Freebie ban versus fiscal rules: Go with what works best

Adebate is raging across India over freebies given by various state governments. Freebies are goods and services that governments provide free to all or some of their citizens, such as targeted free electricity, transport or consumer durables, including laptops, bicycles, TV sets, grinders and debt waivers, among others.

In a recent paper, we consider the case of farm debt waivers, considered to be a contentious freebie. Between 2001-02 and 2018-19, 11 of 16 major non-special-category states in India announced 19 farm debt waivers, representing both prosperous states such as Kerala, Punjab, Maharashtra and Tamil Nadu, and poorer states such as Uttar Pradesh. Farm debt waivers, which involve cash transfers from the government to lending institutions to clear up their balance sheets, varied widely in a range of 0.9%–4.6% of gross state domestic product (GSDP) as per our calculations.

The state of Karnataka announced a waiver four times, followed by Chhattisgarh with three. Only five waivers were announced by incumbent governments before elections, while 12 were implemented as part of election manifesto fulfilment after poll victories. Only two waivers came in between two elections.

India’s southern states—Karnataka, Tamil Nadu, Kerala, Andhra Pradesh and Telangana—which are relatively prosperous have announced nine of the 19 waivers, while laggards Bihar and West Bengal have never announced any. In three-fifths of cases where waivers were announced before an election, the incumbent government lost, suggesting a rational electorate. In 11 cases, waivers were implemented to fulfil election pledges.

A farm-loan waiver policy is neither specific to a party ideology nor a reflection of a partisan model, but rather seems to fit into rationally opportunistic political cycle models. It is no surprise that our empirical results suggest that the timing of farm debt waiver announcements is associated with the timing of the state legislature elections. This points to a pattern of policy manipulation involving election-year targeting of the largest special interest group in the country—i.e., farming households.

There is, however, a trade-off that state governments face while implementing debt waiver schemes. Following the Central government’s adoption of a fiscal rule, most state governments in 2006 enacted fiscal responsibility legislation (FRL) as a commitment towards reducing their fiscal deficit to under 3% of GSDP by 2009. While even earlier, the Centre had control over market borrowings by states to fund deficits and indirectly placed a cap on their fiscal gaps, the official adoption of a fiscal rule further reduces the incentive for fiscal profligacy. An elected government faces a reputational risk in not being seen to be abiding by the fiscal rule.

Even in the presence of an overall fiscal rule, however, incumbent governments can shift the composition of government spending without raising their overall expenditure. A waiver policy increases current spending while allowing a government to lower capital spending, including on other factors that positively influence agriculture, such as irrigation, which is important for resolving agricultural distress, or other kinds of current spending, if total public expenditure is to be maintained in adherence with the fiscal rule.

Our empirical results suggest that loan waivers are associated with an increased revenue deficit, which is accommodated by a nearly one-third cut in capital outlays to control the fiscal deficit, given the existence of a fiscal rule. Given its path dependence, lower capital expenditure also reduces the quality of government spending in subsequent years. Our estimates have a potential under-estimation bias since state governments usually spread the expenditures incurred on debt waivers over 2–3 years after waiver announcements are made. Given that capital outlays have the highest multiplier effect on the state’s output, farm debt waivers leading to lower capital expenditure can have far-reaching consequences for the economic growth of these states.

How should such fiscal profligacy be curbed? It is difficult, a priori, to determine which freebies should be allowed and which should not be, depending on various welfare implications. Also, governments can always come up with new ideas to target special interest groups that allow for a quid-pro-quo relationship. Also, there is no doubt that elected governments in a democracy have decision-making power in this regard.

Rather than banning freebies or trying to curb them directly, a better way would be to consider adopting an expenditure rule or zero revenue deficit rule, which was a part of original Fiscal Responsibility and Budget Management Act of 2003, along with the overall fiscal rule. Expenditure rules have been adopted by several countries in conjunction with deficit or debt rules, though with varying degrees of success. Misra et al (2021) suggest a target ratio for revenue expenditure to capital outlay in the range of 4–5, and offer suggestive support for this range and an alternative of targeting a particular rate of growth in capital outlay or a floor for the capital outlay to GDP ratio.

From a policy perspective, future research should explore the feasibility of adopting an expenditure rule or reinstating the zero revenue deficit rule for the national as well as state governments. This would offer some leeway within a sound fiscal framework.

Pragati Mittal, a graduate of Madras School of Economics, contributed to this article.

Vidya Mahambare & Sowmya Dhanaraj are, respectively, a professor of economics and director (research), Great Lakes Institute of Management, and senior research fellow, Good Business Lab