Should states that spend irresponsibly be penalised?

Table of Contents

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.