Should States that Spend Irresponsibly be Penalised?

Context: The fiscal stress faced by several Indian states highlights the need to rethink how state debt is managed and priced.

Historical Context: New York City’s Fiscal Crisis

• In 1975, New York City was experiencing a severe fiscal crisis and was locked out of financial markets.
• President Gerald Ford initially opposed federal assistance, stating he would “veto any bill that has as its purpose a federal bailout of New York City to prevent a default.”
• Ford’s rationale was that denying a bailout would compel the city to rectify its financial mismanagement.
• This stance was famously encapsulated by the New York Daily News headline: “Ford to City: Drop Dead.”
• Despite his initial resistance, Ford later authorised loans totaling $2.3 billion to assist the city.

Implicit Guarantees in India’s State Borrowings

• Indian state governments are perceived to have an implicit guarantee from the Union government regarding their borrowings.
• This guarantee effectively eliminates credit risk for states, resulting in uniform bond yields regardless of their fiscal health.
• Higher interest rates are not charged to compensate for the credit risk.
• Examples of Fiscal Disparities
  • Gujarat: An economic powerhouse with a lower debt-to-GSDP ratio and revenue surplus.
  • Himachal Pradesh and Punjab: Both states are under significant fiscal stress, with Himachal Pradesh recently unable to pay salaries on time.
• Despite these disparities, bond yields do not reflect the varying fiscal positions of these states.

Fiscal Challenges Facing States

TIPS Problem:

• State finances are burdened by:
  • Tariffs: Low electricity and water tariffs that do not cover actual costs.
  • Interest Payments: A significant portion of state revenues is consumed by interest obligations.
  • Pension Obligations: Rising pension costs due to choices between old and unified pension schemes.
  • Subsidies: Increasing frequency of subsidy announcements without corresponding revenue increases.
• In many states, more than 70% of tax revenues are spent on interest payments, pensions, and power subsidies, leaving little room for development expenditure.
• Some states are borrowing not for capital expenditure (capex), but for funding consumption.

Why Is There a Need To Penalise the States with Higher Spending?

• Promoting Fiscal Responsibility: Penalising irresponsible spending would compel state governments to prioritise essential expenditures, manage resources efficiently, and avoid excessive debt accumulation.
  • This ensures that states do not rely on constant bailouts and are held accountable for their financial decisions.
• Preventing Moral Hazard: If states are not penalised for reckless spending, it creates a moral hazard—an environment where states continue to overspend, expecting bailouts or implicit support from the Union government.
  • Penalization would discourage this over-reliance on federal intervention.
• Market Discipline: Allowing markets to charge higher interest rates for fiscally weak states could impose a natural check on spending.
  • States with weak finances would face higher borrowing costs, forcing them to either reform or face difficulty in accessing credit.
• Equity and Fairness: States that manage their finances responsibly should not be punished by having to share federal resources with states that mismanage theirs.
  • Penalising irresponsible states ensures a fair distribution of central funds, especially when states like Gujarat have strong fiscal health, while others like Punjab face financial stress.
• Sustainable Development: By enforcing fiscal responsibility through penalties or higher borrowing costs, states would be motivated to invest in productive sectors like infrastructure and education rather than populist schemes or unsustainable subsidies.
  • This leads to long-term growth and stability.
• Reinforcing Federalism: Penalising states could reinforce the principle of cooperative federalism, where both the Union and states share responsibility for sound fiscal governance.
  • States should have autonomy, but they should also be held accountable for their financial decisions.

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