Challenges of Sub-National Fiscal Correction : Daily Current Affairs

Date: 31/08/2022

Relevance: GS-3: Issues and challenges pertaining to the federal structure, devolution of powers and finances up to local levels and challenges therein. Separation of powers between various organs disputes redressal mechanisms and institutions.

Key Phrases: Centre State Finance Relations, Fiscal Federalism in India, Fiscal policy, Government Budgeting, Public Expenditure, Fiscal Consolidation

Context:

Recently there is a buzz in the Indian Politico Administrative system concerning the excessive doling out of freebies by States who are pushing back the issue on the grounds of welfare provisioning and protection of the vulnerable sections of the population.

Background:

The State governments have termed it as an incursion into the federal powers of the States.
On the other hand the Central government’s alarm has been on the mounting debt burden and the deteriorating fiscal situation in some States.
As both the Union government and States are expected to work closely in a cooperative federal structure, frictions arising out might have repercussions on both resource sharing and expenditure prioritization thus it is desirable that the Centre and States are on the same page on these issues.

Major friction points in India’s fiscal federalism

India’s fiscal federalism is plagued with broadly 3 set of issues which has led to frequent confrontation between the state and Union governments
First, issues related to Goods and Services Tax (GST)
- Such as the rate structure, inclusion and exclusion of commodities, revenue sharing from GST and associated compensation.
- Issues related to GST have a forum for discussions as they are usually the agenda for GST council meetings.
Second, State-level expenditure patterns especially related to the welfare schemes of States.
Third, the conception and the implementation of central schemes.

What is Fiscal Policy?

Fiscal policy refers to the use of government budgeting, spending and tax policies to influence macroeconomic conditions, including aggregate demand for goods and services, employment, inflation, and economic growth.
The major purpose of these measures is to stabilize the economy.
There are three components of the Fiscal Policy of India:
- Government Receipts
- Government Expenditure
- Public Debt
Through budgeting government implements its fiscal policy which results in 3 types of budgets:
- Balanced Budget: Budget is assumed to be balanced if the expected expenditure is equal to the anticipated receipts for a fiscal year.
- Surplus Budget: A Budget is said to be surplus when the expected revenues surpass the estimated expenditure for a particular business year.
  - Budget becomes surplus, when taxes imposed, are higher than the expenses.
- Deficit Budget :A Budget is in deficit if the expenditure surpasses the revenue for a designated year
  - In the Budget deficit case governments resort to borrowings.

Measurement of deficits:

Revenue Deficit: It refers to the excess of government’s revenue expenditure over revenue receipts.
- Revenue Deficit = Revenue expenditure – Revenue receipts
- Revenue deficit implies that the government is not saving and using savings of different sector of economy to finance consumption expenditure.
Fiscal Deficit: It is the gap between the government’s expenditure requirements and its receipts.
- Fiscal Deficit = Total expenditure – (Revenue receipts + Non-debt capital receipts).
- This equals the money the government needs to borrow during the year.
Primary Deficit: This indicates the gap between the government’s expenditure requirements and its receipts, and excludes expenditure incurred on interest payments on past loans.
- Primary deficit = Fiscal deficit – Interest payments

The Issue of Discretionary expenditure

The quantity and quality of public expenditure by the States is a key issue because
- States demand more fiscal space for increasing discretionary spending
- The Centre is pushing for fiscal discipline by reducing discretionary spending and limiting States to focus on mandatory expenditures.
The aim of enhanced discretionary public expenditure is to stimulate the economy during periods of excess slack through primary consumption.
But discretionary expenditure is generally more volatile than mandatory expenditure and cross-country empirical data show that output growth is also low for discretionary expenditure
Also once a discretionary expenditure is started to boost demand cannot be stopped immediately as the consumption will require counterbalancing measures which leads to fiscal stress.
The current debate around freebies highlights this issue as States which defend their discretionary expenditure arguing ‘models of welfare provisioning’ actually lead to State's fiscal stress which in turn leads to
- burden on fiscal resources of the centre through various provisions.
- overall magnified fiscal slippages, fiscal deficit and not achieving targets of the Fiscal Responsibility and Budget Management (FRBM) Act

The Fiscal Responsibility and Budget Management Act, 2003 (FRBM Act)

The act was passed by the Parliament of India in August 2003.
It aims to
- Institutionalize financial discipline in India
- Reduce India’s fiscal deficit
- Improve macroeconomic management and overall management of the public funds thus moving towards a balanced budget.
Provisions of FRBM Act:
- Originally the act was mandated to
  - Reduction of fiscal deficit to 3% of the GDP by 2008-09 which was to achieve a reduction of 0.3% of GDP per year.
  - Revenue deficit to be reduced by 0.5% of the GDP per year with complete elimination by 2008-09.
  - The revenue deficit and fiscal deficit may exceed the targets specified in the rules only on grounds of national security, calamity and other exceptional grounds.
Amendment to the FRBM Act,2012:
- The amendment mandates the central government to put the following documents before the Houses of Parliament along with the Annual Financial Statement and Demands for Grants-
  - Macro-Economic Framework Statement
  - Medium Term Fiscal Policy Statement
  - Fiscal Policy Strategy Statement
NK Singh Committee Recommendations:
- The committee which was setup in 2016 to review the FRBM Act recommended:
  - To target a fiscal deficit of 3% of the GDP in the years up to March 2020.
  - Subsequently cut it to 2.8% in 2020-21 and to 2.5% by 2023.

Why Fiscal consolidation?

Sustained increase in welfare expenditure by the States leads to fiscal expansion, which necessitates additional resource mobilization.
In many states additional resource mobilization has yielded limited success which leads the States to resort to borrowings.
Such Fiscal expansion financed through debt and the resultant debt accumulation has a high impact on the economy both in the short run as well as in the long run.
- Funding through debt is desirable if used for capital formation.
- Such borrowing could contribute to the real income of future generations and add to the repayment capacity of the government as well.
- But if use of borrowings is to finance only the current expenditure it poses the risk of debt rising to unsustainable levels.
Unfortunately in most of the states the borrowings are used to finance current expenditure and thus have become unsustainable which underlines the immediate need for fiscal consolidation.

Current Fiscal Status

Data published by the RBI show that in recent years, States’ outstanding debt has registered an upward movement, this uptick is partly attributed to
- Implementation of the Ujwal DISCOM Assurance Yojana (UDAY),
- Farm loan waivers, and sustained increase in populist welfare measures
- Growth slowdown especially in 2019-20 and the Pandemic.
Thus a combination of increased expenditure and non-commensurate revenue mobilization efforts has resulted in increased debt-GSDP ratio (gross state domestic product) between 2013 and 2022.
The debt-GSDP ratio of States increased from 22.6 in 2013 to 25.1 in 2018, and estimated to 31.2 in 2022 (budget estimates 2022).
Given the prevailing macroeconomic environment, the debt-GSDP ratio is expected to increase further and overall the decline in revenue receipts due to a fall in the States’ own tax revenue has increased the vulnerability.

Way forward:

While there exists a need for raising additional resources at the state level, expenditure prioritization has to be carried out diligently.
The discussions on freebies need to be understood in the context of capital expending on some important social and economic services and not for populism.
The Centre, too, on its part needs to demonstrate commitment to fiscal discipline by sticking to the announced fiscal glide path.
Therefore in the current circumstances when the economy is recovering from a crisis, there exists an imminent need to adhere to the path of fiscal correction both by the Centre and by the States to ensure the sustainability of a frictionless cooperative federal structure.

Source: The Hindu

Mains Question:

Q. Amid the growing concerns of global economic slowdown, there is an imminent need to adhere to the path of fiscal correction both by the Centre and by the States to ensure a robust economy in the post-COVID-19 era. Discuss .(250 words).