The Hindu Business Line : Fixing the fiscal deficit

The whole issue of over-emphasis on fiscal compression as a matter of public policy needs to be revisited, especially in the current context of India facing a high infrastructure deficit.

ONE of the policy objectives of successive Governments in the post-reform era has been the reduction of fiscal deficit while maintaining growth. The Fiscal Responsibility and Budgetary Management (FRBM) Act has prescribed limits for the elimination of fiscal deficits. Successive Governments have committed themselves to achieving these targets.

Given this background, it may seem inopportune to question these objectives, enshrined as they are in the Statute and the National Common Minimum Programme. Indeed, the learned Chairman of the Council of Economic Advisers, Dr C. Rangarajan, has come out with a rather sophisticated justification in his latest magnum opus — a report of the Twelfth Finance Commission.

He has tried to establish, on the basis of sound logic and detailed economic argument, the need to contain fiscal deficit within manageable limits so that public debt is kept at sustainable levels. He has commended the prescription of the Kelkar Task Force in its report on the implementation of the FRBM Act.

The problem of fixing fiscal deficit targets is not with the economic logic, but with its practical political implications.

Given the political situation, fiscal deficit targets restrain Governments from undertaking fresh investments, much needed though they may be, to bridge the infrastructural deficit. This is because they are unable to raise revenue and contain expenditures on the current account.

The fiscal deficit targets sometimes constrain Governments from undertaking even essential social sector expenditures, such as those on health or education. The refrain of the fiscal purist is simple: control inessential expenditures, such as subsidies, Defence, interest.

Besides, one can always raise taxes. This will help meet fiscal targets as well as social policy goals and facilitate investment in infrastructure. Here is where fiscal ideology confronts political problems.

Raising taxes or increasing prices, though necessary, is difficult. Finance Ministers of developing countries have had to struggle with this dilemma. They have often "resolved" it by sticking to their fiscal targets, albeit at the expense of growth. They've earned kudos from the fiscal purists, but a blank at the ballot!

There has recently been some discussion of this problem in the "exalted" environs of the IMF — the keeper of the world's fiscal conscience. A recent issue of Finance and Development (December, 2004), a quarterly publication of the IMF, featured an elaborate discussion of the related issues arising from fiscal deficit targets. It is co-authored by Mr Richard Hemming and Ms Teresa Minassian, Senior Adviser and Director respectively, Fiscal Department of the IMF. Their comments are timely.

The article states at the outset that finding money to spend on infrastructure and other public projects without jeopardising fiscal stability has become a hot topic in many countries that are seeking to boost economic growth. In particular, it notes how the President of Brazil, Lula da Silva, called on the IMF to allow infrastructural investments to be excluded from the fiscal targets which countries have to meet to qualify for financial assistance. The article notes that he made this request at the UN Conference on hunger and development.

A similar request, the article states, was made by the President of Mexico, Vicente Fox, at last year's G -8 meeting. As the article wryly notes, Presidents do not often get involved in the nitty-gritty of fiscal accounting. The fact that they did raise the issue goes to prove the urgency of the problem posed by the obsession of reformers with the adjustment of fiscal deficit.

On the specific suggestion to exclude public investment on infrastructure from fiscal deficit, the article states that the IMF acknowledge that there is a clear need to promote and protect infrastructure investment. It cites the well-known golden rule that requires Governments to maintain a balance on current revenues and expenditure — what we in India call the "revenue account".

While the article seems to favour the adoption of the golden rule — elimination of revenue account deficit — it points out that the resulting implication that investment be excluded from fiscal deficit, is not straightforward. There remains a danger that all investments may not produce enough returns to service the debt raised to finance them.

The article points out that while the UK had introduced the golden rule, it simultaneously had laid down strict guidelines for allowing debt financing for infrastructure. The article stresses that state-of-the-art fiscal accounting and cost-benefit analysis are needed to prevent the golden rule from being abused. The authors seem sceptical about developing countries being capable of such strict discipline.

The article states that the IMF is prepared to help countries "find scope for additional borrowing to finance productive and cost-effective public investments in a way that is concomitant with economic stability and debt sustainability, paying more attention to the current balance. Governments have to ensure that fiscal adjustment is achieved by mobilising revenues and reducing current rather than capital expenditures".

Though India is fortunately not in a situation where it has to borrow from the IMF, change of emphasis by the IMF on fiscal matters does have potential implications that can change the attitude of those who judge our economic performance.

The article reports that the IMF is engaged in a series of studies on these issues. The results of these studies will be eagerly awaited by all countries, including India, which face the Procrustean fiscal bed. The implication of restricting investment in infrastructure to meet fiscal deficit goals can disappear given the new interpretation.

The debate on fiscal targets is not restricted to India, Brazil and Mexico. The European Union is itself in the midst of a discussion on the Growth and Stability Pact, which "sacrificed" growth at the altar of fiscal prudence. France and Germany have led the fight for the amendment of the fiscal targets which gave them no room for contra-cyclical public spending to avert recession and to combat unemployment.

The fight over Maastricht goals has focused attention of economic polity-makers on the need to tread cautiously with pre-determined fiscal deficit goals, such as 3 per cent of GDP.

The article refers, in particular, to a matter that should concern planners who wish to promote public entities, such as SPVs, which will undertake investment in infrastructure.

An important question of calculation of fiscal deficit numbers concerns inclusion of such investments by public sector entities. This question was, in particular, highlighted by the Latin American Presidents, raising doubts about the inclusion of borrowing by public sector enterprises as distinct from the Government itself in the definition of fiscal deficit.

The cited article tries to allay such apprehensions with a cautious response. "Broad coverage, such as sought by the Latin American Presidents, fails to distinguish enterprises that pose fiscal risks from those that do not.

For that reason, the IMF is considering the possibility of excluding commercially run public enterprises from the coverage of fiscal statistics on the assumption that commercial orientation provides a good guide to fiscal risk." This means that such a public sector entity has the freedom to take business decisions as it sees fit, including those for investment.

This is a sensible recommendation which has, however, profound implications and can be met by Governments ensuring autonomy for public enterprises as well as demanding good corporate governance from them in return. There should be a rational policy for allowing enterprises to "autonomously" price their products and services.

Current misdemeanours, such as the ones practiced by the Government of India and the State governments in respect of enterprises such as oil-sector PSUs and SEBs, should be avoided at all cost. Investment by such aberrant enterprises needs to be penalised by being included in the fiscal deficit calculation.

To sum up, the IMF itself has thrown open the issue of whether to include public investment, particularly in infrastructure, in calculating fiscal deficit or not.

The IMF seems to be approaching the issue sensibly by allowing such public investment to be excluded, so long as its output of goods and services are priced on rational economic criteria by enterprises or the Government itself and managed on business principles.

The whole issue of over-emphasis on fiscal compression as a matter of public policy needs to be revisited, especially in the current context of India facing a high infrastructure deficit and mounting social and defence needs.

India needs to engage in an active dialogue with the IMF on the issue as the Latin American Presidents have done.

It would be useful to revisit the issue before the Government of India commits itself to irrevocable steps pursuing fiscal purity for its own sake.

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