It has been reported that the Comptroller and Auditor General of India is considering ways to take a more holistic view of the financial sustainability of state budgets. The Liz Truss government in the United Kingdom fell owing to fiscal concerns. A CAG audit is a step in the right direction. However, as seen in the UK, a well-functioning bond market can sometimes be more brutal and effective in taming government profligacy.
Caring about the fisc
It takes money for a government to function. Salaries and electricity bills have to be paid. Capital expenditures have to be incurred on building assets in the hope that they will bring economic growth. All of this is largely financed through taxes and other revenues. If they fall short, as they usually do, the government has to borrow. It is possible that the debt becomes so large that most revenues get spent on servicing it and not on incurring developmental expenditure. Excessive debt can further dampen economic growth and lead to higher taxes in the future and inflation. This is why we worry about government finances and insist that the spending is in line with revenues. In 2003, India enacted the Fiscal Responsibility and Budget Management (FRBM) Act, which came into effect in 2004. The Act required the Union government to keep its revenue and fiscal deficits below certain thresholds. By 2010, all states had also enacted their own FRBM Acts.
CAG audits and off-balance sheet exposures
Under the Constitution of India, the CAG is authorised to conduct an audit of the finances of the government(s). It studies where governments spend money, how they manage debt, and whether or not constitutional provisions relating to budgetary management are being adhered to. Evaluating if fiscal deficits are within thresholds specified under the FRBM Act is another objective of the CAG audits. The findings of the CAG tell the legislature whether money is being spent as it was meant to, whether deficits are contained, and if not, where the gaps are. It is a way for the legislature to get a report card of the executive.
The CAG audit of Union accounts for 2017-18 and 2018-19 found gaps in some accounting practices. It showed that the Union government had been undertaking spending from “extra budgetary resources” that do not show up in the standard fiscal calculations. For example, the debt is raised by a State-owned enterprise so it doesn’t show up on the government’s balance sheet. But since it is expenditure incurred by the government, ultimately, it has similar fiscal implications. Such obfuscation also dampens the credibility of the government.
Also read: Why are Bihar, Punjab, Rajasthan fiscally stressed? Every state has its own root cause
The true fiscal burden
It seems that now it is the turn of the state governments who are raising loans through their own enterprises and mortgaging state assets. Off balance sheet borrowings have reached a high of 4.5 per cent of gross state domestic product (GSDP), so much so that the Union government had to exhort them to come clean and allow for further borrowings only after full disclosures of their off balance sheet liabilities.
The discussion so far has only been on explicit borrowings by the state. However, governments often make promises of payments deep into the future, such as their pension obligations. They also provide implicit guarantees to certain institutions — if these fail, then governments are likely to step in and bail them out. Other examples include the wage indexed pension promises for the armed forces, health insurance promises through government-funded programmes, or the cost of recapitalising banks should they get in trouble. If one were to correctly measure state finances, then these liabilities need to be taken into account.
The State and the market
The CAG reports do not penalise governments for fiscal irresponsibility. They can, at best, shine light on the functioning of the executive. It is only when the government has to go to the market to borrow for its expenditures that it has to bear the cost of its excesses. If you are deep in debt and unable to even service your earlier obligations, you can expect that the only people who will lend to you will do so at a higher interest rate. This is, in some sense, the penalty that Liz Truss had to pay for being reckless about the impact of her policies on the budget. The bond markets went for a spin, and the Bank of England had to step in to calm the waters.
Why do our bond markets not penalise the government? This is because we don’t have a true market. We force our financial institutions to purchase government bonds, making them a captive audience for the government. If an insurance firm or pension funds investment guidelines require that contributions be largely invested in government bonds, then there is not much scope for these institutions to walk away. The government has to make no effort to persuade investors to lend to it. It just forces them. Until we reform our bond markets, we will have to rely solely on mechanisms like the CAG to point to the problems and hope that it persuades us to do things carefully.
The author is an associate professor at the National Institute of Public Finance and Policy (NIPFP). She tweets @resanering. Views are personal.
(Edited by Humra Laeeq)