By Nirvikar Singh
India’s government debt is about the highest it has ever been, at 82% of GDP. This is down from its post-pandemic high, but still higher than historical averages. The stock of debt is a major determinant of interest payments to be made, which can crowd out productive government spending, and slow down growth. Interest payments also depend on rates, which are influenced by perceptions of risk. So high debt levels can raise interest rates and create a negative feedback loop. On the other hand, if public borrowing is used for productive investment and raises future growth, then debt can be good, again up to a point.
Some economists have suggested 90-95% of GDP as a key threshold for public debt, but only for developed economies, with a lower critical value for emerging economies. By these measures, India’s debt-GDP ratio is high, and it has been receiving increasing attention from economists. The latest discussion, by three JP Morgan economists, offers a “reimagining” of India’s fiscal architecture, built on “five pillars”: first, focusing on the consolidated debt-GDP ratio rather than annual fiscal deficits; second, deciding how reducing this ratio by 5-10 percentage points should be shared between the Centre and the states; third, establishing risk-based fiscal rules for the states; fourth, introducing market discipline for state borrowing costs; and fifth, using business-cycle-adjusted targets over multiple years.
The states are only responsible for about a third of the consolidated debt, but the potential for improved fiscal management among the states is probably greater than at the Centre. There is wide variation in the states’ fiscal performance, so understanding and learning from these variations can be very helpful. The nature of Indian federalism also raises possible risks at the state level, which soon become the Centre’s problem. Indeed, one challenge for the fourth and fifth pillars is a federal system in which the Centre is responsible for a significant portion of the states’ revenue and simultaneously influences their expenditure patterns through its own expenditure decisions.
The 16th Finance Commission will be dealing with some of these challenges as it conducts its deliberations. Separately, the GST Council continually deals with what is still a relatively new system of sharing the proceeds from the GST, now the dominant indirect tax in India—as opposed to direct taxes on incomes, for which the Finance Commission makes suggestions for division between the Centre and states and among the states.
In essence, the five pillars from the JP Morgan economists are one part of a much larger federal system of public expenditures and revenue collection. Their prescriptions are contingent on the workings of this system. Several underlying features of the system deserve greater attention as they are the foundations on which the five pillars will need to rest. These features include puzzles that need to be solved.
The first puzzle is India’s relatively low tax-GDP ratio. This has been recognised for decades, but it is not clear what will address it best. Does the direct tax base need to be broadened? Do indirect tax rates need to be adjusted? Is there scope for improvements in tax administration? And so on.
The second puzzle is the continued sub-optimality of institutions for management of public finances, including basic accounting and fiscal planning, as well as tracking expenditures and making timely adjustments as needed. Even the World Bank’s funding of projects to improve the states’ basic financial management has not made clear how to fix these systems, what has been accomplished, and how to diffuse the lessons. Credit markets require transparency, and market discipline can be difficult if transparency is poor or absent.
The third puzzle is how to handle political economy constraints. India’s states are too big to fail, so markets expect that state governments will be bailed out. How else can states be incentivised to avoid getting into fiscal trouble? The Centre and several Finance Commissions have struggled with ways of changing incentives. Beyond the structural challenges of the first two puzzles, there may need to be a deeper restructuring to improve management of public finances, including better alignment of revenue authority and expenditure responsibility, especially for states and cities.
To conclude, managing public debt and deficits needs the kinds of rules encapsulated in the JP Morgan pillars. But how those rules play out when economic growth is a key objective — but is affected by the quality of government revenues and expenditures, not just their aggregate balance — also requires attention to other aspects of fiscal architecture. These are old debates, especially at the level of developing countries when they have been pushed towards fiscal austerity by international financial institutions. Of course, global capital has even more of a say in these matters than these institutions, and fiscal management is always important in such a world. But India’s attention to fiscal architecture has to encompass much more than the five JP Morgan pillars.
The author is a Professor of Economics at the University of California, Santa Cruz.
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