The Hindu Business Line : Thinking out of the fiscal box

The RBI and the Centre should put on their best thinking caps and arrive at reasonable limits which take into account the various implications of a rigid fiscal cap. They should even be bold enough to explore all possible options without being committed to such concepts as a rigid fiscal deficit cap. Fiscal deficits, in general, need not per se lead to inflation or balance of payment difficulties.

The Planning Commission, in its latest approach paper, drew attention to the consequences of restrictions imposed by the Fiscal Responsibility and Budgetary Management (FRBM) Act. It pointed out that rigid implementation of the target without relevance to contra-cyclical implications may unduly restrict the necessary investments in the economy, in particular in infrastructure.

It emphasised the need for putting forward the date of implementation of the target for fiscal reduction. Apart from this, the Planners referred to the need for more space for adjusting the revenue deficit, as planned, to zero.

In their view, most of the social sector expenditure in the coming Plan would be classified as revenue account expenses, in the conventional definition. This means the commitment to reducing revenue deficit to zero would mean decreasing the expenditure provisions for education, health and social welfare schemes.

Conventional wisdom, however, would argue that there may not be much scope for buying the Planners' views on revenue deficits as borrowals for current expenditures may not be justified since there would not be tangible financial returns from expenditure on health, education and social welfare.

Although this may be a valid argument against revenue deficits, given the current Dengue and Chikungunya epidemics, one would be hard put to it to argue that there are no returns from such investments in the social sector.

The problem is to translate them into taxes and revenue gains for the public exchequer so that loans borrowed can be repaid. Per contra, lack of health infrastructure can lead to large-scale impediments to growth. There is, therefore, justification for increased social sector outlays. Whether they should be financed by borrowals, which is what a revenue deficit means, or by a mix of borrowings and revenues is the question to be decided.

The fiscal cap

Referring to the FRBM cap on fiscal deficit as such, we have to concede that economists have generally been in favour of "fiscal caps", especially with a view to binding governments not to indulge in unrestrained borrowing and increasing public debt. As part of economic reform, India had also engaged in fiscal responsibility legislation.

However, the validity of a 3 per cent cap as imposed was discussed by the Standing Committee of Parliament. Different views were expressed. Finally, the 3 per cent limit seems to have been arrived at, perhaps based on prevalent international practices, particularly the European Union's Maastricht Treaty.

Experience has, however, shown sharp differences in actual practice, even in the EU. Germany and France tried to justify the exclusion of certain items of expenditure so as to fall within the Maastricht Treaty targets.

Shifting the goalposts showed that the 3 per cent target was itself not politically feasible, though it was intended to be enforced rigorously by sanctions and fines. If even mature economies, such as those in EU, sought the relaxation of the Maastricht targets, it is only natural that a developing country like India should feel the need for fiscal flexibility even more.

I have been suggesting that RBI/Centre should put on their best thinking caps and arrive at reasonable limits which take into account the various implications of a rigid fiscal cap.

In this context, my attention was recently drawn to a comprehensive book Fiscal Policies and Economic Growth in India by Dr Edgardo M. Favaro and Dr Ashok Lahiri (Oxford University Press). The book was published in 2004 although it incorporated papers presented at a conference on the subject held in 2001. The book clarifies a number of issues related to the ticklish subject of fiscal deficits in the Indian context.

Diverse viewpoints

In a central theme paper, Ashok Lahiri and R. Kannan discuss in detail the subject of India's fiscal deficits and their sustainability and present fairly the diverse viewpoints. They classify the different views into the Orthodox School and Keynesian point of view.

According to the orthodox view, high fiscal deficits pose considerable risks to macroeconomic stability. Kannan and Lahiri explain at some length, and in sufficient mathematical detail, which is beyond layman's provenance — the derivation of the Donar condition. According to this, a fiscal deficit is sustainable when the rate of interest is lower than the rate of growth of GDP. This ensures that the amount required for financing the interest repayment is capable of being garnered from the rise in GDP.

It is worth noting that throughout the recent period, although the fiscal deficit/GDP ratio was above the FRBM caps, this condition has been satisfied. While Kannan and Lahiri warn against too facile a conclusion being drawn from this "excess" of the rate of growth over the rate of interest, they appear to concede that this is a favourable feature of India's economic management, notwithstanding their high fiscal deficit.

Debt-GDP ratio

The Keynesians have argued on the basis of the following points. The debt is moderate by international standards. Mihir Rakshit has argued "Why should a 65 per cent debt to GDP ratio be considered too high, considering that instances abound when some countries have debt to GDP exceeding 100 per cent without any apparent clogging of their wheels?"

Second, the debt is more of the domestic than external variety, which means that interest and principal payments are being mostly transfers from the tax-payer to bondholders, both being domestic.

The paper also cites Keynesian arguments to the effect that fiscal deficits, in general, need not per se lead to inflation or balance of payment difficulties. In this view, there need be no spillover of fiscal deficit to the current account of the BoP.

One of the experts, a leading economist, Dr Pulapre Balakrishnan, is quoted as saying: "Economies as diverse as UK and Mexico were cases where they had succeeded reducing their budget deficits, but faced increasing current account deficits. More egregiously, the Mexican economy faced a BoP crisis when their budget was in surplus.

Similarly, the Thai economy had a BoP crisis when its budget was in the pink of health. All this goes to prove that fears regarding fiscal deficits spilling over into BoP problem may not be fully justified.

Some of the Keynesians go one step further. They favour some monetised financing — borrowing from RBI — within limits. To quote Mr Mihir Rakshit, government expenditure financed from the central bank may well reduce the rate of interest. It has also a "crowding in" effect instead of a "crowding out".

This may, in fact, be preferable to imposing requirements, like SLR, which constrain the available pool of loanable fund and crowds out private borrowers and may lead to higher interest costs.

While I do not go to the extent of advocating resort to money financing, I do feel we should be bold enough to explore all possible options without being committed to such concepts as a rigid fiscal deficit cap.

My plea is "do not get committed to a rigid fiscal deficit cap if it comes in the way of achieving a non-inflationary rate of adequate GDP growth, which alone can pull the economy out of its poverty and infrastructural, educational and health deficits, which are more important than fiscal purity". Thinking out of the fiscal box may help.