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Tuesday, Jul 27, 2004

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Fiscal responsibility versus democratic accountability

C. P. Chandrasekhar
Jayati Ghosh

The UPA Government has notified the Fiscal Responsibility and Budget Management Act, and declared that it will abide by it. In this edition of Macroscan, C. P. Chandrasekhar and Jayati Ghosh argue that this Act has adv erse implications for economic growth and democracy, and also that the Kelkar Task Force's projections of revenue increase through tax reform are over-optimistic. This means that this Act may require cutting back on socially necessary expenditure.

The FRBM Act is excessively rigid and ties the Government's hands even in terms of responding to the needs of its citizens. -- Kamal Narang

ONE OF the first legislative actions of the UPA Government was to notify the Fiscal Responsibility and Budget Management Act (henceforth FRBM Act).

This Act was notified on July 2 to come into force on July 5, 2004, only three days before the presentation of the Annual Budget, thereby circumscribing the entire budgetary exercise from the start of the new Government's tenure.

The FRBM Act is apparently well-intentioned, designed to clean up public finances and put them on a sustainable footing. Thus, it requires the reduction of the fiscal deficit and the elimination of the revenue deficit of the Central Government by March 31, 2008 (the deadline is to be extended by a year). This would appear to be a way of forcing the Government to adhere to a discipline which would thereby allow it to spend more on useful capital expenditure.

However, the actual implications of the working of the Act are much more serious and potentially adverse, than is generally understood.

Some of the requirements of the FRBM Act and the associated rules mentioned in the notification are described in Table 1.

The Act effect

The Act requires the Central Government to reduce the fiscal deficit by 0.3 per cent of GDP each year, and the revenue deficit by 0.5 per cent each year, beginning with this financial year. If this is not achieved through higher tax revenues, the necessary adjustment has to be made by cutting expenditures. Further, the Act prohibits the Central Government from borrowing from the Reserve Bank of India (that is, deficit financing, involving the printing of money) to meet its deficit, except for temporary cash advances.

This effectively rules out a cheap source of borrowing and forces the Government to borrow at much higher rates, for no evident reason. The RBI is even to be prohibited from making primary market purchases of government bonds.

But the limitation on borrowing from the RBI, or deficit financing, is not at all something that can be easily justified. The argument that deficit financing causes inflation is not just simply wrong. It is now widely acknowledged across the world to be ridiculous and completely unwarranted, especially in the financially sophisticated world we live in. Inflation control does not at all depend upon controlling the Central Government's borrowing directly from the RBI.

So this directive does not serve any useful purpose. Instead, it unnecessarily forces the Government to pay much higher interest on all its debt, instead of allowing for some low interest debt to the RBI. This raises the interest cost of the Government and, thereby, the total revenue expenditure, perversely making it harder to achieve the revenue deficit targets. It is hard to understand why this portion of the Act has been retained even when earlier discussion in Parliament pointed to the absurdity of this condition.

Furthermore, as can be seen from Table 1, the FRBM Act and Rules require a continuous reduction in revenue and fiscal deficits over the next four years, regardless of the prevailing macroeconomic circumstances. This insensitivity even to more obvious patterns such as the business cycle (which typically affects tax revenues and therefore public deficits) makes the entire legislation excessively rigid and ties the Government's hands even in terms of responding to the needs of its citizens.

Compliance worries

But the most worrying — and potentially undemocratic — part of the FRBM Act relates to compliance conditions. The Act states that "whenever there is a shortfall in revenue or excess of expenditure over the pre-specified levels... the Central Government shall take appropriate measures for increasing revenue or for reducing the expenditure (including curtailing of the sums authorised to be paid and applied for from and out of the Consolidated Fund of India under any Act so as to provide for appropriation of such sums)."

The notification spells this out even more clearly: "In case the outcome of the quarterly review of trend in receipts and expenditure... at the end of any financial year... shows that

i) the total non-debt receipts are less than 40 per cent of the Budget Estimates for that year; or

ii) the fiscal deficit is higher than 45 per cent of the Budget Estimates for that year; or

iii) the revenue deficit is higher than 45 per cent of the Budget Estimates for that year,

then... the Central Government shall take appropriate corrective measures."

This means that if any of these conditions holds (which is very likely in most years) the Government will in effect be forced to cut expenditures even if they are essential for the economy, or required to enforce its popular mandate or to deliver the socio-economic rights of the citizens.

This is going to hit home much faster than many people realise. The Budget 2004-05 contains what are widely recognised to be inflated and highly optimistic revenue receipt projections. Also, the overwhelming part of additional resource mobilisation in the Budget is backloaded, to be available only after September. In addition, the truant monsoon is bound to depress revenues. By September, it is not just likely but almost inevitable that the actual revenue receipts will fall short of the Budget estimates by 40 per cent or more.

When that happens, by the Act that the Government has just notified, it will then be required to cut back on expenditure. This means that even the low and inadequate provisions for employment, education and other goals listed in the National Common Minimum Programme will be further cut, and may not even increase at all.

Much of the opposition to the expenditures projected in the Budget has focussed on the low additional outlays for critical and socially necessary areas, which has been seen as a betrayal of the people's mandate. The total budgeted for these is only Rs 10,000 crore, but imagine the situation if even this small additional outlay is not actually provided, because of the constraint posed by the FRBM Act!

There may be even worse to come. The fearsome combination of heavy floods and severe drought that is affecting different parts of the country is bound to involve lower incomes and thus lower tax collections, as already stated. But it should also require much larger outlays to provide even the most minimal relief to the affected people who are spread across India. Even such critical relief and rehabilitation — including in the form of rural employment and other physical assistance — may be under threat from the absurdly rigid fiscal discipline imposed by the Act.

Shaky abroad

The problems with such fiscal responsibility legislation across the world are now becoming more and more evident. The Gramm-Rudman-Hollings legislation in the US, which was the international frontrunner in this regard, is now really honoured only in the breach, through shifting many expenditures of the US Federal Government to off-Budget heads.

In the European Union, the Growth and Stability Pact, which provides similar constraints, is coming under severe pressure, and France and Germany are already seeking ways to make it effectively meaningless and inapplicable to actual fiscal policy.

Misplaced optimism

However, we in India seem to be blissfully unaware of the potential problems in store. The Task Force appointed by the earlier government, on Implementation of the Fiscal Responsibility and Budget Management Act (hereafter Kelkar Task Force), has just submitted its report in late July 2004. This Report is much more optimistic about meeting the targets defined by the FRBM.

The Report correctly argues that fiscal consolidation should be revenue-led, rather than requiring cuts in expenditure, and even suggests that capital expenditure should be enhanced, in order to balance the contractionary effects of fiscal consolidation. And some of its suggestions for tax reform, such as widening the tax base, enhancing the equity of the system, establishing an effective compliance system, and simplifying the system by removing rebates, are well-known and basically desirable.

However, the Kelkar Tax Force's basic perception appears to be that fewer and lower rates of taxation will lead to much greater compliance and generate a lot of tax buoyancy. This Laffer Curve-type argument has been repeatedly disproved in its country of origin (the US) and there is absolutely no reason to believe that lower rates will generate higher revenues without major changes in tax enforcement.

Nevertheless, the optimistic projections in the Report are based on precisely such an argument. Chart 1 shows the valiant projections of increasing tax revenues over the next four years, which are apparently going to be achieved through lower and fewer rates and reform of the tax administration by introducing VAT for all Central and State government goods and services taxes. Apparently, the reduction in tax rates will not only encourage better voluntary compliance, but will also generate much higher rates of economic growth, which will obviously then mean more government revenues as well.

The largest increase is projected for services taxes (which are projected to increase by more than Rs 45,000 crore from next year to more than Rs 85,000 crore by 2008-09), and the most significant decline is for Customs duties (which are slated to decline progressively, starting from Rs 8,300 crore next year to more than Rs 16,000 crore in 2008-09). All this creates the astounding figure of an additional Rs 1,34,062 crore of tax revenues just four years hence.

Associated with this, there are naturally very optimistic projections regarding tax buoyancy. Table 2 indicates the extent of buoyancy which is predicted, compared to the estimated buoyancy rates of the past five years. Customs duties are the only category for which buoyancy is projected to come down, largely because the Task Force proposes very dramatic declines in such duties. For all other categories of taxes, there are substantial increases projected for buoyancy, mostly without adequate justification. The biggest such increase is for services tax, which is apparently assumed to be relatively easy to collect (a strong assumption in India where unorganised services dominate).

Wishful thinking

In general, such an optimistic scenario appears to reflect the triumph of hope over experience. It is certainly true that such increases in tax revenues (and indeed even larger increases) can be achieved — but this will require not just reduction of rates and simplification of the tax system, but a much more aggressive attitude towards enforcement and punishment of tax evaders.

What has prevented this in the past is not practical difficulty but the absence of political will. There is little to indicate that the political economy of the ruling classes has changed so dramatically in the recent past that such enforcement will be likely.

And until that happens, the unfortunate reality is that the burden of fiscal adjustment will continue to be borne by the poor of the country, through reductions in much-needed public expenditure.

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