E-Paper
The case for states to adopt fiscal reforms
We must discuss how, and through what modalities, the macro policies of the Centre are aligned with those of the states
This is the season for consultation, advice and endeavors to secure the attention of policymakers. The budget session of Parliament is around the corner and discussions on the working of government continues to be relevant in the Indian fiscal calendar. India’s latest quarterly GDP estimates, which were released in late November, pointed to a growth rate of 8.2%. The important question to ask here is: What must be done to sustain growth at or near this level over the next two to three decades? Ensuring this will decide whether or not India can achieve the goal of becoming a developed country when it completes the centenary of its Independence in 2047.
A long-term high growth path requires fulfilment of both necessary as well as sufficient conditions. The former is pretty much the bedrock of such a trajectory. Macroeconomic stability is among the most important necessary conditions for sustained high growth.
India has done remarkably well on this front. After Covid, notwithstanding the spurt which was inevitable during that period, the central deficit fell from 9.2% to 5.6% by 2023-24. Public debt declined from a peak of 89% of GDP in 2020 to about 82% in 2024-25. However, India’s past tells us that periods of strong growth can coexist with missed opportunities.
The first of these missed opportunities arose in the decades following Independence, when India chose a development strategy heavily influenced by Fabian socialism. While well-intentioned, this framework prioritised State control over markets, administrative allocation over price signals, and protection over competition. The result was a prolonged suppression of productivity in land, labour, and capital. The economy grew, but well below potential.
A second missed opportunity followed the landmark reforms of 1991 and our lending from the IMF and World Bank. While the initial liberalisation dismantled the most egregious controls, momentum slowed in the subsequent decade. The story was true even in 1981. India undertook the biggest lending programme from the IMF at the time of five billion SDR (special drawing rights), but did not go ahead with all of the reforms. Second-generation reforms, particularly in factor markets and sub-national public finance, remained incomplete.
The third, and more recent, missed opportunity emerged in the management of fiscal federalism. While the Centre undertook significant fiscal reforms with the fiscal responsibility and budget management (FRBM) in 2003 and 2017, the architecture governing State-level borrowing and debt remained unchanged for many states after FRBM 2017. Looking at the Centre’s fiscal numbers alone is not enough, and one must also look at what is happening in the states for two reasons.
Firstly, international financial institutions and markets take into cognisance the fiscal performance of the “general government” — including both the Centre and the states — and not just the central government, whose fiscal performance indicators get a lot of scrutiny during the Union budget. Secondly, the federal structure enshrined in the Constitution provides a certain degree of sovereignty to the states in fiscal matters. Any reforms on this front have to be sensitive to the larger sanctity of this framework.
The Union finance minister recently said that debt will be the principal fiscal anchor of the forthcoming budget. This recent shift implies a debt-based fiscal anchor at the Centre, to reach 50 ± 1 per cent by FY 2030-31. As somebody who chaired the FRBM Review Committee of 2017, this is not just institutionally but also intellectually gratifying for me. The crux of my argument for focusing on debt rather than deficit numbers while pursuing fiscal stability was to ensure that fiscal policy rewarded long-term prudence and did not end up becoming pro-cyclical, which is what mechanically cutting deficits during slumps would entail. Our Constituent Assembly was also aware of the need for regulating government debt. In September 1947, Gopalaswami Ayyangar warned that financial provisions were too complex to be left to intuition. An expert committee argued that freedom to borrow creates responsibility because markets discipline governments. The committee also warned against uncoordinated borrowing.
Unfortunately, in India, we have prevented the markets from exercising this disciplining function for debt. Our markets do not adequately distinguish between prudent and profligate states. Reform of the state development loan architecture is, therefore, essential if market-based discipline is to operate.
I had once asked if India should contemplate adopting the concept of sub-national bankruptcies, which would help address the problem of markets not being able to discipline state-level borrowing in India. The answer can be found in the principle of coordination without withdrawing autonomy. This is not an argument for a fiscal council, but for a solution rooted in cooperative federalism, building on the FRBM Act and state fiscal responsibility laws.
The idea was endorsed during the framing of the Constitution. BR Ambedkar, chairman of the Drafting Committee in the Constituent Assembly, on August 10, 1949, said, “(Article 292) specifically says that the borrowing power of the executive shall be subject to such limitations as Parliament may by law prescribe. If Parliament does not make a law, it is certainly the fault of Parliament, and I should have thought it very difficult to imagine any future Parliament which will not pay sufficient or serious attention to this matter and enact a law.” That wisdom matters again. While the central government focuses on the fiscal deficit and the debt of the Centre, investors look at the general government. Focusing on the general government is the path forward, and this must be done within the framework of a federal polity. This raises the question of how, and through what modalities, the macro policies of the central government are aligned with those of the state governments.
In 2003, when the first FRBM Act was adopted, all states, except Sikkim and West Bengal, passed their own fiscal responsibility Acts. However, when the central government enacted the second FRBM in 2017, state policies largely remained unamended. It is important that states are incentivised and cajoled into accepting the 2017 FRBM amendments and the finance minister’s recent announcement of making debt the principal anchor of fiscal policy.
How do we do this? Can we create an institutional mechanism that examines the debt and fiscal policy of the general government? Exiting the shadows of Fabian socialism is not about diminishing the role of the State. It is about redefining it — from controller to enabler, from allocator to regulator.
NK Singh is president, Institute of Economic Growth, and chairman, Fifteenth Finance Commission. The views expressed are personal
