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A Non-Merit Subsidy Regime Hurts State Finances

The elected representatives are the trustees and not owners who can spend funds in a way that benefits them.

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The Sri Lankan crisis is staggering. It’s likely to get worse before it gets better. There are lessons in it aplenty.

Also, there are several reasons why our neighbour is sailing (barely) this boat. Some of these reasons are complex, but many are simple. But at the core of it are economic mismanagement, administrative failure and political ambitions. Some politicians seek grandeur. Others focus on populism and don’t look beyond the next election. Advisors and economists nod when they should say ‘no’. They too must share a major part of the blame.

The terrorist attacks of 2019 contracted Sri Lanka’s tourism industry. The pandemic compounded the pain. It also plugged the flow of remittances and intensified the crisis. This contributed to the frailty of an economy running on ‘borrowed’ money. The Ukraine war deepened an already dire situation and choked the economic engine.

The Sri Lankan economy has got where it is because its establishment wanted to simulate ‘welfare’ out of trouble. Tax cuts to stimulate (buy votes) consumption was ‘doomed’ to fail. It is risky to do so in a small, ‘concentrated’ and inward-looking economy. The domestic industries are frail and inefficient. They don’t export, nor can they do so.

Lack of funds choked the pipeline to the ‘promised’ welfare schemes. If this wasn’t bad enough, the ‘Tughlaq’ like move to switch to organic farming resulted in widespread crop failure. Sri Lanka had to import agricultural products, which exacerbated its foreign currency crisis.

What happens next, and how the Sri Lankan economy is managed will either serve as a useful example for other economies at risk or be a warning worth heeding.

*‘Welfarism’ is a currency to win elections. Unethical. Now proliferating

India’s economy is strong and does not suffer from any of the malignancies of that of its neighbour. The structure and the constituents of the economy provide strength. Well-established institutions, strong and agile regulators ensure stability.

However, there are warning signals.

Democracy is at risk when the electoral manifestoes ignore ‘economy and development and seek votes on freebies and non-merit subsidies. This exacerbating culture of translating ‘gratitude into votes’ is a misallocation of people’s resources. It hurts the intended beneficiaries and is unethical.

The vulnerable, and the deserving, such as marginal farmers, the poor and women, must be supported. While investment in health, education and infrastructure are multipliers of growth, free electricity, bus passes, bicycles, laptops and television sets evidently are not.

‘Welfare’ spending is over half of what some states ‘earn’. Non-merit subsidies constitute a fourth. A good percentage of this comes from ‘borrowed’ funds.

*Alarming. Caution ahead

Sample this. Punjab, Andhra Pradesh, Bihar, Kerala, MP, and West Bengal, each have huge and unviable debts as a percentage of their gross state domestic product (GSDP). In the case of West Bengal and AP, the debt is about a third of their GSDP. The percentage of Punjab’s debt to its GSDP is about 50 per cent. The acceptable ratio is 20 per cent.

Some states comfort themselves that debt is good when the growth rate is higher than the outgoing interest rate. It is not. Especially when other economic indicators are less flattering. The high debt-laden-low revenue earners end up paying a tenth of their earnings as interest. In Punjab’s case, the interest outgo is equal to 21 per cent of its revenue earnings. West Bengal is in a similar band.

Three-fourths of Bihar’s income comes from devolution (GST, other taxes) and grants. Only a fourth is earned by the state and yet, it continues to ignore investment in economic growth drivers. Kerala’s ‘committed’ expenditure (salary, interest, pension, administrative) is about 40 per cent of its income. Punjab spends about 50 per cent of its earnings. These numbers must worry us.

Rajasthan (sitting on a burgeoning debt) and Chhattisgarh are reverting to the old pension regime ‒ frittering away the present and, ‘cashing in’ on what belongs to the future. This will benefit six per cent of the families and cost these states about 50 per cent of their tax and non-tax revenue. It will worsen their financials and may deepen the states’ financial crisis.

Some states spend over 85 per cent of their income on ‘revenue’ expenditure (‘committed’ plus welfare spending), denying funds for development, asset building or infrastructure. Punjab spends only six per cent of its income on capital expenditure, (growth and development) Kerala spends eight per cent, and West Bengal and Rajasthan spend 10 per cent. Punjab and Kerala have had a declining tax revenue for the last five years and their non-tax revenue has been volatile.

*Capital expenditure must be channelised, linked, and monetised, to add value.

Our erudite readers must look further and deeper. 

States like Madhya Pradesh and Uttar Pradesh spend about 20 per cent of their earnings on capital expenditure. However, it’s not the capital outlay but the impact that drives growth. There have been cases of massive infrastructure projects that were never completed. Many others were delayed and some were not linked to the ‘last mile’. These assets subtract value and are a drain on the economy.

Investment channelised effectively, has the potential to trigger private investments that boost output, employment, and productivity. It’s a true multiplier.

Free and non-merit subsidised power is an attractive election slogan. And works. The power sector needs reforms, which unfortunately is contingent upon a transparent and merit-based power subsidy framework, which gets stalled by vested interests. 

The other lesson from Sri Lanka is the importance of holistic and diversified growth. The Ukraine war and the pandemic have accentuated the point that excessive dependence on a few sectors or concentrated revenue sources (remittance, agriculture, tourism etc.) hurt during unfavourable times.

The state governments are more than economic entities and owe it to the people to strengthen their fiscal position. They must reform, create assets, and invest in high multipliers. Similarly, they must strengthen the governance structure of the civic bodies, panchayats, and other service providers and empower them to generate resources. This will make them resilient and effective in serving the people. Also, less reliant.

The overarching economic goal of any government must be to ensure an enabling ecosystem that creates growth opportunities. Growth enhances tax and other revenues. This must be ploughed back into multipliers like education, and health, the key to several inclusive indicators and upward mobility. Similarly invest in hard infrastructure (roads, telecom network) connecting rural-urban, and a platform to growth and inclusion.

*Citizens ultimately pay the price.  Always

The elected representatives are the trustees and not owners who can spend funds in a way that benefits them.

People have a role to play. The next time political parties promise, or the government ‘showers’ freebies like free electricity etc. the voters must ask for the source of funds. If there is silence, assume that the funds will come out of the tax the citizen has paid or will be compelled to pay for these freebies.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.

Dr. Vikas Singh

The author is a senior economist, columnist, author and a votary of inclusive development

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