Well, for one, it always helps recalling that governments have no money of their own; it is all citizen’s money. As former British Prime Minister Margaret Thatcher so eloquently stated: “If the state [government] wishes to spend more, it can do so only by borrowing your savings or by taxing you more. It is no good thinking that someone else will pay. That someone else is you.” As such, it should matter to people what their government spends on and how much.

The latest monthly bulletin by the Reserve Bank of India, released on Wednesday, carries a study that looks at how well did Indian governments — both the Centre and various states — spend their money.

The Context

Over the past two decades, the public discourse in India has seen two standout trends.

One is the push for fiscal rectitude or discipline.

Simply put, the government should try to live within its means. To limit the tendency in government to overspend — financed by over borrowings — India instituted prudential norms in 2003 often called the Fiscal Responsibility and Budget Management (FRBM) Act. The FRBM Act stated two things.

First, that the fiscal deficit should ideally not exceed 3% of GDP. In other words, the total money that India’s central government could borrow in order to meet the gap between its total income and total expenditure — the fiscal deficit — was limited to 3% of the total output of the economy.

Second, that the revenue deficit — the gap between everyday income and everyday expenditures of the government — should be zero.

The whole idea behind these two requirements was that the government should only borrow for capital expenditure (and not for paying higher salaries and other similar everyday spending).

It is also important to note that India has now shifted to targeting overall debt (add up all the past deficits) as a percentage of GDP — instead of an individual year’s fiscal deficit — as a way to maintain fiscal discipline.

The second key shift has been the push for higher capital expenditure

Capex, as it is often called, is the kind of expenditure that boosts productive capacity of the economy. As such paying salaries is “revenue” or “current” expenditure while building a road is capital expenditure. There has been a growing realisation that India needs to boost its physical infrastructure in order to be able to grow fast.

The whole point behind these two shifts is to improve the quality of public expenditure. That’s because better improving the quality of public expenditure results in better outcomes of citizens both in terms of economic growth as well as social metrics such as health and education.

However, while there is a broad political consensus around these two desirable trends, India has also faced several crises such as the Global Financial Crisis of 2008 and the technical recession during the Covid-induced lockdowns of 2020. Add to that the increasing tendency among politicians to either waive loans or provide more handouts in the form of direct cash transfers and other “freebies” such as free electricity. All of these, in turn, militate against the quality of public expenditure.

RBI’s Index

Any one variable — say, fiscal deficit or capital expenditure — will never be able to capture the full story about the quality of public expenditure. As such, the RBI has used the data since 1991 to create an index called “Quality of Public Expenditure” (QPE) index for both the Centre and states.

This index is, in turn, based on five variables:

1. 01

   Capital outlay to GDP ratio

   The money set aside by governments towards building physical infrastructure, expressed as a percentage of GDP; the higher the ratio the better the quality of public expenditure.

2. 02

   Revenue expenditure to Capital outlay ratio

   This captures the relative weight of the two kinds of expenditures; the lower the value of this ratio the better the quality of public expenditure.

3. 03

   Development expenditure to GDP ratio

   Development expenditure is a broad term that refers to all public expenditure that is “intended to stimulate economic growth by enhancing the economy’s stock of production factors (labour and capital) or by improving their productivity”. The most frequently cited categories include education and training, public infrastructure investments, R&D (which drives technological advancement and innovation), and healthcare (which boosts both the size and productivity of the labour force by extending the span of healthy life). In some cases even subsidies — “particularly those aimed at improving nutrition, such as food subsidies” — are also considered part of development expenditure as they bring long-term welfare gains.

4. 04

   Development expenditure measured as a percentage of a government’s total expenditure

   The higher the value of this ratio the better.

5. 05

   Interest payments to total government expenditure ratio

   Interest payments pile up if governments run up high deficits in the preceding years. A lower value of this ratio shows better quality of public spending.

India’s record

In Charts 1 and 2, the RBI captures the net effect of all these factors on the quality of public spending since economic reforms in India. The RBI has broken the whole period — 1991 to now — in six phases “illustrating how structural forces have shaped the quality of public expenditure at both levels of government.”

Chart 1: Quality of Public Expenditure index for the Centre. The six colour bands denote the six phases. Source: RBI estimates

In the first phase, the Centre’s index (Chart 1) showed a slight improvement, while the States’ index (Chart 2) declined modestly. These movements were driven by the fiscal pressures faced by both levels of government. “Public investment fell as fiscal consolidation took precedence,” states the RBI study.

In the second phase, both indices experienced a sharp decline, “reflecting the combined impact of the Fifth Pay Commission implementation, rising interest payments, and the persistent dominance of revenue expenditure over capital outlay”.

Chart 2: Quality of Public Expenditure index for the States. The six colour bands denote the six phases. Source: RBI estimates

The third phase shows the positive effects of both fiscal discipline (as FRBM Act started guiding government borrowing) and fast economic growth making more money available for spending. States also benefited from higher fiscal devolution (read higher share in taxes). The index rebounds sharply until the world is hit by Global Financial Crisis of 2008.

In the fourth phase, the GFC “prompted the Centre to adopt countercyclical fiscal measures, including stimulus packages”. In other words, governments, especially the Centre had to spend more in order to counter the slowdown and hurt caused by the GFC. While this continued to push up the index during this phase, higher spending levels resulted in higher deficits and it eventually started eroding the quality of public expenditure.

The fifth phase saw the trajectory of the index go in opposite directions for the Centre and the states. The QPE saw an improvement in states with improvements in development spending as well as more money being available to them thanks to the recommendations of the 14th Finance Commission. The Centre further faced challenges with GST revenue sharing initially favouring the states.

The sixth phase is marked by another crisis (Covid pandemic) and another bump of fiscal stimulus. However economic recovery especially driven by the “heightened focus on capital expenditure” helped push up the quality of public expenditure.

As things stand, according to RBI’s index, the quality of public expenditure in India (both at Centre and state levels) is close to the highest point they have ever been since the start of economic liberalisation in 1991.

Share your views and queries at udit.misra@expressindia.com

Take care,

Udit