The Hindu Business Line : Revisiting the debate on fiscal purity

Backed by a wealth of data and analytic insights, a recent set of articles by a group of economists exposes the fault-lines in the traditional approach to fiscal consolidation. Perhaps a radical relook at the concepts they present may help clarify several issues that threaten to impede the country's growth.

The Economic and Political Weekly of November 4-10, 2006 carried a number of articles by eminent economists reappraising the debate on fiscal responsibility. These experts include Drs Mihir Rakshit, Prabhat Patnaik, Amit Bahaduri, Errol D'Souza and D.K. Srivastava.

They discuss, in particular, the points of view put forth by the National Planning Commission on this issue, with particular reference to the case advanced by it for deferring the target dates for the FRBM limits on fiscal deficit. They also refer to the points of view raised by the Finance Minister and the RBI on the issue. The authors' views are generally supportive of the Planners' point of view, except for Dr Srivastava, who points out the virtues of fiscal purity.

It is relevant to point out that the Prime Minister has, in a magisterial but uncharacteristic way, discussed the plea of the planners and lent support to fiscal purism. He has obviously been persuaded by his advisers that it is better to appear fiscally prudent than to open the floodgates to expansion, which a loosening of FRBM targets may involve. But a Prime Ministerial decision does not erode the logic of planners, who have pointed out that there are large infrastructural deficits to be met and that the fiscal deficit targets will restrict Government's capacity to bridge the gaps — unless, of course, tax revenues rise in an uncharacteristically steep fashion.

Fiscal Targets

This requires higher GDP growth, which means better infrastructure and more investment. The logic of the planners is inescapable, but the politics of sound finance in a globalised financial environment in which foreign institutional investors look for insignia of fiscal virtue is also inescapable. If the Government relaxes fiscal targets, it risks annoying the high priests of international investment, which may affect the flows of FII resources and FDI, which may affect our Balance of Payments.

Caught in this dilemma, the Government and the RBI are perhaps right in being on the side of angels, but there is a cost in terms of growth foregone.

Summarised below are some of the relevant inputs of the economists who have contributed to the EPW debate. First and foremost, they point out that there is no logical basis for the ratio of 3 per cent of fiscal deficit to GDP, which the FRBM has laid down.

The closest they come to a "logical" basis is that the Maastricht Treaty laid down the same ratio for the states of the European Union. But, even there, there was no clear basis for saying why it should be 3 per cent and not 4 or 5 per cent. Fiscal deficit is the quantum amount a nation borrows to meet expenditure.

Provided we abide by the golden rule — restrict borrowing to investment needs — it does not seem logical to say why a nation should borrow only 3 per cent of its GDP to make investments. The investment needs are independently determined by the structural developments in the economy, its stock of capital and its planned growth profile. Why should a figure of 3 per cent be resorted to? The FRBM gurus do not have an answer.

Flawed Argument

Dr Prabhat Patnaik in a hard-hitting piece "What is wrong with sound finance?" argues that the conservatives' arguments against a higher fiscal deficit are flawed. He crosses swords with the Economic Advisory Council of the NDA Government (headed by I.G. Patel), which had put forward the proposition that fiscal deficit, if monetised, will cause inflation or otherwise crowd out private investments.

To quote Dr Patnaik, that is "an argument that is so untenable that it was surprising to see some of India's most distinguished economists appending their signatures to the document". All this shows that all is not smooth sailing in the FRBM sea. Economists of the stature of Dr Patnaik have lent their voices against rigid adherence to the 3 per cent rule and fixed targets.

Dr Mihir Rakshit has a more provocative suggestion — provocative to the gurus of fiscal purity, that is. He points out that seignorage (resort to printing money or borrowing from the central bank, prohibited by the FRBM Act) becomes a preferred mode of financing government investment, in the absence of any "cost" of taxation. It does not matter whether the government borrows from the central bank or the public sector for capital expenditure, so long as the social return exceeds the opportunity cost — being the return on private investment.

He concedes that there is a limit beyond which seignorage becomes counterproductive. The optimum seignorage, as a ratio of GDP, is around 2 per cent for a 6 per cent rate of GDP growth and can be more than 3 per cent when a well-designed investment programme pushes the growth rate to 8.5 per cent.

This opens the door for fruitful dialogue between the planners and the central bank, provided both abandon their ideological prejudices in favour of, or against, the prohibition on Central Bank's finance — a key tenet of the FRBM Act. Perhaps, it is hoping for the impossible to so breach this fortress of fiscal purism.

Revenue Deficit

The economic experts who have contributed to the EPW debate also discuss openly the issue of revenue deficit raised by the planners. The latter point out that revenue deficit, as conventionally defined, covers expenditure on the creation of assets, which should be taken into account separately.

The experts, especially Dr Rakshit, suggest the exhibition of two other measures of revenue deficit that take account of the planners' concerns. Whether this will assuage the planners' difficulties is not clear. But it is worth considering.

The EPW articles raise the important question why State Governments currently have rich cash surpluses and yet face difficulties. The experts dismiss the arguments put forward by the Finance Ministry that these reflect poor performance in States. The former emphasise that it is rather the FRBM limit, added to the skewed nature of Central assistance and the high cost of borrowing from small savings.

Be this as it may, the experts incidentally raise an important issue arising from the 12th Finance Commission's recommendations that the States' debt-to-GSDP ratio shall not exceed 30 per cent for a State to be eligible for concessions. The contradiction is that this debt/GDP ratio means that, assuming a GDP annual rate of growth of 13 per cent (nominal), the fiscal deficit will be 3.9 per cent (30 per cent of 13 per cent). This contradicts the limit of 3 per cent on fiscal deficit laid down in FRBM Act on States.

The articles contributed by a brilliant group of economists cannot be adequately summarised in a brief piece like this. But they yield a wealth of data and analytic insights, which go to show that the fiscal landscape is not so simple that legislation can set it right.

Perhaps, a radical relook at the concepts that the experts have put forward will help clarify many issues that threaten to stop the country's growth in its tracks.

True, greater fiscal laxity is an easy option. But fiscal purity is a self-imposed stranglehold on growth. India deserves better. EPW has done yeoman service to the nation by exposing the fault-lines in the traditional reformers' rigid approach to fiscal consolidation.