By R Gopalan & MC Singhi

The debate on welfarism and freebies has attracted attention of late, especially when state government finances have recently not been in good shape. We assess here how the state governments have fared on freebies/welfarism and make suggestions on how to approach the issue.

As their core function, governments are generally expected to provide a legal framework for economic transactions. They have, however, also assumed a responsibility for welfare by producing goods and services, distributing them, redistributing income etc. Such welfarism is generally offered through the social and economic services of the state governments and specific allocations are made in their respective budgets.

There is a difference of opinion at various levels on whether many of the freebies or welfare programmes are necessary. RBI feels that the freebies are public welfare measures that are provided free of charge and which can be distinguished from public or merit goods. There can be an element of subjectivity assessing the programmes on these criteria. The political system has the final say on what type of expenditure is to be incurred and how are the resources raised for these. A welfare programme in one state can be a freebie in another. Instead of making value judgment, one can consider if the objective is to restore the health of the state finances and reduce the spread of such programmes. In such cases, it may be appropriate to look at the expenditure and revenue from social and economic services that the states provide and see how the gap can be covered. One method for doing so is recovering costs through user charges.

Some questions arise in this regard. Is allocation to such programmes optimal and does the amount go to the actually needy? Does the government have resources to undertake such welfare measures? By such allocation, does the government encourage the excess use of resources? While looking into this issue, the Eleventh Finance Commission suggested cost-based indexing of user charges. The subsequent Finance Commissions were of this view too.

We computed the recovery of user charges of the states for four five-year periods—2001-2006, 2006-2011, 2011-2016 and 2016-2022 (6 years). It was observed that the recovery rates witnessed a declining trend from 2006-07. The recovery rates from social services showed an upturn during 2012-2016. In economic services, a clear inverted U-shaped pattern was seen, which increased till 2003-04, and fell thereafter.

A clear deceleration in growth was visible in the decade 2011-22 across receipts, growth of revenue from social and economic services, and cost recovery. Meanwhile, the structure of expenditure, as indicated in the share of receipts and expenditure, did not undergone any change. On the contrary, the combined cost recovery for both social and economic services was below 10% during this period.

An overall revenue deficit could also be seen during 2001-06, followed by years of revenue surplus. From 2013-14 onwards, the states had a persistent revenue deficit. The finances of the states thus witnessed continued deterioration post 2013-2014. This had very little to do with the transfer of resources, per the Finance Commissions. From 29% in 2005, transfers now stand at 41%. There has been a sharp deceleration in revenue receipts of the states in 2012-22, especially their own revenues. On the other hand, expenditure grew at 1.5 times the revenue growth on an annual basis. If cost recovery of 10% for social services and 30% for economic services was attempted, revenue deficit became zero in this period. The best solution is the states deciding the percentage of cost recovery for each social or economic service based on their respective political philosophies, so long as cost recovery on social and economic services are achieved to make the revenue deficit zero. The fiscal situation of the Centre was also not good post 2012-13, as revenue buoyancy remained at just 1%. As utilities and freebies are provided at the state level, we have considered the health of the State finances only.

Large interstate differences in cost recovery and per capita expenditure on social and economic services were observed. The cost recovery we talk of is only on the revenue side. The recovery rate as calculated by us would go down if we consider return on capital assets.

Cost recovery to offset revenue deficit is critical for maintaining intergenerational equity. Empirically, there has been an increase in freebies, particularly after 2013-14. Some of them are necessary to reduce specific hardships. The Finance Commission also needs to build in their devolution to encourage user charges recovery and it must incentivise the states appropriately. Normative principles in assessment of revenue and expenditure can be considered, so can the penalisation of deficit-generating tendencies amongst the states. Within these parameters, states can decide on which freebie to focus on, so long as there is sufficient cost recovery to make revenue deficit zero. This will be the first step in curbing freebies. In the second step, each freebie must have an end date. There should be a permanent institutional arrangement, like the Office for Budget Responsibility (OBR) in the UK, which can assess the finances of the Centre and the states continuously and see if indicators set by the Finance Commission are met every year. If their assessment reveals that the states have not adhered to the Finance Commission parameters set for them, they would reduce allocation as recommended by the Commission.

As an incentive, a certain percentage of devolution to states can also be earmarked by the Finance Commission, to be allocated based on the assessment by an OBR-like body. This would be given to the states who meet their targets of revenue deficit reduction set by the Finance Commission. As the country develops confidence in the OBR-like body, it may be also tasked to assess the likely financial condition of the states arising out of various poll promises made by major parties and disseminate such assessments through the Election Commission to the voting population.

The authors are former civil servants. Views expressed are personal.