States, as well as the average citizen, seem to regard the Center as Santa Claus. Even economists forgot to worry about debt and wanted more fiscal spending during the Covid-19 pandemic. But the whole world is suffering the consequences of overspending by the United States. Sri Lanka brought home the risks of over-indebtedness to fund the grants. Yields can soar and foreign funds dry up for emerging markets (EM). The Indian government’s debt-to-GDP ratio is about half that of advanced economies, but its interest payments ratio is more than double theirs. These payments gobble up almost half of the revenue.

The alternative of taxing more is not acceptable. A common view is GoI must give. And what kind of gift is it if it is taxed? But that is precisely the point. If the government gives to someone, it must take from someone else. Either directly, through taxes, or indirectly by taxing citizens through inflation, or by crowding out private borrowing and making debt unsustainable as interest rates rise with borrowing. India’s narrow tax base and huge population make matters worse.

Increasing productivity and growth is the only way to generate more resources. Unfortunately, the “gifts” reduce the government’s productive expenditure. Second, they distort both production and consumption decisions. Over-irrigation induced by free electricity and the choice of rice cultivation contributed to the highest increase in debt and reduction in capital expenditure in Punjab.

One of India’s biggest failures is in the provision of public services. This has limited economic inclusion despite full political inclusion. The quality provision of quasi-public goods such as education and health, requiring good quality air, water and sanitation, are the main merit goods that build capacity. These are redistributive and have significant externalities, so the private sector does not provide enough. Price caps on essential public goods and services, in the context of large cost shocks from the 1970s, reduced their quality. The poor, who depend on these services, have been more affected.

Health and basic education dominate state subsidies. But the quality is so poor that even the poor avoid using public facilities. With low confidence in the public sector, reforms blindly seek to reduce the size of government. But some services are essential. Costa Rica is the only MS in the list of the 20 “happiest economies”. Excellent public services include local primary health care teams that go to people’s homes for preventive actions.

powerless electricity

Improving public services requires decentralization and capacity building at the third level, where accountability to the user is higher. User fees and property taxes can be elastic sources of revenue, but states prefer subsidies such as electricity. Low prices without adequate state payments have tainted power generation. Repeated restructurings have increased state debt, while central bailouts have perpetuated mispricing and reduced state tax effort.

In line with the Santa theory, a persistent myth is that the Center could give more to the states. But the independent Finance Commissions (FCs), whose constitutional goal is to distribute tax revenues equitably between the Center and the states in order to standardize basic public services, protect the rights of the states. It is efficient for the Center to collect elastic taxes such as income tax. Otherwise, migration could reduce the tax base of states.

Constitutional limits on states’ borrowing capacity are also necessary for macroeconomic stability. Off-budget loopholes used are closed, as they should be. All taxes were made shareable in the 2000s, except for surcharges and surrenders. A big grunt is that these latter components have gone up. But so is spending on centrally sponsored schemes (CSS) that seek to compensate for states’ poor delivery of essential services.

After the 73rd and 74th Constitutional Amendments, state-level laws can be passed to delegate funds, officials, and functions to the third level. But all parties seem reluctant to share power. Many states have not even established state finance commissions, requiring the CF to provide certain funds, which are limited to grants.

Competitive populism worsens outcomes for all. Gifts intended to attract voters reduce state resources, waste taxpayers’ money and increase the cost of elections. Even better, there is no evidence that they actually increase the chances of election. But the fear that one party will win by promising gifts compels all parties to do so. The solution is institutional strengthening, limiting the temptation to make such offers.

Parties must be free to make promises to the electorate. But any plan must have details of how it will be funded, including the cost to the taxpayer. Any of the current constitutional bodies of India can impose such conditions. A budget council could be mandated to improve transparency and promote the convergence of accounting procedures within the States.

Overfunded Freebies

Raising voter awareness will have an impact on political strategies. Regulators must be strengthened, with the power to interfere in prices taken away from governments. Then the parties can start competing to provide better public services. There is now the possibility of direct transfers for the truly vulnerable.

The government tends to have too few employees in some categories and departments, and too many in others. Restructuring and partnerships with the private sector based on comparative advantage would improve public services. CSS as well as multiple state-specific schemes should be streamlined with the best scheme being funded.