I have seen articles discussing how Indian state governments lack sufficient fiscal space to run large-scale public services. Recently, Andhra Pradesh joined Delhi and Punjab as one of the few states where state-run bus service is free for women.
I do not have any issues with such schemes, nor do I believe targeting women for these benefits is bad. After all, women in this country rarely have enough income to pay for travel. I believe that everyone should have access to free public transport (perhaps with distance quotas) because mobility is crucial for economic and social growth. It provides people with greater flexibility in where they work and allows them to visit their relatives with ease. For instance, women could be given a greater distance allowance per month compared to men.
I want to discuss the economics of such schemes, which involve large outlays, such as state-run pension schemes, free transport, and free food grains. The mainstream media often decries these schemes as ‘financially imprudent,’ claiming that the states lack the fiscal space to implement them. The latter is partly true, but the issue isn’t with states lacking fiscal space but with the Central Government having ‘infinite’ fiscal space.
State governments are severely fiscally constrained
Indian state governments are severely constrained. They lack monetary sovereignty and must rely on the Central Government for funds. While they do have the power to tax, unlike regular citizens, there are times when no politically feasible tax would be sufficient to cover the expenditures of a state government seeking to make efficient use of its resources. In such cases, they are at the mercy of the Central Government.
The Indian Central Government is well known for using various tactics to avoid paying states, including those governed by the ruling party.1 Why is the Central Government constraining its own state governments? The answer lies in neoliberal ideology. The Central Government believes it is financially constrained (which it is not) and wants to show foreign investors that it is ‘fiscally prudent’ by minimizing fiscal deficits. Strangling states and squeezing revenue out of them is a way to achieve this.
The reality is that the Indian Central Government has no financial constraints; it only faces real resource constraints. What do I mean? Let’s say the Government decides to implement universal free public transport with 200 km monthly quotas, costing ₹1000 crore. But what about real resources? If the Government implements such a scheme, public transport would see an increase in demand. Will this increased demand lead to overcrowding? If so, can the Government acquire new buses through public, private, or foreign sectors? How quickly can this be done? Would a phased implementation be better to allow the system to adjust?
These are the real resource constraints: is enough labor available, and can resources be mobilized in time? There are no financial constraints for a sovereign government; the issuer of Rupees doesn’t need to worry about where to obtain them, as it can create them out of nothing. That’s how all spending is done, regardless of the extra accounting entries in between (such as bond issuance).
As Keynes said:
“Anything we can actually do, we can afford.”
For some weeks at this hour you have enjoyed the day-dreams of planning. But what about the nightmare of finance? I am sure there have been many listeners who have been muttering: “That’s all very well, but how is it to be paid for?”
Let me begin by telling you how I tried to answer an eminent architect who pushed on one side all the grandiose plans to rebuild London with the phrase: “Where’s the money to come from?” “The money?” I said. “But surely, Sir John, you don’t build houses with money? Do you mean that there won’t be enough bricks and mortar and steel and cement?”
“Oh no”, he replied, “of course there will be plenty of all that”.
“Do you mean”, I went on, “that there won’t be enough labour? For what will the builders be doing if they are not building houses?”
“Oh no, that’s all right”, he agreed.
“Then there is only one conclusion. You must be meaning, Sir John, that there won’t be enough architects”. But there I was trespassing on the boundaries of politeness. So I hurried to add: “Well, if there are bricks and mortar and steel and concrete and labour and architects, why not assemble all this good material into houses?”
But he was, I fear, quite unconvinced. “What I want to know”, he repeated, “is where the money is coming from”.
To answer that would have got him and me into deeper water than I cared for, so I replied rather shabbily: “The same place it is coming from now”. He might have countered (but he didn’t): “Of course I know that money is not the slightest use whatever. But, all the same, my dear sir, you will find it a devil of a business not to have any …”
Had I given him a good and convincing answer by saying that we build houses with bricks and mortar, not with money? Or was I only teasing him?
Keynes, Collected Works XXVII1
State governments have financial constraints on top of real resource constraints
While the Indian Central Government has infinite financial capacity, state governments must rely on the sovereign for funding. In essence, they are currency users, not currency issuers, making them more akin to regular individuals than to the Central Government.
This financial constraint does not mean that state governments lack real resource constraints. For instance, if a state government wants to produce glass, it needs to obtain sand. Suppose it has a fiscal surplus of ₹500 crore, meaning it has collected ₹500 crore more in taxes than it has spent. This surplus could be used to purchase sand. However, if the state has no sand, no amount of money can conjure sand out of thin air, even if the state is running a surplus.
The state government has some options. It could enter foreign exchange markets, obtain foreign currency, and buy sand from countries willing to accept that foreign currency. The issue here is that no other government is obliged to accept your currency, and if no one else wants it, you are screwed.
This situation applies even to sovereign governments. India, for example, cannot produce oil and must import it. Fortunately, the rest of the world is willing to accumulate Indian Rupee assets in exchange for oil. However, this dependency makes India vulnerable. If the global demand for Indian Rupees decreases, the exchange rate depreciates, making oil imports costlier. This occurred in 2022 when oil prices spiked due to Russia’s ‘special military operation’ and OPEC’s decisions. Also, interest rate hikes by Western central banks, such as the U.S. Fed caused massive capital outflows from India, further depreciating the exchange rate and exacerbating the inflation caused by the oil price spike.
State governments have another option, they can request resources from other states. Since all states use Rupees, they can usually provide the needed resources, as long as they have a sufficient supply.
Thus, even if a state government has a fiscal surplus, it is still constrained by the availability of real resources.
What are the implications of this?
If the Indian Central Government continues squeezing state governments and denying them tax revenue, they will be forced to cut back spending or go into debt, usually both. This problem is further complicated by the fact that the Central Government restricts state governments’ debt-to-GSDP ratio to an arbitrary amount, say 3%. If a state exceeds this limit, the Central Government denies them grants, making the problem worse.
Given that the Indian Central Government isn’t financially constrained, there is no need for any of this to happen. The Central Government can simply credit the accounts of the state governments, so the states will no longer have to hope the private sector buys the debt they issue. Another option is for the Central Government to guarantee state government debts, meaning if the state government is unable to pay, the Central Government, as the sovereign, can pay back the debt. This would reduce the interest rates on state bonds to that of the Central Government’s. There are other similar options as well. This is why Rupee-denominated Central Government bonds typically don’t have a credit rating and are labeled ‘Sovereign,’ unlike municipal or state bonds which have ratings like ‘AA’ or ‘BBB’. Central Government debt denominated in Rupees has no credit risk and can always be paid back.
It is unfortunate that Indian state governments are forced to borrow from sources other than the Central Government to operate. For instance, state governments often ask for loans from international financial institutions like the Asian Development Bank or the World Bank to fund projects denominated in Rupees. This is stupid, as the ADB cannot create Indian Rupees; only the Central Government can. The only way these institutions can obtain Rupees is if the Central Government provides them or if they purchase Rupees issued by the Indian Government in the foreign exchange markets.
None of this needs to happen. The Central Government can always provide state governments with the Rupees they need if it sees a particular project is worthwhile.
High cost programs (in monetary terms) must be funded directly or indirectly by the Central Government
I had previously discussed the absolute necessity of a universal job guarantee to address unemployment issues in the country. In the article, I mentioned that such a program must be funded by the Central Government. Why is that? As previously mentioned, the Indian Central Government is the sovereign issuer of the Indian Rupee and has the ability to tax its own people. The Central Government can never go bankrupt in Indian Rupees; any constraint on Central Government spending in Indian Rupees is purely self-imposed and unnecessary.
State governments cannot and should not finance such a scheme. Doing so would require raising taxes to a level that would collapse demand, decrease tax revenues, and force the state government to default on its debt. The Central Government has no such issues.
Therefore, any large-scale scheme requiring significant financial outlays must be financed by the Central Government. This can be done in several ways: the Central Government can directly fund it by crediting the bank accounts of state transport corporations to ensure they are always solvent, create a national transport company majority controlled by the Central Government, or credit the accounts of the state governments, which then provide the necessary funds to the state transport corporations. Any of these methods would ensure that all states have free public transport.
The management of the transport corporation would then need to handle the increased demand for public transport and ensure there are enough buses, trains, etc., available to meet the demand. They shouldn’t have to focus on financials or worry about earning a profit. As long as society and the economy as a whole benefit, it is worth it.
That’s all.
- https://www.aljazeera.com/economy/2024/1/18/as-pm-indias-modi-secretly-tried-to-massively-cut-state-funds ↩︎
- https://academic.oup.com/ej/article-abstract/93/369/209/5220453 ↩︎