Finance Commission deserves commendation for focusing on public debt reform

The 15th Finance Commission (FC) report was tabled in Parliament along with the Union Budget. The report covers the period 2021-22 to 2025-26. The report is aptly titled ‘Finance Commission in Covid Times,’ pointing to the overarching constraints under which the FC’s recommendations must be seen. It may be recalled that the FC had earlier presented its interim report for 2020-21.

The FC report — in addition to covering the usual topics of vertical devolution of resources between the Centre and states, horizontal distribution amongst states, grants to rural and urban local bodies and so on — has made certain path-breaking recommendations for improving the overall public finance architecture of the country.

A prominent theme running across the FC’s recommendations is the urgent need to address issues in public debt management – its definition, recording, management and disclosure. Both the FC report and the Economic Survey 2020-21, which were released a day apart, seem to vindicate the government’s stand that an increased public expenditure is essential to pulling back the economy out of doldrums.

The Economic Survey, in Chapter 2 titled, “Does Growth Lead to Debt Sustainability? Yes, but Not Vice-Versa!”, makes out a case for higher public spending, albeit with a commitment to fiscal prudence. Increased government spending would, of course, result in high levels of debt not seen in the recent past. It is in this context that the FC’s recommendations on public debt assume significance.

The FC believes that the public debt to GDP ratio should continue to guide fiscal policy in the medium-term, with fiscal deficit as the near-term target. The report, accordingly, targets a declining trajectory for the ratio towards the later part of the award period.

Successive governments have been accused of using creative methods to mask fiscal deficit and debt numbers – routing borrowings through state-owned entities like the Food Corporation of India and postponing payments to the next financial year being two such methods.

The FC report highlights the urgent need to identify and record all extra-budgetary outstanding liabilities and liquidate them in a time-bound manner. The expanded definition of Central government debt adopted in the 2018 amendment to the FRBM Act includes such extra-budgetary debt.

The 2021-22 Budget has taken a significant step by taking into account a large chunk of such borrowings. The FC Report recommends that state governments must also amend their Fiscal Responsibility and Budget Management (FRBM) Acts to expand the definition of debt along the lines of the Central FRBM Act.

Arguing that the enhanced borrowing limits recommended take care of the expenditure requirements of the Centre and states, the report, in strong words, discourages the use of “off-budget or any non-transparent means of financing for any expenditure”. The message seems to be loud and clear – stay away from creative methods to camouflage debt.

Governance reforms

The report recommends administrative and governance reforms that can release scarce resources for discharging debt. It elaborates a few potential areas such as rationalisation of GST rates, increasing professional tax, property valuation reforms, better targeting of Centrally Sponsored Schemes (CSS) and many others.

The report recommends a tapering down of the net borrowing limits for state governments, starting from 4% of the Gross State Domestic Product (GSDP) in 2021-22 to 3% for the years 2023-24 to 2025-26. This excludes any additional borrowing on account of the shortfall in GST compensation and incentive-based additional borrowing space linked to power sector reforms. By allowing the option for states to carry over the unutilised borrowing space to subsequent years within the award period, the FC has provided the much-needed flexibility for states to plan their expenditure and debt levels.

Even in its recommendation on amendments to state FRBM Acts, the FC’s focus on a more inclusive definition of “debt” and on time-bound achievement of debt sustainability is apparent. A further set of public debt-related recommendations relate to market-based borrowing by state governments. Citing international best practices, the report urges states to go for credit ratings, which can open up avenues of short-term market borrowings and eventually reduce the cost of debt. Public disclosure of financial position, more importantly, contingent liabilities, is another measure which the FC feels can help states prepare to access market-based debt instruments.

On the institutional front, the report encourages the formation of Public Debt Management Cells (PDMCs) in states on the lines of the one in the central government and constitution of a High Powered Inter-Governmental Group for anchoring the restructuring of the FRBM Acts. It would be worthwhile for states to extend the mandate of the PDMCs to include cash management as well, since government cash and debt management go hand-in-hand and need to be managed in conjunction. The report calls for adopting standards for government financial reporting, again emphasising on disclosures on public debt and contingent liabilities and risks accompanying such liabilities.

Overall, the FC must be commended for focusing on public debt reform when we are on the cusp of a debt explosion as the Centre and states scramble for resources to fund their spending plans to jumpstart the economy. Full marks for acknowledging the role of states in making the reforms happen. In FC Chairman N K Singh’s own words in an interview, “The important thing I realised is that there is no point in any debt framework which doesn’t involve the partnership of the states.”

The FC also makes certain broader recommendations for improving the overall public finance architecture of the country such as a public financial management framework, independent fiscal councils with an advisory role, and the need to transition to accrual accounting in the long run.

(The writer is a chartered accountant and public finance expert)