Hence, a merit freebie can end up creating a virtuous cycle over a period of time. In fact, it is more or less clear that the more literate states in the country are also better-placed on the economic front.

On the flip side, a non-merit freebie is something that a government or a political party offers and which rarely has a long-term benefit to the society at large. Take the case of political parties offering consumer durables to citizens if they win an election. The benefit in this case is short-lived. Nonetheless, even in this case, a positive argument can be made around the freebie.

Let’s consider a political party promising mixer-grinders to women. An argument can be made that the use of a mixer-grinder will free up time in a woman's life and that time can be possibly used towards fulfilling other obligations that she has.

Or a political party can offer laptops or mobile phones to young students. An argument can be made that with so much good free content available on the internet, access to a laptop or a mobile phone can facilitate and fasten the learning process. The point being that it is not always easy to draw a line where a merit freebie ends and a non-merit freebie begins.

Another example is that of a state like Punjab which offers free electricity to farmers. This is a clear non-merit subsidy incentivising behaviour which isn’t good for the society at large. There are instances of farmers leaving their pump sets on even when they don’t need them. Also, free electricity is one of the reasons why farmers in Punjab choose to grow a water-intensive crop like rice in a semi-arid region. This has led to water-level in the state falling.

Of course, this is a political choice that people of the state and its politicians have decided to make for the past three decades. Due to historical reasons, the central government, through the Food Corporation of India, ends up buying a lot of rice directly from farmers in Punjab and that also incentivises them to grow it. While Punjab needs to grow less rice and more crops that are less water-intensive, the issue remains stuck. (This is a longer and a complicated issue which I had written about earlier.)

Another great example of a non-merit freebie is the regularisation of unauthorised colonies by state governments before an assembly election. It offers immediate benefit to many people who live in these colonies; nonetheless, it hurts the system as such over the medium to long-term, incentivising unscrupulous elements to sell land they don’t own. Many innocent people get conned in this process.

The seen and the unseen

The freebies that we have talked about up until now are freebies that everyone has been talking about. We can call them the seen freebies.

But there are many unseen freebies that economists are not talking about. And these freebies have been offered by the central government (the current one and the ones before it).

Take the case of farm loan waivers. These waivers have been offered both at the central government level and by parties across the political spectrum fighting state assembly elections. Economists have been critical of these waivers and so have bankers.

In fact, in March 2017, Arundhati Bhattacharya, the then chairperson of the State Bank of India, had said: “Today the loans will come back as the government will pay for it but when we disburse loans again then the farmers will wait for the next election expecting another waiver.”

In that sense, it spoils the credit culture. It makes people who have been repaying loans religiously look stupid. Also, over the long-term, it hurts the business of banking, which depends on people repaying the loans they have taken on.

It also leads to a situation where banks, in the aftermath of a waiver, are reluctant to give out loans to farmers. As the Report of the Internal Working Group to Review Agricultural Credit, published by the Reserve Bank of India (RBI) in September 2019, pointed out: “The economic rationale for loan waivers comes from alleviating the debt overhang of beneficiaries thus enabling them to undertake productive investment and boost real economic activity (investment, production and consumption).”

This is because a “loan waiver of highly indebted farming households can potentially free up lines of credit enabling them to make new investments”. Of course, this is “provided [that the] supply of bank credit to them is not affected by the changed risk-profile of the household.”

The trouble is that a farm loan waiver impacts the devolution of loans to farmers by banks. There is a “decline in agricultural credit disbursements in the years of loan waiver programmes”. This lending tends to bounce back in the years to come. Further, borrowers who have taken on farm loans “choose to default strategically in anticipation of future bailouts”.

So, farm loan waivers are non-merit freebies which can be seen and don’t go down well with economists and bankers. But they rarely talk about corporate loans being written off. Of course, there is a difference between a write-off and a waiver. A waiver is a government decision whereas a write-off is an accounting eventuality.

When a government – state or central, for that matter – announces a farm loan waiver, it needs to compensate the banks for the amount of the waiver. Of course, the borrowers end up not repaying the loan.

A write-off works differently. Basically, loans which have been bad loans for four years can be dropped from the balance sheet of banks by way of a write-off. A bad loan is a loan which hasn’t been repaid for a period of 90 days or more. In that sense, a write-off is an accounting eventuality.

During the four years, a bank ends up adequately provisioning or setting aside enough money against the bad loan to be able to write it off. Also, this does not mean that a bank has to wait for four years before it can write off a loan. If it feels that a particular loan is unrecoverable, it can be written off before four years, as long as it has been adequately provisioned for.

Take a look at the following chart. It plots the total amount of loans written off by commercial banks in India (public sector banks, private banks, foreign banks and small-finance banks) from 2004-05 to 2021-22.

In fact, loans amounting to Rs 12.61 lakh crore have been written off over the last eight years. These are loans that have been defaulted on. A bulk of these defaults have been corporate loans given by the government-owned and -run public sector banks (PSBs).

The term write-off suggests that once a loan is written off, it’s gone forever and is no longer recoverable. In India, things work a little differently. In fact, almost all the bad loans written off are what are termed as technical write-offs.

The RBI defines technical write-offs as bad loans written off at the head office level of the bank but remain as bad loans on the books of branches. Hence, recovery efforts are supposed to continue at the branch level.

Now, the question is, how much of the loans that are written off have actually been recovered over the years? Data sourced from a November 2013 speech by Dr KC Chakraborty, a deputy governor of the RBI at that point of time, suggests that less than a fifth of the loans written off by banks between 2000-01 and 2012-13 had been recovered.

Further, as the 68th report of the Standing Committee on Finance in the 16th Lok Sabha, published in August 2018, states: “RBI, in their post-evidence reply, furnished the following in respect of rate of recovery for written-off loans for a period of April 2014 to April 2018: ‘Based on the data on write-off and cash recovery out of write-off for the 4-year period viz. FY 2014-15 to FY 2017-18, it was observed that recovery rate in PSBs was 14.2 percent followed by Private Banks at 5.0 percent.’”

I wasn’t able to find the rate of recovery of bad loans post the above stated period. But the data that we have suggests that the write-off of bad loans of banks has been largely similar to a farm loan waiver, given that in both the cases loans aren’t repaid. Of course, one is due to a decision taken by politicians and the other is due to the way the system actually operates.

In fact, up until a few years back, a corporate could default on a bank loan and live happily ever after. Now, due to the Insolvency and Bankruptcy Code, things aren’t as easy as they used to be.

Nonetheless, the corporates have got this write-off freebie through the system as it has existed over the years. It’s just that this freebie hasn’t been visible. It is unseen. And most of us don’t know about it.

Further, here’s another example of an unseen freebie. Politicians use public money to advertise in the media and build their own brands. They are not spending money out of their own pockets or even their party money, but using the taxes paid by the citizens. This happens both at the state and the central level.

State versus centre

The narrative that is emerging around this issue seems to suggest that the politicians at the state government level are the ones going around giving freebies.

But is that true? The midday meal scheme was first pioneered in Tamil Nadu and that later became a national-level scheme. Or take the case of the Rythu Bandhu programme launched by the Telangana government. This scheme, along with the Odisha government’s Kalia scheme, was the inspiration behind the Pradhan Mantri Kisan Samman Nidhi in which the central government pays Rs 6,000 per year to farming households as minimum income support.

Hence, what state governments do today, the central government tends to do tomorrow – at least when it comes to merit freebies.

Further, let’s consider another example of what has turned out to be another unseen freebie. In September 2019, the central government cut the base corporate tax rate from 30 percent to 22 percent. This was subject to the condition that the companies will not avail any exemption or incentive. The idea, as the press release accompanying the announcement put it, was “to promote growth and investment”.

How did this play out? Let’s consider the 5,000-plus companies listed on the stock exchanges. From 2018-19, the year before the corporate tax rate was cut to 2021-22, the last financial year, the profit before tax of these companies went up by 114 percent. In comparison, the corporate income tax paid by these companies went up by just 21 percent. This helped drive up the net profit of these companies by 171 percent.

The idea behind lower taxes was to encourage companies to invest more. Nonetheless, the investment to GDP ratio in 2018-19 was at 29.5 percent. In 2021-22, it was at 28.6 percent. Of course, the spread of the Covid pandemic has had an impact on this.

The lower rate of corporate income tax has also led to the central government struggling to collect taxes, in an environment where listed corporates are not paying enough taxes though their profits have gone through the roof. This is another great example of an unseen freebie.

The central government could have easily reinstated the earlier rate of corporate income tax, but it chose not to do that. Instead, it decided to increase the excise duty on petrol and diesel, in order to shore up its tax revenues.

So, blaming the state governments for offering freebies isn’t fair. The central government has been at it as well though the freebies in this case are unseen.

The why behind merit freebies

The Indian economy, as it has evolved post 1991, has largely benefitted the top 10 percent of the population – the skilled lot. As economist Rathin Roy put it in a recent column: “The top 10 percent of India has enjoyed transformative economic prosperity since 1991.”

There is a dearth of work going around for the population at large. This can clearly be seen from the number of highly-qualified individuals who end up applying for extremely low-level government jobs. It can also be seen from the demand for work under MGNREGS. From April to July 2022, the work demanded under this scheme has been around 19 percent higher than the same period in 2019 before the Covid pandemic had broken out.

That said, things have improved in comparison to last year. The work demanded between April and July this year has been around 13 percent lower than the same period in 2021.

In fact, the lack of jobs can also be seen from the falling labour participation rate over the years. The following chart plots the falling labour participation rate.

Labour participation rate is the ratio of the labour force to the population greater than 15 years of age. And what is the labour force? As per the Centre for Monitoring Indian Economy, the labour force consists of persons who are of 15 years of age or more, and are employed, or are unemployed and are actively looking for a job.

A falling labour participation rate means many individuals who can’t find a job stop looking for one and aren’t counted as a part of the labour force. Hence, jobs available haven’t grown at the pace that could accommodate the new individuals, both men and women, entering the workforce. The fall of the labour participation rate in case of women has been huge.

In this scenario, there is pressure on politicians to do something. The Pradhan Mantri Kisan Samman Nidhi is an outcome of this and so are other income support schemes and food subsidy programmes. On the flip side, seen freebies also become a selling point for a politician to distinguish themselves from others around them.

The cost of freebies

There is no free lunch in economics. Every freebie – merit or non-merit, seen or unseen – has to be paid for. The money for this comes from the taxes collected by the governments as well as their borrowings. We saw earlier that the lower corporate tax rate has forced the central government to increase the excise duty on petrol and diesel, which all of us end up paying for.

Further, let’s take the case of corporate loans being defaulted on and then being written off. The central government, as a major owner of the public sector banks, needed to constantly recapitalise these banks in order to keep them going. And this recapitalisation costs money.

Before October 2017, the government would set aside money in the annual budget to recapitalise these banks. Of course, money going towards these banks could have easily gone towards something else. This was the cost of the freebie or the inability of the system to recover corporate loans that had been defaulted on.

Since October 2017, things have changed. The government issued recapitalisation bonds in order to recapitalise public sector banks. Essentially, the government issued bonds which were bought by the public sector banks. The government then used this money to recapitalise these banks. In short, this is how the government borrowed the deposits of banks and invested it back into the banks. This helped the government control its fiscal deficit.

This way of recapitalising public sector banks is what economists called budget neutral. To that extent, the government wasn’t spending money earned from taxes or borrowing money to recapitalise these banks. It was simply postponing the problem.

According to the union budget, as of March 2022, the government has issued recapitalisation bonds worth Rs 2.79 lakh crore in total. These bonds pay an interest of 6-8 percent per year. The interest that the government pays is paid out of the annual budget. Nonetheless, the first of these bonds matures only in 2028 and the bonds continue to mature until 2036.

When the bonds mature, they will have to be repaid and for that, the central government will have to make annual allocations in the budgets of those years. Hence, the idea of recapitalisation bonds in a way kicked the bad loans problem down the road. Instead of allocating money to recapitalise banks every year and in the process push up its fiscal deficit, the government decided to sell bonds, which they would have to repay in the years to come.

Again, this is a clear example of why every freebie comes with a cost associated with them, irrespective of whether the cost is paid for now or in the future, like is the case here.

The funding for freebies

The funding for the write-off freebie isn’t very transparent, given that the cost of this freebie has been postponed. Now as long as the funding for freebies is transparent, there shouldn’t be a problem.

The 15th finance commission recommended that the fiscal deficit limit of a state government should be four percent of its gross domestic product (GDP) in 2021-22, 3.5 percent in 2022-23, and three percent during 2023-26. This was accepted by the central government. Fiscal deficit is the difference between what a government earns and what it spends, and is largely financed through borrowing.

The RBI, in its latest annual report, pointed out that state government finances were budgeted to improve in 2021-22 with the fiscal deficit narrowing to 3.5 percent of the GDP from 4.7 percent in 2020-21. In fact, as the report pointed out: “Provisional accounts (PA) data of 26 states available for April-February 2021-22 indicate that their consolidated gross fiscal deficit was lower by 31.5 per cent than a year ago.”

State governments can be made to achieve the fiscal deficit target simply because any borrowing by them requires prior permission from the central government.

So, the state finances as per RBI seem to be in a position that they should be. Then what’s the problem? It seems some states are financing their expenditure by borrowing outside the budget and not accounting for it. In fact, the Print reports that in mid-July, finance secretary TV Somanathan made a presentation to chief secretaries of state governments in which he said that states were mortgaging municipal parks, hospitals and other public offices to take on loans.

These off-budget borrowings – where the principal as well as interest has to be repaid from the state governments’ budget – are not declared in the net borrowing ceiling of a state as prescribed by the central government. This leads to a situation where the total outstanding borrowings of a state government are not correctly stated. It also leads to the fiscal deficit being under-declared, given that the expenditure funded through off-budget borrowings would have otherwise ended up in the budget.

In fact, the central government followed this process of off-budget borrowings for many years, by getting the Food Corporation of India to borrow in order to fund food subsidies. This led to the under-declaration of both the overall borrowings as well as the fiscal deficit of the central government. But the central government has cleaned up its act on this front.

Another news-report in the Print points out that “five states – Andhra Pradesh, Uttar Pradesh, Punjab, Madhya Pradesh, and Himachal Pradesh – raised up to Rs 47,316 crore in the two years ending March 2022” through this method.

Clearly, this is the main problem at the heart of the entire freebies issue. A few states, in particular Andhra Pradesh and Punjab, are at the heart of the problem. As a recent RBI report on freebies pointed out: “The freebies have exceeded two percent of gross state domestic product (GSDP) for some of the highly indebted states such as Andhra Pradesh and Punjab.”

And this needs to be sorted. These states need to be asked to correctly declare their expenditure as well as their overall borrowings.

When it comes to freebies, many economists and journalists have quoted the RBI report to paint all the state governments with the same brush. But almost none of them have mentioned that the report also states that “the financial risks from freebies [faced by the five most indebted states] seem to be moderate in case of these states, except Punjab which spends a large amount on provision of free utilities”.

So, there is a problem. Nonetheless, it’s not as universal as the narrative emerging around the issue is making it out to be.

Once the state governments numbers are declared properly and there is no off-budget borrowing, then there is only so much a state government can spend in a given year and not go beyond that. That will automatically limit the temptation to dangle a freebie unless the government has the ability to finance it during that given year.

Conclusion

There is a call to define what a freebie is. As we saw earlier in the piece, the trouble is it is difficult to exactly define what is a freebie and what is not. In fact, as we have seen, what was considered as a freebie when first launched at the state government level has morphed into central government policy over the years.

Also, a freebie is a political choice between the government of a state and the people who have elected it. The Supreme Court has suggested that an expert body “for suggestions on how to control freebies by political parties during campaigns” be set up. The trouble with this entire argument of trying to define a freebie is that it considers voters to be unsophisticated. And that’s wrong.

The basic point at the heart of this issue is that a few state governments aren’t declaring their numbers correctly and that needs to be corrected.

Update on Aug 26: The Rythu Bandhu programme was launched by the Telangana government, not Andhra Pradesh. This has been corrected.

Vivek Kaul is the author of Bad Money.