Even after three decades of reforms, government still main driver of India’s economy

Nobel Laureate Amartya Sen often quotes a phrase of his teacher, “Whatever you can rightly say about India, the opposite is also true.” Contradictions exist in all aspects of India’s being, including the dynamics of its economy. On one hand, every government seems to advocate for divestment of PSUs and privatisation of management functions of the civic society, while on the other, governments within India remain the principal drivers of the country’s economy. The rallying cry for ‘Minimum Government and Maximum Governance’ juxtaposes with the paradoxical economic data, which reveals that India mainly thrives on heavy spending by the government.

Over the past three decades, general government expenditure, that is, spending by the Centre and States combined, has hovered between 25% and 30% of India’s GDP. Despite being liberalised for more than three decades and the rise of private sector, India’s over-dependence on the spending by Central and State governments is stark—anywhere between one-third to one-quarter of the economy; this indicates that government spending is pivotal to maintain buoyancy in the economy.

According to an IMF paper titled ‘Growth Convergence and Public Finances of India and its States’, general government expenditure increased sharply from about 26% of GDP in FY19 (pre-Covid) to almost 30% of GDP by FY23. Indian states together account for around 60% of total general government (central and states) expenditures amounting to about 18% of GDP in FY23, the report adds.

When more than 800 million people need subsidised rations, it is a foregone conclusion that India has a disproportionate reliance on the government even for basic sustenance, while the other engines of economic growth, namely consumption and investment, are performing inadequately.

This is further corroborated by the fact that private final consumption expenditure (PFCE), a measure of consumption in the economy, declined to 55.8% in FY24 from 61% in FY19. This dip in consumption and the investment aversion of India Inc. puts the onus of growth on the central and state governments. 

Governments are crucial for infrastructure development and providing socio-economic assistance to the weaker sections of society. A large section of India owes its meagre comforts to the doles from central or state governments’ coffers. From primary education to subsidised ration, housing, healthcare, electricity, toilets, to financial aid for childbirth, marriage, and funeral expenses, the poor depend on alms from the government. And these aids and subsidies are draining the government’s coffers. Currently, subsidies are 2.1% of GDP for the Central government and 1.5% of GDP for all State governments combined. The percentages are high enough to challenge India’s claims of being a capitalist paradise, revealing a strong socialist foundation underneath.

Public Finance: A Snapshot

While general government expenditure (centre and states combined) hovered between 25% and 30% of GDP, general government revenue has stagnated at about 20% of GDP over the past three decades, which is significantly lower than the average of 25% of GDP for Emerging and Middle-income Economies, as per an IMF Report. Additionally, interest expenditure is alarmingly high at 5% of GDP, or about 25% of total revenues, restricting the availability of resources for development and investment purposes, the report adds.

There has been a significant rise in the Central government’s fiscal deficit and public debt post-pandemic. Fiscal deficit increased from about 4% of GDP in FY19 (pre-pandemic) to 9.5% of GDP in FY21 before coming down to 6.6% and 5.6% of GDP in FY23 and FY24 respectively. The government has budgeted FY25 fiscal deficit to 5.1% of GDP, still substantially higher than the pre-pandemic years.

At the same time, the Central government’s expansionary fiscal policy has come at a sizable cost of increased public debt of 6% in just four years, from 50% to 56% of GDP. The combined outstanding liabilities of the states have increased in recent years from 22% of GDP in FY15 to 28% of GDP in FY23 because of increased fiscal deficits.

Vulnerability to Global Developments

Being an import-dependent country, global events impact India’s nominal GDP and revenue growth quite substantially, and the economy and public finances of the general government are therefore vulnerable to global developments.

The current Donald Trump regime in the US is adamant about increasing tariffs on imports which is creating an upheaval on global economic fronts. The US is India’s largest trading partner so any escalation of tariff is expected to severely impact the top line and bottom line of India Inc., which, in turn, may slow down growth of corporate tax collection in India.

Over 32 years from FY91 to FY23, the buoyancy of Indian taxes has averaged about 1.04, that is, total tax revenues’ growth divided by nominal GDP growth. However, tax buoyancy and collections in India have been substantially impacted by global developments from time to time. Several years of low buoyancy and declining nominal GDP growth have been associated with negative global developments such as the Asian Financial Crisis in 1998, the 9/11 tragedy in the US in 2001, the global financial crisis of FY09, taper tantrums in FY14, and the Covid-19 pandemic in FY20-FY21, states the IMF Report.

Based on historical evidence, the Indian government may face trouble in maintaining revenue growth in the current times when tariff wars are on the anvil. This may impact government expenditures and thus curtail economic growth. Already, in Q2FY25, India’s GDP growth has slumped to a seven-quarter low of 5.4%.

State Governments Hostage to High Public Debt

Many Indian states have already breached the Fiscal Responsibility and Budget Management (FRBM) Act’s implied target for public debt, which should be lower than 20% of Gross State Domestic Product (GSDP). Hence, the state governments may be forced to curtail their expenditure, which does not augur well for the already sluggish Indian economy.  

The FRBM (Amendment) Act, 2018 states that the Central government shall endeavour to ensure that the general government level does not exceed 60% of GDP and the Central government debt does not exceed 40% of GDP, implying that state government debt should not exceed 20% of GDP. The borrowing limit for state governments, that is the fiscal deficit each state can run, has been set at 3% of GSDP.  

The revenue of many Indian states like Bihar, Punjab and West Bengal are barely sufficient to meet their committed expenditure like interest, pensions, and administrative services. Consequently, these states are heavily reliant on central transfers to meet their revenue development expenditure. Their capital expenditures are financed almost entirely by borrowings and their current level of spending will need to be reduced to adhere to the FRBM targets. This will limit the public investment of many states going forward thereby reducing their potential GSDP growth, states the IMF report.

The rise in states’ public debt as a share of GDP and of individual states as a share of their GSDP is alarming. When the total revenue is stagnant and states cannot breach the fiscal deficit/GSDP ratio of more than 3%, hard times cannot be ruled out.

Any increase in expenditure to enhance growth would lead to an even more elevated level of public debt that could make it challenging to preserve macroeconomic stability, especially in the presence of an adverse economic shock.

The government is stuck between a rock and a hard place. With high public debt and a large population on government doles, it is becoming increasingly difficult for the Centre and State governments to choose between fiscal prudence and high economic growth that will stoke inflation.