The Menace Of Rising Public Debt: Should India Be Worried?

In its latest working paper, authored by Barry Eichengreen and Poonam Gupta, the National Council of Applied Economic Research (NCAER) focused on the debts accumulated by state governments.

State debt burdens vary from less than 20 per cent of corresponding state GDPs (in states like Odisha, Maharashtra and Gujarat) to almost 50 per cent (Punjab).

If the current trend continues, the paper estimates that most states will be more indebted around 2027-28. The fiscal conditions of more indebted and less indebted states will also continue to diverge. In other words, the more indebted states will borrow more, and the less indebted will borrow less.

There is, of course, a strong case for reforms to strengthen fiscal discipline at the state level through a set of recommendations.

Missing Element Of Fiscal Federalism

Though the discussion mainly revolves around fiscal prudence of the state governments and does not discuss fiscal federalism, the issue of centre-state revenue is intricately linked to the subject.

There is a large vertical gap in revenue and expenditure between the states and the Centre. The state governments collect roughly a third of total public revenues but spend about two-thirds of total public expenditures.

After the advent of the centralised goods and services tax (GST) in 2017, state governments are left with fewer ways to mobilise finances on their own.

Apart from relatively smaller revenues under heads like stamp duty, property tax, land revenue and motor vehicle tax, the bulk of state-specific revenues are now generated from excise duty on alcoholic beverages and value-added tax (VAT) on petroleum products.

On top of all these, the trend of the central government introducing new cesses and surcharges, has resulted in a decline in the states’ share of gross tax revenue. Legally, revenue generated from central cesses and surcharges is not to be shared with the states.

As a result, the share of states in total combined tax revenue dropped to 30 per cent in 2023-24, from 35 per cent in 2015-16.

This trend undermines the fundamental logic of fiscal federalism by further curtailing the fiscal autonomy of the state governments. In any case, India’s Centre-state structure is a quasi-federal one, with a stronger central government holding more power than the states.

So, any discussion on the mounting debt of different state governments has to be contextualised in this light.

Three Phases Of Government Debt Surge

The share of state governments’ debt in total government debt increased from around 30 per cent to 40 per cent of GDP between 1991 and the mid-2000s. However, in recent times, the states’ share has once again gone down to 34 per cent of the GDP, aggregated across states.

State debt ratios have progressed in tandem with the central government debt. In the last three decades, there have been three major episodes when the combined general government debt-to-GDP ratio spiked considerably.

During the first phase, between 1996-97 and 2003-04, the combined debt-to-GDP ratio increased by 19.2 percentage points. The debt ratio of the states increased by 12 percentage points in this phase while that of the Centre rose by 7.2 percentage points.

The second phase was from 2014-15 to 2019-20. During this phase, the combined debt ratio increased by 8.6 percentage points. While the Centre’s debt-to-GDP ratio increased by 3.7 percentage points, the debt ratio of all states rose by 4.9 percentage points.

The third phase, between 2019-20 and 2020-21, was due to the pandemic. The combined debt-to-GDP ratio jumped by 14.1 percentage points within a year. As the central government did the bulk of the spending in this period, it accounted for a 9.7 percentage points increase, while the state debt ratio increased by 4.4 percentage points.

Reasons Behind Growing Government Debt

Higher primary deficits, a less favourable interest-rate-growth-rate differential and higher contingent liabilities are three major reasons behind the state government debt going up at the aggregate level.

The primary deficit shows the current difference between the government’s revenue and spending, excluding interest payments on debt. Fiscal deficit figures consider interest payments.

A situation, when the primary deficit is zero but there is a fiscal deficit, implies present government borrowing is done to pay-off the interest on previous debts. So, the primary deficit is an indicator of the current fiscal health of the government, while the fiscal deficit represents the cumulative borrowing requirement of the government.

The average annual fiscal deficit for the Centre between 1990-91 and 2022-23 was 5.2 per cent of GDP, during which, the overall fiscal deficit of the states stood at 2.9 per cent. The central government’s average primary deficit during this period was 1.5 per cent of GDP, while the average for state governments was 1 per cent.

So, there have been attempts by the state governments to bring fiscal prudence, but possibly more is needed to be done.

The difference between the borrowing interest rate and the growth rate of GDP (called the nominal effective interest rate) determines how quickly or slowly a country’s public debt rises or falls relative to its output. Any economy desires a relatively lower differential in this regard.

The state governments faced relatively higher effective interest rates (compared to growth rates) till the mid-2000s, but since then it has declined. The average effective interest rate for the states between 2000-01 and 2022-23 was 8.1 per cent, while that of the Centre was 7.7 per cent. The data shows that the states incur more borrowing costs compared to the central government.

Contingent liabilities represent the potential future financial obligations of a government. A project with a government financial guarantee can be a good example. Though the government does not have to pay anything immediately, it may have to in future if the project fails.

While contingent liabilities of both central and state governments diminished in the last two decades, the states’ contingent liabilities continue to exceed the Centre’s.

This underlines the rising trend of state government underwriting projects and possibly implementing central schemes and projects with more state-specific financial guarantees.

Composition Of Government Debt

The composition of debtors of the state governments has changed in recent times. The share of the market borrowings by the states has risen from around half (51.4 per cent) of total state debts in March 2018 to close to two-thirds (66 per cent) of the total in March 2024.

Banks, insurance companies and provident funds are major holders of these marketable securities. These institutions invest in government securities mainly due to statutory requirements. Public sector banks are the largest category within this class of institutions.

In non-market debt to the governments, the National Small Savings Fund (NSSF) is the biggest contributor. The central government’s borrowing from the NSSF has increased from 15.4 per cent of the total in 2017-18 to 17.5 per cent in 2021-22.

However, state governments’ borrowing from the NSSF has dwindled by more than half in the same period, with the gap bridged by market-linked borrowings. The Centre’s market borrowings, on the other hand, have slightly decreased from 66 per cent of the total in 2017-18, to 63.6 per cent in 2021-22.

This signifies greater reliance of the state governments in recent years on market borrowings — from banks, insurance companies and provident funds. Of course, the cost of these borrowings will be relatively higher.

Another notable feature of the state debt composition is the rise in loans from the Centre. After the advent of the GST, the central government started collecting a compensation cess to compensate states for their revenue losses. However, the collection fell short in 2019-20 and subsequent COVID years.

As a result, the Centre started borrowing the requisite amounts and release those to the states through back-to-back loan facilities. These loans, along with 50-year interest-free loans distributed to the states for capital investment during COVID, pushed the loans from the Centre to the states up again to 7.2 per cent of the total in 2021-22, from 3.8 per cent in 2017-18.

So, claiming that the state governments resorted to fiscal profligacy, resulting in higher debts for the states, would be a sweeping statement. For a few states, it may be true, but for the rest, the reality is much more complicated and nuanced. Factors like dwindling flexibility of the state governments in levying taxes, past burden of indebtedness and growing pressure of population growth (for some states) play a role in their rising debt burden.