GS Paper III

News Excerpt:

In a recent development, the Government of Kerala has approached the Supreme Court (SC) for a resolution of the following question: How much can the State government borrow from the market to bridge the excess of its expenditures over receipts?

Background of the Case:

• The financial relationship between the Union and various State governments has been a matter of vigorous debate. 
• In the present case Kerala has contended that by curtailing its borrowing powers, the Centre is undermining the State’s ability to fulfil some of its basic financial commitments and violating the principle of federalism.
• The SC has now referred Kerala’s plea for additional borrowing to a Constitution Bench. 

How States Spend More than Union:

• The power to raise taxes rests largely with the Union government while a greater part of the overall government spending is done by the State governments.
• The overwhelming responsibility of spending on the social sector lies on the shoulders of the State governments.
  • On social services, which include health and education, the expenditure incurred in 2022-23 was ₹2,230 billion (1 billion = ₹100 crore) by the Union government while the combined expenditure by all State governments was ₹19,182 billion.
  • The expenditures of all the States put together were bigger than the expenditure of the Union by 8.6 times in social services as a whole; 2.6 times in education; and 3.8 times in health. 
• The spending priorities of the Union and the States are guided by the constitutionally allocated powers and functions for them. 
  • The Union government’s spending on defence was approximately twice as high, while its spending on transport, urban development and energy combined was 2.4 times higher. 

• Developmental and non-developmental expenditure:

• • The Reserve Bank of India (RBI) has categorised the budgetary expenditures by the Union and the State governments as ‘developmental’ and ‘non-developmental’. 
    • Developmental expenditure includes expenditures on social services and economic services (such as on agriculture and industry) 
    • Non-developmental expenditure refers to interest payments, pensions, subsidies, and so on.

Developmental expenditure of the Union and States:

• Developmental expenditures, and within that, the expenditures on social services incurred by the State governments have risen significantly over the last two decades. 
• As a proportion of the country’s Gross Domestic Product (GDP), the combined developmental expenditures by all State governments increased from 8.8% in 2004-05 to 12.5% in 2021-22. 
• On the other hand, the social and developmental expenditures by the Union government remained somewhat unchanged over the two-decade period. 
• The upsurge in spending during the 2008-12 period was reversed over the next eight years, with a brief revival after 2020.
• It was the spending by the State governments that helped to alleviate the livelihood crisis in the country, caused due to the slow growth of rural incomes and employment. 

Kerala’s Example:

• Kerala provides an excellent example of the power of government spending to positively transform a region’s economy and society.
• The expenditure on education, health and other social sectors as a proportion of the total budgeted expenditures by the State government in Kerala ranged between 40% and 50% from the 1960s to 1990s.
• The proportion of social sector spending in Kerala was way ahead of the corresponding average of all other States until the middle of the 2000s.
• A substantial part of Kerala’s budget (6% in 2022-23) is now devolved to Local Self-Governments (LSGs). 
• If the spending by the LSGs on social sectors is taken into account, the proportion for Kerala could still be higher than the average of all other Indian States.

• A sizable chunk of the Kerala government's expenditure on social services is in the revenue account, paid as salaries and for covering day-to-day expenses. 
• The large body of teachers, nurses, and other government employees in Kerala has been a key driver of the State’s social achievements over the decades. 
• The pensions paid to retired government employees as well as to members of the disadvantaged sections (such as the elderly, agricultural workers, and widows) make up 16.4% of all budgeted expenditures by the Kerala government. 
• This is markedly higher than the average proportion allotted for pensions by all Indian States (9.7%). 
• Only 10.6% of Kerala’s budgetary resources were directed to capital expenditure (in 2022-23) which is indeed a matter of concern.

Sources of funds of state governments:

• Own revenues (tax and non-tax); 

• Transfers from the Union government as shares of taxes and as grants; 

• Market borrowings. 

Reasons for the drop in Kerala’s funds:

• In 2020-21, the Kerala government had sharply increased its spending to 18% of its GSDP, to provide economic relief in the wake of the COVID-19 pandemic, aided by the relaxation in borrowing norms then. 
• As a ratio of GSDP, the Union government’s transfers to Kerala declined to 2.8% in 2023-24, significantly lower than previous years, even as the State’s own revenues remained at around 8.0%. 
• This meant that, in 2023-24, the State government could meet its modest budget expenditure, equivalent to 14.2% of GSDP, only by raising the borrowing to 3.4% of the GSDP — which, however, would cross the borrowing limit set by the Centre.
• The Union government has set the ‘Net Borrowing Ceiling’ quantified as 3% of its projected Gross State Domestic Product for 2023-24.

A case for more government spending by the states:

• More Government spending can help Kerala to translate its enormous advantage in the social sphere to advances in domestic income creation.
• Expenditure on higher education and research will help build a facilitative environment for a knowledge-driven economy. 

How can States spend more?

• Given the current state of federal fiscal relations, such an increase in government spending can occur only with greater market borrowings. 
• A large part of the government borrowing in Kerala, as elsewhere in India, is from domestic financial institutions, including public sector banks and insurance companies, which mobilise savings from the wider public. 
• Kerala is a region with a large reserve of private savings, which could be channelled for productive purposes. 

Way Forward:

• The concerns about debt-financed government expenditures are often exaggerated. 
• Keynesian economics has shown that government borrowing can generate a virtuous cycle if the borrowed resources are deployed effectively to create new incomes and jobs. 
• Many of the development dilemmas that Kerala faces today — an ageing population, the large outgo for pensions, and outmigration of its youth — are problems that most other States will also face in the coming years. 
• The Union and the State governments should join hands to ward off these challenges. 
• On its part, Kerala should be able to convince that its borrowing is part of a larger plan to rebuild the economy and not a firefighting exercise to meet immediate financing needs.