Beware of Lanka-like crisis with 'non-merit freebies'

The economic crisis in Sri Lanka is worrying the RBI. It cites this crisis to flag state governments' rising "non-merit freebies" in its June 2022 bulletin and caution that their fiscal conditions "are showing warning signs of building stress". Such freebies, it said, ranged from 0.1% to 2.7% of GSDP for different states and exceed 2% for highly indebted ones like Andhra Pradesh and Punjab in FY23 (BE). Its July bulletin hammers in the point further by asking: "Are financial risks moving sub-national?".

These bulletins don't talk about the central government's freebies or its rising debt. In fact, these reports appear to approve the Centre's fiscal management and see no future danger to the economy either.

Its July bulletin says: "With crude prices at $105 per barrel as assumed by the MPC, the net terms of trade index will worsen from 100.6 in 2021-22 to 98.5 in 2022-23. This will cause the CAD to widen from 1.2 per cent of GDP in 2021-22 to 2.3 in 2022-23, ceteris paribus (all other factors remaining constant). With crude at US $120, the terms of trade index falls further to 97.4 and the CAD expands to 2.8 per cent of GDP but it remains within the sustainable limit of 3 per cent. External debt remains modest as a proportion to GDP and has actually declined between March 2021 and March 2022."

But for states, the same bulletin sounds ominous: "States' outstanding debt at end-March 2022 stands at 31.2 per cent of GDP, which is the highest in the past 15 years. The most indebted states are expected to remain stressed, with their debt-GSDP ratios likely to exceed 35 per cent by 2026-27." It largely blames the rise in "non-merit freebies" for this while acknowledging other factors: macroeconomic uncertainty, declining own tax revenue, relaunch of the old pension scheme by some states, expanding contingent liabilities and the ballooning overdue of DISCOMs.

Freebies are worrying the Supreme Court and the Prime Minister too.

A few days ago, the apex court worried about "irrational freebies" that political parties announce during elections and asked the Centre to find ways to curb this practice by bringing in the Finance Commission (FC) and the Election Commission of India (ECI) into the picture. The Prime Minister issued a warning against "revdi" (freebies or largesse by another name). He said: "People of revdi culture feel that by distributing free revdis to people, they can buy them. Together we need to defeat this thinking. Revdi culture needs to be removed from the country's politics."

What are freebies and 'revdis'?

The RBI spells out "non-merit freebies" and also their adverse impact in its June bulletin (only in the context of state governments).

It says: "…the provision of free electricity, free water, free public transportation, waiver of pending utility bills and farm loan waivers are often regarded as freebies, which potentially undermine credit culture, distort prices through cross-subsidisation eroding incentives for private investment, and disincentivise work at the current wage rate leading to a drop in labour force participation. Some freebies may benefit the poor if properly targeted with minimal leakages, but their advantages must be evaluated against the large fiscal costs and inefficiencies they cause by distorting prices and misallocating resources. Additionally, the provisions of free electricity and water are known to accelerate environmental degradation and depletion of water tables."

The apex court wants "irrational freebies" be stopped from being announced at the time of electioneering. It wanted the ECI to chip in with suggestions but it had washed off its hands during the very hearing, by stating that it was a matter to be "considered and decided by the voters of the state". FC isn't a permanent body; it is set up once in every five years. The last one, 15th FC, had submitted its report in 2021. One of its terms of reference (TOR) was to consider proposing "measurable performance-based incentives for states" under which "control or lack of it in incurring expenditure on populist measures" was a key element.

In the TOR and the 15th FC, freebies got another name "populist" measures or schemes.

The 15th FC did not define what is "populist", which it was supposed to be, to put a check. Instead, it said "some states" opposed this TOR and "many states" stressed that categorisation of schemes into populist and non-populist couldn't be done objectively, as development requirements differed from state to state. These states argued that since elected governments were accountable to the people of the state they should decide it, rather than the FC.

This report was submitted after the pandemic hit. Taking into consideration the uncertainties, contemporary realities and challenges, it said the FRBM Act of 2003 "needs a major restructuring". It recommended setting up a "high-powered inter-governmental group" to examine "the time-table for defining and achieving debt sustainability". It also recommended setting up "independent fiscal council" to ensure effective implementation of fiscal rules and strengthen fiscal performance – a global practice. Successive FCs have recommended "fiscal council" but it was never accepted. These councils exit in several countries and act as fiscal watchdogs, checking freebies and flagging broken government commitments.

Not just such a council but there is no sign of "High-powered Inter-governmental Group” either.

Size of freebies/subsidies

The RBI doesn't define what is "non-merit" freebies. In its estimation of various fiscal scenarios for states, it takes into account both "subsidies" and "freebies" – the relevant column reads "subsidies/freebies". That is because it finds that "in the recent period, state governments have started delivering a portion of their subsidies in the form of freebies". Since these are only about states, the RBI bulletins are silent on the total "subsidies/freebies" in the economy (GDP) or the Centre's contributions to these.

Sudipto Mundle, well-known economist and chairman of Centre for Development Studies (CDS), writes that "total volume of subsidies", which includes both "merit" subsidies and "unwarranted subsidies" is about 10% of the GDP. Of this, "unwarranted subsidies" account for two-thirds, or 6% of the GDP. He doesn't spell out which are "unwarranted subsidies" but lists four "merit" subsidies, marking them for their large benefit to society: (a) food for the poor (b) basic education (c) basic health and (d) water and sanitation.

Additionally, Mundle also estimates "tax exemptions and concessions" (what is also known as "revenue foregone") to constitute another 5% of the GDP – marginally less than 6% on "unwarranted" subsidies. He doesn't reveal whether this calculation includes ₹1.45 lakh crore of corporate tax cut given in September 2019.

It is known that the Indian tax system is very regressive, and for a very long time. Indirect tax contributing far more than direct tax. The budget documents reveal that tax exemptions and concessions benefit bigger corporations, rather than smaller ones. For example, the "effective tax rate" for corporations making profit before tax (PBT) of ₹10-15 crore is much higher than those with PBT of ₹500 crore and more. Further, in FY21, corporations (both listed and unlisted) made historic high net profits but paid less than income tax paid by non-corporate entities for the first time in the 2011-12 GDP series. It was in this context (completely regressive tax structure) that an earlier Fortune India article had explained "why high GST collection is bad taxation and bad economics".

Mundle didn't take into account another subsidy for corporations, called non-performing assets of banks or NPAs.

NPAs are nothing but bank loans not paid by big corporations, sometimes deliberately and they are better known as "willful defaulters". A recent analysis showed the amount not paid by "willful defaulters" (of ₹25 lakh and above) went up 10 times in 10 years – from ₹23,000 crore in FY12 to ₹2.4 lakh crore in FY22. The total NPAs written off by scheduled commercial banks (SCBs) between FY12 and FY21 stands at ₹11.09 lakh crore – a substantial amount. For example, in FY21, the NPAs written off (₹2.08 lakh crore) works out to be 1.5% of the GDP (₹135.58 lakh crore).

Should tax exemptions and concessions (revenue foregone) and NPA write-offs be counted as "freebies"? These are availed by those who don't need "free" or "subsidised" food to survive. Currently, 62.5% of the population are given "free" grains (5 kg per person) over and above "subsidised" food grains (35 kg per household).

Should fertilizer subsidy, 0.95% of the GDP in FY22, which is directly given to corporations, not farmers, be counted as "freebies"?

There is no clarity on these three and are certainly not being talked about now.

These three instances are for illustration purpose, for there are much more to government largesse to the privileged hidden from plain sight.

Why the freebie and fiscal debates are highly skewed

Now revisit what the RBI said about "freebies" (quoted earlier). It said "…free electricity, free water, free public transportation, waiver of pending utility bills and farm loan waivers are often regarded as freebies, which potentially undermine credit culture, distort prices through cross-subsidisation eroding incentives for private investment, and disincentivise work at the current wage rate leading to a drop in labour force participation".

Who are the beneficiaries of the freebies the RBI lists? The poor.

If the poor are getting freebies worth 6% of the GDP (taking Mundle's estimate for ease of comparison), the rich are already getting more – 5% in tax exemption and concessions (Mundle), 1.5% in NPA write-offs (in FY21), 0.99% in corporate tax cut (in FY20 but is continuing). All these add up to 7.5% of the GDP.

Don't these freebies of 7.5% of the GDP worry the RBI, the apex court or the Prime Minister? Don't they damage credit culture and fiscal conditions?

There is yet another dimension to the debate.

What about the fiscal performance of the Centre and states? Here is how they fare in three key fiscal parameters.

• The Centre's debt during FY19-FY21 (for which data is readily available) is 51.4% of the GDP (an annual average) – as against states' 27.6%. The FRBM says the Centre's debt should be 40% or less and states' 20% or less (standard limit is 60% of the GDP). Thus, states are clear winners with average deviation of 7.6 percentage points against Centre's 11.4.

• As for fiscal deficits, the FRMB limits it at 3% for both. During the above three fiscals, the Centre's fiscal deficit was 5.7% (annual average) and states' 2.7%. In FY22, fiscal deficits of the Centre and states were 6.8% (revised estimate) and 3.7% (budget estimate), respectively.

• If one considers capital expenditure, the Centre has spent an annual average of 1.8% of the GDP in 11 years between FY12 and FY22, while states 3.1%. (For more read Fortune India's Centre vs states: Who's fiscally more profligate?

Meanwhile, India's CAD is expected to go up and reach $105 billion this fiscal year, that is 3% of the GDP (upper sustainable level), according to the Bank of America Securities' latest update – up from 2.6% estimated earlier. The RBI's July 2022 bulletin also says the CAD will go up from 1.2% of the GDP in FY22 to 2.3% at crude price of $105 and 2.8% at $120.

So, why this blinkered debate over "freebies" and fiscal management? What purpose do such debate serve – vested interest groups or the economy as a whole?