Need for bold fiscal reforms

If the governments of United States and many European countries suffer from massive debt burdens and downgrading of their sovereign debts, India too suffers from a similar malaise of high government debt. Combined fiscal deficit of Central and state government is as high as 12 per cent of the GDP. Almost 35 per cent of the central government budget is funded through borrowings.

The Government’s recent announcement of additional borrowing of Rs 53,000 crore will bring the total borrowing just this year alone to a staggering Rs 4.75 lakh crore. Profligate government spending has also taken a toll on the Indian currency. The rupee tumbled more than 15 per cent against the dollar in a matter of weeks.

Many state governments too have indulged in imprudent borrowing. According to recent figures from Reserve Bank of India (RBI), four states have a debt burden of more than Rs 2 lakh crore while many other states have crossed the Rs 1 lakh crore mark.

A study by an independent economist on behalf of ministry of finance has predicted that combined state government debt for this year alone will touch Rs 2 lakh crore. The newly elected governments of West Bengal and Tamil Nadu are demanding a special financial package from the Centre due to unsustainable fiscal policies adopted by previous governments.

High nominal GDP

For now what differentiates India from the western countries that are in debt crisis are economic growth and high nominal GDP. A slowdown in growth can bring to fore the perilous nature of our government finances. Bear Sterns and Lehman Brothers went from strong financial institutions to bankruptcy in a matter of weeks. Greece went from being solvent to insolvency in a short period of six months.

The hope for people of India is that there is sufficient time to set the Central and state government finances on the right footing before market forces confront our political leaders with a panoply of bad choices. Also, there is sufficient evidence from research to show that high level of public debt impairs government’s ability to deliver essential services that severely impacts the lower strata of society. Hence it is imperative upon the Central and state governments to enact a debt consolidation plan sooner to avoid adverse consequences later.

A sweeping fiscal reform that can accompany the introduction of GST is to ask state governments to balance their budgets and restrict them from off budget borrowings. The Central government in turn should relieve them of their current debt burden. An entity, say, ‘The Debt Corporation of India’ should be created and all the state government debt transferred to this entity.

The Centre should service this debt and retire it at an appropriate time. And for agreeing to introduce GST in their respective states without any restriction, a Devolution Trust Fund can be set up to assist state governments on a need basis for a period of say three years to compensate the loss in revenue.

Moody’s in its recent annual credit analysis calculates India’s central government debt to be 71 per cent of the country’s GDP. Total public debt of our country will be less than 90 per cent of GDP after the enactment of this debt consolidation plan, a far better proposition than many of the debt laden European countries. Such a plan will also act as a deterrent on future borrowing of Central Government. Legally, a balance budget clause for states can be added to the Constitutional Amendment Bill that is before parliament for introduction of GST.

The deal will be palatable to state governments given that they will be relieved of their outstanding liabilities particularly of market loans in a rising interest rate environment. And from the debt sustainability point of view, most states will get relief since they are unable to comply with the Twelfth Finance Commission recommendation of IP-RR (interest payment to revenue receipt) ratio of 15 per cent. For the Central government, the incentive to offer debt relief to states will ensure that its top economic priorities are met – smooth introduction of GST, controlling of inflation and a fillip to its economic agenda.

The goldilocks decade that just ended saw no action from our Central and state governments to shore up its finances. The budget season is upon us and it’s time to debate and enact bold fiscal reforms that would preserve the fruits of economic liberalisation for the next generation.

A fiscal consolidation of this nature will compel state governments to enhance productive expenditure, hive off some of the loss making state public sectors, reform state electricity boards that are money guzzlers and learn to live within their means. Central government too will be forced to carry out many of the second generation reforms that will firmly position India to become the fastest growing economy in the near future.

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