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Growing concerns about the sustainability of the fiscal policy in India have evoked serious concerns in the recent past. The present paper has assessed the Indian fiscal trends in terms of inter-temporal budget constraint (IBC) for the Central and State Governments separately and together by employing Gregory and Hansen [J. Econometrics 70 (1996) 99] tests of co-integration with structural breaks. By addressing the issue of regime shift, this paper finds that while the fiscal stance of the Central and the State Government at the individual level is unsustainable, it is weakly sustainable for the combined finances as it nets out inter-governmental financial flows. Thus, claims about sustainability of India’s public finance, made on the basis of the assessment of individual finances and neglecting inter-governmental flows and the possibility of regime shifts seems exaggerated.

In the recent times, the issue of sustainability of public finance has drawn considerable attention. Significantly, this concern for fiscal sustainability is spread over both the developed and developing world. For example, while Maastricht treaty required governments not to run budget deficit and debt–GDP ratio beyond a point (3% and 60% of GDP, respectively) as a precondition to enter the European Monetary Union, the recently passed Fiscal Responsibility and Budget Management Bill of India has envisaged complete elimination of revenue deficit in the medium term. For a federal country like India having 28 States and 2 Union Territories (UTs), with the State Governments having independent executive, legislative and judicial wings, the issue of sustainability of public finance has an added dimension. During the 1980s and 1990s, there has been a steep rise in the outstanding liabilities of the Government at both national and sub-national level. The liabilities of the Central Government as a proportion to GDP increased from 41.4% as at end-March 1981 to about 60% as at end-March 2002. Similarly the aggregate liabilities of the State Governments increased from 16.6% to 25.0% during this period. These numbers indeed seem to be alarming, and in the recent times, serious concerns have been expressed about the sustainability of India’s public debt at various fora. Reports from the Comptroller and Auditor General of India, a statutory body that audits the finances of both the Central and the State Governments, expressed concern about the level of sustainability of the Central Government finances. More recently, a World Bank Report found that the fiscal deficit of the general government (i.e., Centre plus States) averaging over 9% over the past 6 years to be alarming. This Report also found that about 60% of this deficit is at the Centre and 40% at the State level, where much of the recent fiscal situation has occurred (World Bank, 2003). There are, thus, two sources to this crisis viz., the Central Government and the State Governments, and efforts to look into the empirics of debt sustainability in India by concentrating only on Central Government finances are at best partial and hence faulty. In this light, we, in the present paper, have looked into the ramifications of the fiscal scenario from three standpoints, viz., Centre, States and combined. How do we measure sustainability? The term fiscal or debt sustainability perhaps implies a set of fiscal policies that could be continued unaltered without jeopardising the economic policy objectives such as economic growth, price stability and external balance. Traditionally, the ability of the government to maintain its fiscal policies is measured in terms of debt–GDP ratio and a given fiscal stance is considered sustainable if debt–GDP ratio does not grow to explosive proportions over time. There are, however, alternative approaches to test the sustainability of debt. One approach, which is sometimes referred to as “Accounting Approach”, is that of satisfying the steady-state Domar condition in which rate of growth of income must exceed the interest rate on public debt, subject to the condition that primary balance is either positive or zero. As is evident, in this approach, income growth–interest rate differential is the key element for ensuring debt or fiscal sustainability. In case of rate of GDP growth less than the interest rate, fresh borrowings due to rising debt-service obligations would grow more rapidly than the growth of GDP that the fiscal stance would be unsustainable as debt–GDP ratio would be on an explosive growth path. Measuring the sustainability of deficit from the Domar condition could be naı̈ve; after all, a debt–GDP ratio might be stable at 200% — however, this may be quite unsustainable. In order to get rid of such incredible outcomes, the standard approach in the literature is measuring the inter-temporal budget constraint (IBC). In the IBC approach, a sustainable debt would require not only the debt–GDP ratio to remain stable in the future, but it must also be ensured that the outstanding debt is finally repaid. Formally, inter-temporal budgetary constraint requires that discounted value of the expected future surpluses generated by the government are sufficient to repay the outstanding stock of government debt. Equivalently, the condition requires that the present value of the government debt stock tends to zero over time. Since, the IBC approach requires that the debt must be finally repaid, it is also termed as solvency condition for a sustainable debt. In econometric terms, the sustainability of public finance, thus, gets translated in terms of comovement between revenue and expenditure. In other words, non-existence of a co-integrated relationship between revenue and expenditure could be interpreted as lack of sustainability. It is, however, well known that the powers of these co-integration tests are rather low. In particular, presence of structural breaks seriously affects the validity of co-integration test. Seen in this backdrop, the present paper is different from its predecessors from two standpoints — one relating to coverage and the other relating to econometric methodology. First, it explicitly looks into finances of the Central Government and State Governments, as well as their combined revenue and expenditure patterns. Secondly, in doing so, it explicitly looked for possible presence of any structural breaks in discerning co-integrating relationship(s) between revenue and expenditure. We find that while the finances of Centre and State Governments are individually unsustainable, the combined finances are sustainable provided, allowance is made for structural breaks in the co-integrating relationship between revenue and expenditure series. Further investigation, as to why combined finances are sustainable when individual finances are not, indicates that while inter-governmental transfers lead to overstatement/overestimation of the gap between revenue and expenditure of governments at the individual levels; at the combined level, the impact of these transfers is neutralised and the gap between revenue and expenditure gets narrowed down. In view of this, conclusions on sustainability of Indian public finances, based on the evidence at the individual levels of governments, could be biased. We, thus, conclude that any credible assessment of public debt in the Indian context should necessarily be of the combined finances, which excludes the impact of inter-governmental transfers emerging from financial intermediary role of the Central Government. Rest of the paper is organised as follows: Section 2 is a brief review of the literature on measurement of sustainability of debt using the IBC approach. The stylised facts on the trends in revenue and expenditure of the governments in India are discussed in Section 3. The empirical estimates and the analysis of the results are then detailed in Section 4. Section 5 concludes the paper.

The present paper primarily focuses on three issues in its attempt to extend the existing analysis on sustainability of Indian public debt. First, whether India’s public debt is sustainable if structural changes on account of regime changes are taken into account. Second, whether financial intermediary role of the union government is a significant factor influencing the sustainability of the public debt. Third, if the public debt is found to be sustainable, what is the degree of sustainability? From the series of tests conducted on Central, States and combined finances it is found that while the finances of both Central and State Governments are unsustainable individually (whether or not the allowance is made for structural break), their combined finances are sustainable when structural break is taken into account. Investigation as to why combined finances are sustainable when individual finances are unsustainable brings out the importance of financial intermediary role of the Central Government. In India, to bring about vertical as well as horizontal equity across the government finances, there are sizeable statutory and non-statutory transfers from the Centre to the State Governments. These inter-governmental flows lead to overstatement/overestimation of the gap between revenue and expenditure of the Central Government. At the combined level, with the netting out of inter-governmental flows, the gap between revenue and expenditure becomes narrower. To that extent, conclusions regarding sustainability of Indian public debt based on the individual level of governments are biased. It emerges that any credible assessment of public debt in the Indian context should necessarily be of the combined finances, which excludes the inter-governmental flows. Furthermore, we find that public debt of the combined Government sector is weakly sustainable, implying that the speed at which the inter-temporal borrowing constraint is satisfied is quite slow and is likely to result in higher growth rate of debt. Higher growth of debt could result in rise in interest rate, which might eventually create problems for marketing or rolling over of public debt in future. In other words, while fiscal stance of Government is sustainable at least in the short-run, for long-run sustainability government needs to alter its fiscal policies to prevent any adverse repercussions.