Everything you always wanted to know, but were too afraid to ask
The activity rate is the ratio between the active population and the population over 15 years of age. And what is the labor force? According to the Indian Economic Monitoring Center, the labor force is made up of people aged 15 or over who are employed or unemployed and are actively seeking employment.
A declining labor force participation rate means that many people who cannot find a job stop looking for one and are not counted as part of the labor force. As a result, available jobs have not increased at the rate that could accommodate new individuals, men and women, entering the labor market. The drop in female labor force participation has been enormous.
In this scenario, there is pressure on politicians to do something. The Pradhan Mantri Kisan Samman Nidhi is the result, as are other income support programs and food subsidy programs. On the other hand, seen gifts also become a selling point for a politician to stand out from others around them.
The cost of freebies
There is no free lunch in economy. Every freebie – meritorious or not meritorious, visible or not – must be paid for. The money for this comes from taxes collected by governments as well as from their borrowings. We saw earlier that the lower corporate tax rate forced the central government to increase excise duties on gasoline and diesel, which we all end up paying.
Also, consider the case of business loans that default and then write off. The central government, as the major owner of public sector banks, had to constantly recapitalize these banks in order to keep them in business. And this recapitalization costs money.
Before October 2017, the government would set aside money in the annual budget to recapitalize these banks. Of course, the money going to these banks could easily have gone to something else. It was the cost of forfeiting or the inability of the system to recover business loans that had not been repaid.
Since October 2017, things have changed. The government issued recapitalization bonds to recapitalize public sector banks. Essentially, the government issued bonds which were purchased by public sector banks. The government then used this money to recapitalize these banks. In short, this is how the government borrowed deposits from the banks and reinvested them in the banks. This has helped the government control its budget deficit.
This way of recapitalizing public sector banks is what economists have called neutral budget. To that extent, the government was not spending tax money or borrowing money to recapitalize these banks. It was simply postponing the problem.
According to the union budget, in March 2022, the government issued recapitalization bonds with a total value of Rs 2.79 lakh crore. These bonds pay an interest of 6 to 8% per year. The interest paid by the government is taken from the annual budget. However, the first of these bonds does not mature until 2028 and the bonds continue to mature until 2036.
When the bonds mature, they will have to be repaid and for this the central government will have to make annual allocations in the budgets of those years. Therefore, the idea of recapitalization bonds kind of kicked the problem of bad debts. Instead of allocating money to recapitalize the banks each year and, in doing so, widening its budget deficit, the government decided to sell bonds, which they would have to repay in the coming years.
Again, this is a clear example of why every freebie has a cost associated with it, whether the cost is paid now or in the future, as is the case here.
Funding for freebies
The financing of the waived gratuity is not very transparent, since the cost of this gratuity has been deferred. Now, as long as the financing of the gifts is transparent, there should be no problem.
The 15th Finance Committee said a state government’s budget deficit limit should be 4% of its gross domestic product (GDP) in 2021-22, 3.5% in 2022-23 and 3% in 2023-26. This was accepted by the central government. The budget deficit is the difference between what a government earns and what it spends, and is largely financed by borrowing.
The RBI in its latest report highlighted that state government finances are expected to improve in 2021-22, with the budget deficit narrowing to 3.5% of GDP from 4.7% in 2020-21 . In fact, as the report points out: “Available provisional accounts (PA) data for 26 states for April-February 2021-22 indicate that their consolidated gross fiscal deficit was 31.5% lower than a year ago. a year”.
State governments may be driven to meet the budget deficit target simply because they require prior central government approval.
So state finances according to RBI seem to be in a position they should be. So what’s the problem ? It seems that some states finance their spending by borrowing off budget and without accounting for it. In reality, that in mid-July, Finance Secretary TV Somanathan made a presentation to chief secretaries of state governments in which he said that states were mortgaging city parks, hospitals and other public offices to take out loans.
These off-budget borrowings – where principal as well as interest must be repaid from state governments’ budgets – are not reported against a state’s net borrowing limit as prescribed by the central government. This leads to a situation where the total outstanding borrowings of a state government are not correctly reported. It also leads to under-reporting of the budget deficit, since spending financed by off-budget borrowing would otherwise have ended up on budget.
In fact, the central government has followed this process of off-budget borrowing for many years, having the Food Corporation of India borrow to finance food subsidies. This has led to the under-reporting of global borrowing as well as the central government budget deficit. But the central government has cleaned up on this front.
Another report in points out that “five states – Andhra Pradesh, Uttar Pradesh, Punjab, Madhya Pradesh and Himachal Pradesh – raised up to Rs 47,316 crore in the two years ending March 2022” through this method.
Obviously, this is the main problem at the heart of the whole issue of freebies. A few states, notably Andhra Pradesh and Punjab, are at the heart of the problem. As recently pointed out: “Giveaways exceeded 2% of State Gross Domestic Product (GSDP) for some of the highly indebted states such as Andhra Pradesh and Punjab.”
And that needs to be sorted. These States must be invited to correctly declare their expenditure as well as their global borrowings.
As for the freebies, many economists and journalists have cited the RBI report to paint all state governments with the same brush. But almost none of them mentioned that the report also indicates that “the financial risks associated with gifts [faced by the five most indebted states] seem to be moderate in the case of these states, with the exception of Punjab which spends a lot on the provision of free public services”.
So there is a problem. Nevertheless, it is not as universal as the narrative emerging around the issue makes it out to be.
Once state government figures are reported correctly and there is no off-budget borrowing, a state government can only spend a limited amount in any given year and cannot not go beyond. This will automatically limit the temptation to suspend a freebie unless the government has the capacity to fund it in that given year.
There is a call to define what a freebie is. As we saw earlier in the article, the problem is that it is difficult to define exactly what is a gift and what is not. In fact, as we have seen, what was seen as a giveaway when launched at the state government level has turned into central government policy over the years.
Also, a freebie is a political choice between the government of a state and the people who elected it. The Supreme Court suggested that “suggestions on how to control gifts from political parties during campaigns” be put in place. The problem with this whole argument of trying to define a giveaway is that it views voters as unsophisticated. And it is wrong.
The fundamental point at the heart of this problem is that a few state governments are not reporting their numbers correctly and this needs to be corrected.
Update August 26: The Rythu Bandhu program was initiated by the government of Telangana, not Andhra Pradesh. This has been corrected.
Vivek Kaul is the author of Bad Money.