Creating fiscal space for the states

In our previous column, we spelt out a menu of fiscal options for the country to finance possible additional expenditures of up to five per cent of Gross Domestic Product (GDP). In this column, we elaborate on the idea, specifically on how the financing should be allocated between the Centre and the states.

Start first with the basic principle of public finance in a federal system. The states raise resources and spend it on local goods while the Centre raises it for providing national public goods, one of which is preventing and managing national crises. In a typical financial crisis affecting the entire economy, it is only appropriate that the Centre should both raise and spend money. But the Covid-19 crisis is unusual in that the crisis is national but the response has to be much more local, by states as well as local bodies. Today, two areas where significant government intervention is needed — health and agriculture — are both state subjects in the Constitution, and that’s where implementation will happen.

We cannot be certain about exact magnitudes but we can sa­fely say substantial amounts will be needed to be spent by the sta­tes. How should the sta­tes obtain resources, swiftly and feasibly?
We had suggested five public financing options for India:

1) Eliminating wasteful or “un­spendable” expenditures
2) Borrowing from multilaterals and non-resident Indians (NRIs)
3) Borrowing from public (via markets and financial repression)
4) Printing money
5) Raising “solidarity resources” via increasing taxes or cutting subsidies

Historical experience and prudence suggests external financing must be done exclusively by the Centre. Macro-economic stability is a sovereign responsibility and any external borrowings by sub-national governments will inevitably undermine it. This route is a non-starter for the states.


And the recent experience with state governments’ bond issuance — high interest ra­tes and widening premium from g-secs — suggests that the market borrowing route is all but ruled out for them in the immediate future.

The central government must first unambiguously announce that fiscal responsibility limits on the states (as for itself) will be suspended for this (extraordinary) financial year. However, this is necessary, but far from sufficient for the states to actually obtain the required resources.

Next, it is imperative that additional resources the Centre raises for the Covid-19 crisis — via options two and three above — should be shared with the states say in line with the 15th Finance Commission’s interim recommendations which have been accepted by all parties. This would ensure that vertical and horizontal distribution are rules-based and do not get mired in partisan wrangling. However, some flexibility should be envisaged. If the states need to spend the lion’s share, then our sharing rule would apply both to items two and three above. On the other hand, if the Centre’s burden is greater, the sharing could be limited to foreign financing alone.

Third, states need to acquire resources urgently. The Reserve Bank of India (RBI) has in­creased the Ways and Means Advances (WMA) limit for the first half of the financial year by 30 per cent. While a promising start, it is imperative that this limit be substantially increased by an amount to be decided jointly by the RBI, the Centre and the states. This amount could have a ceiling, say one per cent of each state’s GDP (as an indicative number).

To be clear, we are suggesting that while the Centre raise resources via options two and three — external financing from multilaterals and NRIs and internally via market borrowings and financial repression — and share that with the states in line with FFC recommendations; and that monetary financing should be used to finance additional deficits by the states. That might be the quickest way to get the states the necessary resources since the Centre has wider options.

But fiscal federalism is a two-way street. The Centre’s responsibilities will have to be matched by binding reciprocal responses by states, else it might encourage profligate be­haviour. The states must agree to freeze their current wage and pension bill for the entire duration that the Centre and RBI agree to monetary financing of their additional de­ficits. In 2019-20, this bill for the states (BE) was Rs 11.6 trillion (8.1 and 3.5, respectively). It is not clear what the states have budgeted for 2020-21, but we estimate that a wage-pension freeze could save the states between Rs 50,000 crore and Rs 1 trillion (the latter was the increase in this bill over the previous two years). The Centre too must implement a similar freeze but the savings there would be smaller (about Rs 30,000 crore) because the Centre’s total wage and pension bill in 2019-20 was close to Rs 4.2 trillion.

Such a wage freeze might appear paradoxical at a time of contracting demand and output. Policy should be counter-cyclical while the freeze seems pro-cyclical. Its logic is three-fold. First, the wage freeze is not expenditure cutting but expenditure switching, from the privileged organised sector to the precarious unorganised sector. Second, it represents a solidarity contribution of those in secure em­ployment (about 10 per cent of the workforce) for the tens of millions who have lost their livelihoods. And finally, it is also the prudent reciprocal quid by the states for the quo of monetary financing made available to them.

Fiscal federalism is always a hard balancing act, and in times of such an unprecedented national crisis, even more so. This crisis — much more than a fiscal crisis — requires unprecedented coordination and cooperation between the Centre and the states and among states themselves.

If time was not a luxury, and a spirit of bipartisanship prevailed, then the country could create new institutions such as a Cou­ncil for Co­operative Federalism or a Council for Fiscal Federalism (CFF) (as Bibek Debroy and Rathin Roy among others have propo­sed). But India does not have that luxury. Instead, the government could attempt one of the following.

It could resuscitate existing institutions such as Inter-State Council (ISC), envisaged under Article 263 of the Constitution, or the National Development Council (NDC), the apex body on development matters in India. Or, the GST Council could be expanded to take on the functions of the ISC and NDC.

The exact institutional form is less important than the need, in these grave times, to em­brace the full spirit of cooperative federalism to operationalise the countless decisions that need to be taken jointly. That means, frequent meetings between the prime minister, along with key Cabinet ministers, and chief ministers of all states and UTs.

While we have proposed rules for resource flows, some discretion will be necessary to complement the rules given that Covid-19’s impact will vary across the states. Collective discretion, exercised through joint meetings of the Centre and the states, will have to guide the flow of resources. The massive uncertainties require room for discretion to serve as a necessary handmaiden of rules that cannot alone cater to all contingencies and contexts.

Finally, there will be a “morning after” when exiting from the crisis fiscal arrangements will have to worked out. The Finance Commission is the appropriate body to do this. But it should wait to do so until after this crisis has passed since only then will we know the true fiscal health of the Centre and the states, and from that, the optimal path forward.
This is the second of a three-part series. Read the first part — Fiscal space: Not if but how, and the concluding part - Solidarity today, new social compact tomorrow.

Kapur is professor, Johns Hopkins University; Subramanian is former chief economic adviser, government of India

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