GS Notes

6. Economics Notes 21

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Elaborate Notes

Public Expenditure Management in the Post-Liberalisation Era

Public Expenditure Management (PEM) refers to the systems and processes governments use to manage public resources, encompassing budget formulation, execution, and reporting. In the post-liberalisation period (post-1991), the Indian government faced a complex set of challenges in managing its expenditure, driven by the dual objectives of fiscal consolidation and meeting socio-economic development goals.

  • The Infrastructure-Welfare Dilemma: The post-1991 era necessitated significant public investment in physical infrastructure (roads, ports, power) to attract private and foreign investment. Simultaneously, democratic pressures and welfare commitments required substantial spending on social infrastructure and safety nets (health, education, subsidies). As argued by economists like Jean Drèze and Amartya Sen in their work, “An Uncertain Glory: India and its Contradictions” (2013), India’s growth story was often marred by a neglect of human development indicators, creating a persistent pressure for higher welfare spending. This created a fundamental trade-off in budget allocation.

  • Stagnant Tax-to-GDP Ratio: Despite significant tax reforms, such as those recommended by the Raja Chelliah Committee (1991) and later the Kelkar Task Force (2002), India’s tax-to-GDP ratio remained stubbornly low compared to its emerging market peers. The reforms rationalised tax structures but failed to substantially widen the tax base, constraining the government’s revenue envelope and, consequently, its expenditure capacity.

  • Shifting Fiscal Federalism Dynamics:

    • The 80th Constitutional Amendment Act, 2000, based on the recommendations of the Tenth Finance Commission (1995-2000), mandated that all central taxes be shared with the states. This made corporate tax and customs duties part of the divisible pool, reducing the discretionary funds available to the Centre.
    • Successive Finance Commissions increased the states’ share in the divisible pool. The Fourteenth Finance Commission (2015-2020), chaired by Dr. Y.V. Reddy, made a landmark recommendation to increase the share of states from 32% to 42%, the largest single increase ever. While promoting cooperative federalism, this significantly curtailed the Centre’s fiscal space.

  • Adoption of Rule-Based Fiscal Policy: The enactment of the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, marked a shift from discretionary fiscal policy to a rule-based framework. It imposed legal limits on fiscal deficit and revenue deficit, constraining the government’s ability to borrow and spend freely, especially during economic downturns when counter-cyclical spending might be needed.

  • Vulnerability to External Shocks: The integration of the Indian economy with the global economy post-LPG reforms increased its susceptibility to external shocks. The Global Financial Crisis of 2007-08 forced the government to provide a large fiscal stimulus package, which led to a significant deviation from the FRBM targets and increased public debt. Similarly, global trade wars and oil price shocks have direct implications for government finances through subsidies and revenue collections.

  • Challenge of Off-Budget Financing: To circumvent the FRBM constraints, governments increasingly resorted to off-budget financing. This involves public sector undertakings (PSUs) like the Food Corporation of India (FCI), IOCL, etc., borrowing from the market on behalf of the government to fund government schemes (e.g., food and fertilizer subsidies, oil subsidies through “Oil Bonds” during the UPA era). These borrowings are not reflected in the Union Budget, which, as pointed out by multiple CAG reports, undermines fiscal transparency and understates the true extent of the government’s liabilities and deficit.

  • Focus on Deficit Numbers over Quality of Expenditure: The primary goal of the FRBM Act was not just deficit reduction but also fiscal correction by reorienting expenditure from revenue (consumption) to capital (investment). However, in practice, governments often resorted to cutting capital expenditure—which is easier to cut than committed revenue expenditure like salaries and pensions—to meet the fiscal deficit targets, thereby compromising long-term growth potential.

Government Responses and Fiscal Consolidation Measures

  • Strategic Disinvestment: The government shifted its approach from minority stake sales to strategic disinvestment, which involves selling a majority stake (≥51%) along with management control to a private entity. The privatisation of Air India in 2021 is a prominent example. The rationale, as articulated by the NITI Aayog, is that this not only generates non-debt capital receipts but also improves the efficiency and competitiveness of the enterprise.

  • Behavioural Economics and “Nudge” Techniques: Influenced by the work of Nobel laureate Richard Thaler (“Nudge,” 2008), the government has employed behavioural insights to achieve policy objectives. The “Give It Up” campaign (2015) successfully persuaded millions of affluent households to voluntarily surrender their LPG subsidies. The “Selfie with Daughter” campaign aimed to address gender bias, reflecting a low-cost, non-coercive approach to social change.

  • Inflation Targeting: The formal adoption of a flexible inflation-targeting framework in 2016, through an agreement between the Government and the RBI, aimed to keep inflation within a band of 4% (+/- 2%). This helps in managing public expenditure, as controlled inflation reduces the pressure on the government to increase subsidies (e.g., food, fertilizer) and dearness allowances, thereby contributing to fiscal discipline.

The FRBM Framework and Its Evolution

The FRBM Act, 2003, institutionalised fiscal discipline. It mandates the government to place several key documents before Parliament along with the Union Budget to ensure transparency and accountability.

  • Documents Required Under FRBM:

    • Medium-Term Fiscal Policy Statement: Sets out a three-year rolling target for fiscal indicators.
    • Macroeconomic Framework Statement: Provides an assessment of the economy’s prospects.
    • Fiscal Policy Strategy Statement: Outlines the government’s strategic priorities regarding taxation, expenditure, and debt management.
    • Medium-Term Expenditure Framework (MTEF) Statement: Mandated by an amendment in 2012, this provides three-year rolling targets for expenditure, broken down by department, aiming to better integrate the budget with long-term fiscal goals.

  • Evolution of FRBM Targets:

    • FRBM Amendment Act, 2012: Set targets to eliminate Revenue Deficit (RD) and reduce Fiscal Deficit (FD) to 3% of GDP by March 31, 2015.
    • FRBM Amendment Act, 2015: The deadlines were postponed, with the new target for achieving an FD of 3% set for March 31, 2018. These frequent postponements highlighted the challenges of adhering to a rigid framework.

  • FRBM Review Committee (N.K. Singh Committee, 2017): This committee was constituted to review the FRBM framework and suggest a new path.

    • Primary Target: It recommended using Debt-to-GDP ratio as the primary anchor for fiscal policy, arguing that it is a better indicator of a country’s long-term fiscal health. It proposed a target of 60% of GDP for the general government debt by 2023 (40% for the Centre and 20% for the States).
    • Operational Targets: It suggested a glide path to reduce the Fiscal Deficit to 2.5% of GDP and Revenue Deficit to 0.8% of GDP by 2023.
    • The “Escape Clause”: The committee formalized the concept of an “escape clause,” allowing for deviations from fiscal targets under specific, well-defined circumstances. The FRBM Act was amended in 2018 to incorporate this, permitting a deviation of up to 0.5 percentage points from the FD target in a year under conditions like national security threats, acts of war, calamities of national proportion, structural reforms with unforeseen fiscal implications, or a sharp decline in real output growth.

Public Debt in India

Public debt refers to the total liabilities of the Union government that are payable from the Consolidated Fund of India, as per Article 292 of the Constitution.

  • Classification:

    • Internal Debt: Borrowings from domestic sources. It is further divided into:
      • Marketable Securities: G-Secs and Treasury Bills, which are tradable.
      • Non-Marketable Securities: Intermediate Treasury Bills issued to states, special securities issued to the National Small Savings Fund (NSSF).
    • External Debt: Borrowings from foreign lenders (governments, multilateral institutions like the World Bank, commercial banks).

  • General Government Debt: This is a broader concept that includes the combined liabilities of the central and state governments.

  • Financing the Deficit and its Challenges:

    • Internal Sources: Loans from RBI, market borrowings, etc. The primary challenges are inflation (if the deficit is monetized by printing new currency) and the “crowding out” effect, where extensive government borrowing absorbs available savings and drives up interest rates, making it more expensive for the private sector to borrow and invest.
    • External Sources: While external borrowing can prevent domestic crowding out, it exposes the country to currency exchange risk. If the Rupee depreciates against the currency in which the debt is denominated (e.g., US Dollar), the cost of servicing the debt in Rupee terms increases significantly. Masala Bonds are an innovation to mitigate this; they are Rupee-denominated bonds issued in foreign markets. In this case, the currency risk is transferred from the Indian issuer to the foreign investor.

  • Public Debt Management Agency (PDMA): For years, there has been a debate on separating the government’s debt management functions from the RBI. The rationale is to resolve the conflict of interest where RBI, as the monetary authority, aims to keep interest rates stable, but as the government’s debt manager, it may be pressured to keep rates low to reduce borrowing costs. A temporary Public Debt Management Cell (PDMC) was set up in the Ministry of Finance in 2016 as a precursor to a statutory PDMA.

Infrastructure and Its Financing

Infrastructure comprises the basic physical and organizational structures (e.g., transport, power, communication, social services) needed for the operation of a society or enterprise.

  • Benefits and Economic Impact:

    • Positive Externalities: Good infrastructure, like sanitation or education, generates benefits for society beyond the immediate user.
    • “Crowding-in” Private Investment: Public investment in core infrastructure can reduce costs and increase the profitability of private investment, thereby encouraging it.
    • Multiplier Effect: As explained by Keynesian economics, investment in infrastructure has a multiplier effect, where the initial expenditure leads to a larger increase in national income and employment.

  • Types of Infrastructure:

    • Economic: Power, transport, communication.
    • Social: Education, health, housing.
    • Hard: Physical networks like roads, bridges, railways.
    • Soft: Institutions and systems that maintain the economy, like the financial system, education system, and governance structures.

  • Challenges in Infrastructure Financing:

    • Asset-Liability Mismatch: Banks, which have traditionally been major funders of infrastructure, raise funds through short-term deposits but lend for long-term infrastructure projects. This mismatch creates a risk if depositors withdraw their money before the project generates returns.
    • Fiscal Constraints: The government’s ability to fund infrastructure is limited by its fiscal consolidation commitments under the FRBM framework.
    • Nascent Bond Market: India’s corporate bond market is not deep or liquid enough to meet the massive financing needs of infrastructure projects.
    • Regulatory and Procedural Hurdles: Issues like land acquisition, environmental clearances, and contractual disputes have led to a large number of stalled projects. This is sometimes referred to as “regulatory cholesterol.”
    • Constraints on Pension and Insurance Funds: While these funds have long-term liabilities and are natural investors for long-term infrastructure, regulatory guidelines by bodies like IRDAI have historically restricted their exposure to the infrastructure sector.

  • Government Initiatives and Mechanisms:

    • National Infrastructure Pipeline (NIP): Announced in 2019, the NIP is a plan for social and economic infrastructure projects worth over ₹111 lakh crore to be executed between 2020 and 2025. It encompasses both greenfield (new) and brownfield (existing) projects.
    • National Monetisation Pipeline (NMP): Launched in 2021, the NMP aims to unlock value in brownfield infrastructure assets by engaging the private sector, transferring to them revenue rights but not ownership, and using the funds generated for new infrastructure creation.
    • Public-Private Partnership (PPP): A risk-sharing mechanism where the government partners with private companies to deliver infrastructure projects and services. The Vijay Kelkar Committee (2015) was set up to review and revitalise the PPP model in India.
    • Viability Gap Funding (VGF): A one-time grant provided by the central government to support infrastructure projects that are economically justified but not financially viable. The grant covers up to 20% of the project’s capital cost, with another 20% potentially coming from the sponsoring authority.
    • Infrastructure Debt Funds (IDFs): These are investment vehicles that raise funds from domestic and foreign investors to refinance existing debt of infrastructure projects, thereby releasing capital for banks to lend to new projects. The reduction of withholding tax on interest payments to foreign investors from 20% to 5% was a step to make IDFs more attractive.

Prelims Pointers

  • 80th Constitutional Amendment Act, 2000: Made corporate taxes part of the divisible pool of taxes to be shared with states.
  • 14th Finance Commission: Recommended increasing the states’ share in the central divisible pool of taxes to 42% from 32%.
  • Off-Budget Financing: Borrowings by PSUs like FCI or IOCL on behalf of the government, which are not part of the official budget calculations. E.g., Oil Bonds.
  • Strategic Disinvestment: Sale of 51% or more of government stake in a PSU, transferring management control.
  • Nudge Theory: A concept in behavioural economics involving positive reinforcement and indirect suggestions to influence behaviour. Associated with Richard Thaler.
  • FRBM Act Documents: The government must present:
    1. Medium-Term Fiscal Policy Statement
    2. Macroeconomic Framework Statement
    3. Fiscal Policy Strategy Statement
    4. Medium-Term Expenditure Framework (MTEF) Statement
  • N.K. Singh Committee (FRBM Review):
    • Recommended using Debt-to-GDP ratio as the primary fiscal anchor.
    • Proposed a target of 60% Debt/GDP ratio (40% for Centre, 20% for States).
    • Suggested new FD target of 2.5% and RD target of 0.8% of GDP by 2023.
  • Escape Clause (FRBM Act): Allows deviation from fiscal deficit target by up to 0.5 percentage points in a year under specific conditions like war, national calamity, structural reforms, or sharp decline in growth.
  • Article 292: Empowers the Union Government to borrow upon the security of the Consolidated Fund of India.
  • Consolidated General Government Debt: Refers to the total liabilities of both the Centre and the State governments combined.
  • Crowding Out: A situation where increased government borrowing drives up interest rates, thereby reducing or ‘crowding out’ private investment.
  • Masala Bonds: Rupee-denominated bonds issued in foreign markets. The currency risk is borne by the investor, not the issuer.
  • National Infrastructure Pipeline (NIP): A plan for infrastructure projects worth ₹111 lakh crore between 2020-2025, covering both greenfield and brownfield assets.
  • National Monetisation Pipeline (NMP): A pipeline for monetising core, brownfield assets of the central government through private participation.
  • Viability Gap Funding (VGF): A one-time capital grant to support infrastructure projects that are not financially viable on their own. The central government provides up to 20% of the Total Project Cost.
  • Infrastructure Debt Fund (IDF): A fund to refinance existing debt of infrastructure projects, typically attracting long-term investors like insurance and pension funds.

Mains Insights

1. The Trilemma of Public Expenditure Management in Post-LPG India The Government of India has consistently faced a trilemma in public expenditure management:

  • Maintaining Fiscal Prudence: Adhering to rule-based fiscal policy (FRBM) to ensure macroeconomic stability and investor confidence.
  • Fueling Economic Growth: Undertaking large-scale capital expenditure in infrastructure to remove supply-side bottlenecks and ‘crowd in’ private investment.
  • Ensuring Social Equity: Allocating sufficient resources for welfare schemes, subsidies, and social sector development to address poverty and inequality, a key political and constitutional imperative.
  • Analysis: Often, these three objectives are conflicting. For instance, increasing capital expenditure or welfare spending can breach fiscal deficit targets. To meet targets, governments have often cut capital expenditure, harming long-term growth. The use of off-budget financing is a direct consequence of this trilemma, representing an attempt to meet expenditure demands while seemingly adhering to fiscal rules, which ultimately compromises transparency and long-term fiscal health.

2. Fiscal Federalism: A Constraint or a Strength? The increasing devolution of funds to states, as recommended by the 10th and 14th Finance Commissions, is a double-edged sword for the Centre’s expenditure management.

  • Cause-Effect: Higher devolution strengthens states’ financial autonomy, enabling them to address local needs more effectively (Principle of Subsidiarity). However, it shrinks the Centre’s discretionary financial resources, limiting its ability to fund pan-India schemes, defence, and other central responsibilities.
  • Debate: Is this a healthy trend for cooperative federalism, or does it weaken the Centre’s capacity to drive national policy and manage macroeconomic stability? The rise of centrally sponsored schemes with high central funding shares can be seen as the Centre’s attempt to retain policy control despite reduced untied funds.

3. The Evolving Philosophy of Fiscal Rules: From Deficit Targeting to Debt Anchoring The recommendations of the N.K. Singh committee mark a significant evolution in India’s fiscal policy framework.

  • Shift in Rationale: The initial focus of FRBM (2003) on Revenue and Fiscal Deficits was to control government borrowing and consumption expenditure. The shift to a Debt-to-GDP ratio as the primary anchor reflects a more holistic and long-term view of fiscal sustainability. A high debt stock implies higher interest payments, which crowds out development expenditure.
  • Rules vs. Discretion: The introduction of a formal ‘Escape Clause’ is a crucial analytical point. It represents a pragmatic compromise between the need for a credible, rule-based framework and the necessity for fiscal flexibility to respond to severe shocks. This addresses the long-standing criticism that the FRBM was too rigid and pro-cyclical.

4. Public Debt Management: The Conflict of Interest Debate The proposal for a statutory and independent Public Debt Management Agency (PDMA) highlights a critical governance challenge.

  • The Conflict: RBI’s dual role as the monetary policy authority (mandated to control inflation) and the government’s debt manager (mandated to borrow at low cost) creates a potential conflict. To keep government borrowing costs low, the RBI might be tempted to keep interest rates artificially low, which could conflict with its inflation-targeting mandate.
  • Historiographical Viewpoint: Globally, most advanced economies have separated these two functions to enhance the credibility of both monetary policy and public debt management. In India, the debate continues, with the RBI arguing that its dual role allows for better coordination. A successful transition to a PDMA would require deep and liquid government securities markets, which is still a work in progress.

5. Infrastructure Financing: Beyond Traditional Models The government’s push for NIP and NMP reflects a strategic shift in infrastructure financing.

  • Analysis of NMP: The National Monetisation Pipeline is an innovative approach to finance new infrastructure without stressing the fiscal deficit or resorting to privatisation of ownership. However, its success is contingent on several factors:
    • Regulatory Certainty: Ensuring a stable and predictable regulatory environment for private players is crucial.
    • Asset Valuation: Fair and transparent valuation of assets is necessary to avoid accusations of cronyism.
    • Risk of Private Monopoly: Care must be taken to ensure that monetisation does not lead to the creation of private monopolies that engage in price gouging.
  • The PPP Model: The Vijay Kelkar Committee (2015) highlighted systemic issues in India’s PPP framework, including imperfect risk allocation, lack of a robust dispute resolution mechanism, and stalled projects leading to the ‘Twin Balance Sheet’ problem. New models like the Hybrid Annuity Model (HAM) in the roads sector are attempts to rebalance this risk, with the government taking on a larger share of the initial financial burden. This shows an evolution towards more pragmatic and balanced PPP frameworks.

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