies in total revenue expenditure by states has also risen from 7.8 per cent in 2019-20 to 8.2 per cent in 2021-22,” it stated.

The CAG data found that Jharkhand, Kerala, Odisha, Telangana and Uttar Pradesh were the top five states with the largest rise in subsidies over the last three years, and states like Gujarat, Punjab and Chhattisgarh were spending more than 10% of their revenue expenditure on subsidies. Flagging its concern, the RBI said, “Subsidies, however, are known to crowd out resources from other useful purposes.”

Covid-19, however, was an exceptional time not just for the states but also for the Centre. During the two years of the pandemic, controlling subsidies could have resulted in higher numbers of deaths, economic distress and political unrest.

For instance, during the first Covid-19-induced lockdown, lakhs of labourers belonging to states like Bihar and Uttar Pradesh, that generally witness massive out-migration, were forced to return to their villages from the cities to avoid dying of either the virus or hunger away from their families. Uttar Pradesh chief minister Yogi Adityanath and Bihar chief minister Nitish Kumar had to deploy additional resources to provide for the health and food requirements of a large population that had suddenly become jobless.

Aware of the fix that the states had found themselves in, the Centre had permitted them to increase their fiscal deficit to up to 5% of the GSDP in 2020-21, within which, 1% was conditional on the implementation of reforms by states in areas such as one nation one ration card, ease of doing business, urban local body or utility and power distribution.

“Revenue uncertainty in the time of the pandemic was exogenous. These revenue uncertainties were not within the control of the state,” says Lekha Chakraborty, member of the governing board of management, International Institute of Public Finance, defending the states’ financial decisions during Covid-19. “The volatility in the intergovernmental fiscal transfers [from the Centre to a state] also affected states’ fiscal space,” she adds.

Faulting the Freebies

As far as policies doling out freebies are concerned, it must be noted that the Union government runs the world’s biggest foodgrain transfer programme that provides wheat and rice free of cost to 80 crore people across the entire country.

As per the RBI’s estimate, expenditure on freebies range from 0.1-2.7% of the GSDP for different states. For some of the highly indebted states, like Andhra Pradesh and Punjab, the freebies have exceeded 2% of GSDP.

Provision of free electricity, free water, free public transportation, waiver of pending utility bills and farm loan waivers are often regarded as freebies, which potentially undermine credit culture, distort prices through cross-subsidisation, erode incentives for private investment and disincentivise work at the current wage rate leading to a drop in labour force participation, the RBI article pointed out.

“Some freebies may benefit the poor if properly targeted with minimal leakages, but their advantages must be evaluated against the large fiscal costs and inefficiencies they cause by distorting prices and misallocating resources. Additionally, the provisions of free electricity and water are known to accelerate environmental degradation and depletion of water tables,” it added, targeting states that are more focused on welfare policies.

Where does that leave a state like Kerala in the near future? The state has been on top of the human development indicators for decades now and has achieved it on the back of its welfarist approach towards development. Kerala’s near perfect health infrastructure also earned it international recognition during the Covid-19 outbreak.

Integrating the human development index in intergovernmental transfer mechanisms, especially the formula-based unconditional fiscal transfers by the Finance Commissions, is a matter of debate, says Chakraborty. “However, such policy initiatives are welcome to avoid penalising states with better human development,” she adds.

Universal/un-targeted subsidies are a drain on public finances, but in a country like India, it is not possible to do away with subsidies or freebies, says Devendra Kumar Pant, chief economist at India Ratings. “If a man using one fan and a bulb is getting free/subsidised electricity, the state government will have to give it to him to provide him the minimum standard of living,” he says.

Pant further points out that between the Centre and states, it is the latter that carry out expenditure that really helps citizens. “If the state does not spend on the health and education of people, the quality of labour force and, in turn, economic growth will suffer.  It will not be possible for the Centre to take care of those needs. Moreover, if there are no state roads and highways, what will be the use of national highways?” Pant asks.

The GST Burden

Five years ago, when the goods and services tax (GST) regime was accepted by states, they believed that the “one nation, one tax” regime will bring efficiencies within the economy, resulting in a higher revenue collection. Sadly, the reality has been a far cry from that.

An India Ratings report shows that the share of state GST (SGST) in States’ Own Tax Revenue (SOTR) stood at 55.4% from FY18 to FY21 as compared to 55.2% during FY14–FY17 before the GST was properly implemented. That indicates that the growth in the SGST component of the SOTR has been broadly similar. In five years, only a handful of states like Uttar Pradesh, Andhra Pradesh and Assam reported a higher growth in revenue post GST. On the other hand, 18 states reported lower growth with Punjab, Kerala and Karnataka reporting close to only 2% growth.

The RBI article highlighted that there was a difficult road ahead for the states with the Centre’s GST compensation payout for the states’ shortfall coming to an end in June 2022. This, it said, would further reduce the headroom available for social sector expenditure.

With the compensation period coming to an end, many states will now not only have to compromise with their welfare schemes but will also have to be on good terms with the Centre to be able to successfully run schemes that can benefit the masses and yield political benefits.

After all, is it not all about political benefits anyway?