The left panel of the figure shows actual and counterfactual capital expenditure as a percentage of GDP, while the right panel shows actual and counterfactual growth. Growth would have had to be substantially higher to maintain the keep the observed path of debt-to-GDP: 5 percentage points higher over the Eighth Plan period on average; 6 percentage points over the Ninth Plan period; and 3 percentage points over the Tenth Plan period. Besides, this additional growth is a lower-bound as, at a minimum, we would expect a rise in interest rates and an increase in O&M to complement the increase in capital expenditure. These would call for even faster growth to keep debt-to-GDP on the observed path.

Since a debt-financed increase in infrastructure spending by the government presents clear macroeconomic risks, alternative strategies must be found. A less risky alternative would be to address the weakness in the public finances and the infrastructure gap simultaneously through an overhaul of the public finances, including states’ fiscal adjustment along the lines discussed in section 3.2. This alternative becomes compelling in view of the probable size of the investments involved.

The citizens of India will ultimately pay for infrastructure either as users or as taxpayers—and this is true no matter who finances it. If the government borrows money to finance a highway then Indian citizens have to pay the interest—either as taxpayers or users. If private contractors build a highway and finance the construction themselves then Indian citizens have to pay the interest—either as taxpayers or as users. The advantage of some private sector engagement in infrastructure finance in a country like India is not that it puts additional resources on the table in net present value terms—it is that public-private partnerships (PPPs) often offer a transparent commitment to finance the additional infrastructure by users, not taxpayers. Given the pressure on fiscal space, this is an important advantage. However, PPPs need strong supporting institutions and monitoring to manage and minimize contingent liabilities in connection with guarantees private operators might seek from the government on minimum rates of return, turnover etc. If there is to be an increase in the usage of PPPs, the Government of India (GoI) would have to work to strengthen oversight of their fiscal costs and assist state governments in doing the same.

To encourage PPPs, GoI announced in the 2005 Union Budget that it would provide viability gap financing for infrastructure projects which are socially and/or economically beneficial, but too risky or not profitable enough to be attractive to the private sector. Up to 40 percent of the financing needs of such projects can be met through viability gap financing.<sup>44</sup> A coordinating facility has been housed within the Ministry of Finance, budgetary allocations have been made, and guidelines to avail of the financing have been prepared, but no amount has been drawn down yet.<sup>45</sup> In conjunction with the viability gap funding support, a Special Purpose Vehicle for long-term financing is also being established.

Other options to increase fiscal space include additional revenue mobilization, which holds out considerable promise, as discussed in section 3.1; and reforming existing expenditures, which we now discuss. Expenditure reform is needed not only for fiscal sustainability, but also to make the government a more effective agent of development. Any significant increase in public investment and developmental spending needs to be largely compensated by accelerated reduction of the revenue deficit and movement toward generating revenue surpluses (i.e., positive saving). As shown in Table 5 above, the share of interest, administration, and pensions remains

> 44 Viability gap funding can take various forms, including capital grants, subordinated loans, O&M support grants or an interest rate subsidy. A mix of capital and revenue support may also be considered. 45 World Bank (2006b).

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