Freebies are a passport to tax disaster
India is a Union of States. It is not a confederation of states. It is not a question of holding together but of coming together. The Union is indestructible. The configuration of the States which constitute the Union may change. The Union is therefore an integral part of both the Center and the States. The strength of the Center lies in the strength of the States.
Consequently, the macroeconomic stability of the Union depends on the macroeconomic stability of the Center and of the States. That is why, grappling with the complex issues of the Fifteenth Finance Committee, of which I was Chairman, we have devoted all of Volume IV to the States. Each statement in this volume of the report has been analyzed at length. The same goes for their individual deficits, debts, and macroeconomic stability, which includes the development challenges that each of the states faces.
The political dialogue built around gifts is strewn with pitfalls. There is great ambiguity in what “free” means. A distinction must be made between the concept of merit goods and public goods on which disbursed expenditures have global benefits. The strengthening and deepening of the public distribution system, job guarantee programs, support for education, and increased health spending, especially during the pandemic, are examples. All over the world, these expenses are considered desirable expenses.
Therefore, it is not a question of how cheap gifts are, but how expensive they are for the economy, quality of life and long-term social cohesion. We must fear the idea of reproducing the culture of competitive free politics. We must take the path of achieving higher rates of economic growth. The race for efficiency is the race for prosperity.
There are seven reasons for this. First, the giveaways undermine the basic framework of macroeconomic stability. The gift policy distorts spending priorities. Expenditures focus on grants of one type or another. So what does this mean for the fiscal sustainability of already over-indebted states?
As an illustration, in the case of Punjab, although estimates vary, some have speculated that the pledge could cost around Rs 17,000 crore to implement. If we take into account everything that has an impact on the debt ratio of Punjab, there will be an additional impact of 3% of the GDPS. As we know, Punjab’s debt to GDP ratio is already at 53.3% for 2021-22, which would get worse due to these new measures.
Second, there is the question of the distortion of the priority of expenditure. Take, for example, the move to the new contributory pension plan from the old plan, which had a fixed return. Rajasthan has announced that it will revert to the old pension scheme. This decision is regressive because the abandonment of the old regime was based on the fact that it was inherently unfair. Rajasthan’s pension and salary income accounts for 56% of its tax and non-tax revenue. Thus, 6% of the population, made up of civil servants, would benefit from 56% of state revenues. This is fraught with dangers not only of intergenerational inequality, but also affects broader principles of fairness and morality.
Third, the issue of intergenerational equity leads to greater social inequalities due to the distortion of spending priorities away from growth-promoting elements.
Fourth, get away from the environment. When we talk about gifts, it is in the context of providing, for example, free electricity, or a certain amount of free electricity, water and other types of consumer goods. This diverts spending away from environmental and sustainable growth, renewable energy and more efficient public transport systems.
Fifth, the distortion of agricultural priorities. This affects agricultural practices that do not depend on intensive use of water and fertilizers. Depletion of the groundwater supply is an important issue to consider when discussing gifts relating to free consumer goods and resources.
Sixth, its debilitating effect on the future of manufacturing. Freebies reduce the quality and competitiveness of manufacturing by undermining an efficient and competitive infrastructure that enables high-factor efficiencies in manufacturing.
Seventh, it raises the question of whether the time has come to consider recourse mechanisms such as
bankruptcy. The giveaways challenge the market differentiation between profligate and non-prodigal states and whether we can have a recourse mechanism for subnational bankruptcy.
The race to the bottom involves government deregulation of markets and businesses. This ultimately means that states are competing to outbid each other when it comes to cutting taxes, spending, and regulation. Rather, we must fight for a race for efficiency through laboratories of democracy and blood federalism where states use their authority to harness innovative ideas and solutions to common problems that other states can emulate.
The gift economy is invariably wrong. John Maynard Keynes said, “It’s okay to be wrong sometimes, especially if you find out quickly. In this case, it was quickly discovered that the economics and politics of gifts are deeply flawed. It’s a race to the bottom. Indeed, it is not the path to efficiency or prosperity, but a quick passport to fiscal disaster.
The writer was chairman of the 15th Finance Commission. Edited excerpts from a speech delivered at the Delhi School of Economics Annual Day Celebration on April 19, 2022