The four rules to giving out 'freebies'

Photo: Shutterstock
Photo: Shutterstock


Spending choices should be left to governments but fiscal rules must keep their profligacy in check

The freebies issue has expectedly taken a political turn, but its main essence is being missed. The choice of spending should ideally be with the government, as priorities vary. The problem surfaces when the fiscal deficit reaches high levels, which is not sustainable as debt levels rise. Interestingly, before the pandemic, the level of state debt was around half that of the Centre. Also, while the Centre never logged a fiscal deficit ratio of less than 3% after 2007-08, all states combined had clocked less than 3% after 2004-05 right up to 2020-21, barring 2015-16 and 16-17. Here too, it was less than 3.5%.

Hence, there is a priori reason to believe that states have managed their fiscal deficit ratios better. They have tended to be more constrained because of the Fiscal Responsibility and Budget Management (FRBM) rules, which cap the deficit at 3% of gross state domestic product. Breaching this level requires special permission, which brings in internal discipline. The same does not hold for the Centre, which has been advised but never compelled, given the level of responsibility taken on.

If it is assumed that states and the Centre have the right to spend money where they want, as any money given in the form of subsidy or cash transfer ultimately benefits someone, a route needs to be devised to ensure that the fiscal deficit is kept in check. At the end of the day, states should not be borrowing more than they prudentially should, which is denoted by this number. There are rules needed to cap the deficit as well as ensure transparency. If this is done, then the quality of spending can be kept aside for a separate debate.

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First, we need a rule that is binding on both the Centre and states. The Reserve Bank of India can be made the door-keeper to ensure that access to the debt market closes beyond a prescribed level. This level can be fixed as thought fit, but must be held sacrosanct. There is actually no basis for the 3% mark (which was the standard for being part of the Eurozone during its monetary union). The FRBM Act offers a path that is not enforceable and hence does not help.

Second, we must include contingent liabilities as part of the fiscal deficit—both of the Centre and states. This will deliver transparency and ensure that debt doesn’t build up outside budgets. The Centre has already made a serious correction by including Food Corporation of India borrowings in the budget in 2020-21. The same should hold for states, so a true picture of debt emerges.

Third, as a rule, guarantees by the government to any publicly-owned entity should be banned. These tend to create a perverse incentive of not taking responsibility for performance. Once removed, the entity will be forced to operate on commercial terms. This will hold for power distribution companies in particular. Once guarantees are gone, they will have to borrow money from the financial system based on their strength and performance. They will no longer be subsidized by a backstop. As a result, they would not be able to provide free power and accumulate losses, which are presently funded by banks and financial institutions. If free power has to be given, the state must pay for it from its budget, which will be constrained by the deficit rule. This will ensure discipline.

Fourth, if it is felt that capital expenditure is the job of the government, then a certain portion of the borrowing should be earmarked by a rule. This will ensure that the responsibility of the government in building infrastructure is never compromised. Here, the apex authority, which should be the Finance Commission, must strongly mandate the level of capex at, say, 20% or 25%. This would lessen the space for cutting back on such expenditure whenever a government opts for ‘freebies’.

These simple rules can make implementation easier. Governments can offer free power or write off loans, but will have to pay from their budget. As such measures are often taken to gain political mileage, the electorate can decide whether a larger section is being left out of the development programme and take a call accordingly at election time. If a government spends more on giving free power to farmers and cuts spending on health and education, such an establishment could be voted out.

The issue today is that there has been a tendency of proliferating competitive announcements by all governments of so-called freebies that get camouflaged by terminology. Any ‘incentive’ is acceptable while a ‘subsidy’ is frowned upon. A corporate tax cut is applauded, while giving sewing machines is not found acceptable. Funding banks with capital is a solution when banks run dry due to provisioning for non-performing assets, but farm loan waivers are seen to create a moral hazard. There are different sides to these arguments and we may never find a satisfactory answer.

Hence, clipping the state’s wings at the final level of borrowing, as reflected by its fiscal deficit, will address these issues, though it may take time. This way, the onus of decisions remains on the government. The fiscal deficit number becomes sacrosanct irrespective of funding from cash balances, market borrowings or the National Small Savings Fund. The concept of freebies can still be a subject for discussion, but will not really matter then.

These are the author’s personal views.

Madan Sabnavis is chief economist, Bank of Baroda, and author of ‘Lockdown or Economic Destruction?’

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