Is it time for a new Fiscal Responsibility Act?

C RANGARAJAN DK SRIVASTAVA | Updated on January 11, 2018 Published on May 15, 2017

A roadmap for fiscal discipline Let’s stick to what's there, in the absence of conceptual clarity   -  Bennian/shutterstock.com

There should be no rush to amend the existing law or push through a new one until there is convincing evidence that India’s financial savings have fallen for good

Following a commitment made in the Union Budget for FY17, Fiscal Responsibility and Budget Management review committee was constituted in May 2016.

In its report entitled Responsible Growth: A Debt and Fiscal Framework for 21st Century India, the committee recommended enactment of a new Debt Management and Fiscal Responsibility Act, which provides for a medium-term target for general government debt at 60 per cent of GDP consisting of 40 per cent and 20 per cent of GDP for the Central and State governments, respectively.

Advocating the use of fiscal deficit as an operational target, the committee specifies the path of fiscal and revenue deficits relative to GDP up to FY23. For fiscal deficit to GDP ratio, the specified path retains the target of 3 per cent during FY18-FY20, and then reduces it incrementally to 2.8 per cent and 2.6 per cent, finally reaching 2.5 per cent in FY23.

It is gratifying that the committee has adhered to the need for maintaining fiscal discipline and not opened up windows for unwarranted relaxation. The committee needs to be complimented on this.

There are, however, a number of issues that need to be considered. These relate to the targets to be achieved, the trajectory to be followed, and the flexibility that has to be built in.

Debt ratio and fiscal deficit

The committee has set up a target for debt-GDP ratio and then derived the path for fiscal deficit which is the operational target. There is considerable discussion in the literature on the sustainable level of debt and there is no unanimity. The committee itself refers to seven different ways in which the problem can be approached. Under these circumstances, is it not appropriate as the present FRBM Act has done to go directly and determine the appropriate level of fiscal deficit?

The committee makes a reference to our previous work (Rangarajan, C, & Srivastava, DK (2005), ‘Fiscal Deficits and Government Debt: Implications for Growth and Stabilisation’, Economic and Political Weekly) in emphasising the role of household financial savings in determining the fiscal deficit target. The household savings in financial assets combined with current account deficit provide available resources to be used by the deficit sectors which are corporates, government administration and public sector enterprises.

The Twelfth Finance Commission had suggested that the available fiscal space for general government borrowing could be considered as 6 per cent of GDP. At that time, the household sector’s net financial saving was 10 per cent of GDP and sustainable current account deficit was considered to be 2 per cent of GDP. This was divided equally between the general government and the rest.

Some adjustments

It is true that in the last few years, the household sector’s savings in financial assets has come down but it cannot be assumed that this will be a permanent feature and that fiscal deficit should be brought down to 5 per cent as recommended by the committee. For a growing economy like India to assume a significantly lower long-term savings rate will also require adjusting the growth assumption downwards.

It may be noted that the fiscal deficit path specified by the committee enables a fall in the Centre’s debt-GDP ratio from the current level of 49.4 per cent to below 40 per cent in FY23. This target, however, will also be attained in the same year by retaining the level of fiscal deficit of 3 per cent of GDP as per the current FRBM Act and Rules (p 71, Volume 1, review committee report).

In any case, since even under the specified fiscal deficit path recommended by the review committee, there is no change in the target of fiscal deficit of 3 per cent of GDP for three years, there should be no rush to amend the existing Act or push through a new Act until there is convincing evidence that India’s financial savings have fallen for good to 7.5 per cent or less.

In our view, however, this is unlikely to happen. Besides, States cannot reach the prescribed debt-GDP ratio of 20 per cent under their current fiscal responsibility legislations. This is also shown by the review committee under their “present FRBM” scenario (p 63, Volume 1).

It can further be shown that if their fiscal deficit is higher than 2.1 per cent in the aggregate, it is unlikely that they will ever be able to reach this target. In fact, for them to reduce their fiscal deficits below 2.5 per cent would violate the principle of equal sharing of the available fiscal space for general government borrowing advocated by the review committee (p 59, Volume 1).

It can further be shown that the sustainable level of debt-GDP ratio is 24.2 per cent of GDP for a fiscal deficit ratio of 2.5 per cent and an underlying nominal growth of 11.5 per cent. This can be verified by using the relationship given in the minute of dissent (p. 171).

The minute of dissent recommends focusing on primary deficit. Today, interest payments of the Government constitute about 34.5 per cent of revenue receipts. It is this which has acted as a big deterrent for increasing development expenditure. Focusing on primary deficit which excludes such a huge expenditure may not be the right approach, either theoretically or operationally.

Escape clauses

The review committee has suggested certain ‘escape’ clauses, where the Centre can breach the path of fiscal deficit prescribed in the proposed Bill.

This is permitted on account of (a) over-riding considerations of national security, acts of war, etc; (b) far-reaching structural reforms in the economy with unanticipated fiscal implications; and (c) a decline in real output growth of at least three percentage points below its average of the previous four quarters.

In contrast, the existing FRBM Act also provides an escape clause, where departures from targets are permitted on “ground or grounds of national security, or national calamity, or such other exceptional grounds as the central government may specify”.

The first two clauses of the review committee’s proposal are qualitative in nature and can be invoked by the Centre in the same manner as under the present FRBM Act. It is clause (c) that adds a quantitative and verifiable guidance. Given the way it is drafted, however, it can prove to be pro-cyclical, and ineffective.

Suppose the average growth in the previous year was 7 per cent and in the current year, the growth falls to 5.1 per cent. Since the fall is less than 3 per cent, no fiscal action is initiated. If growth continues to fall in the subsequent year averaging only 2.2 per cent, still no fiscal action would be called for, since the comparison would be with the lower growth of 5.1 per cent.

In the meanwhile, government expenditure would fall as tax revenues fall reinforcing the recessionary trends. The issue of pro-cyclicality was raised strongly in the minute of dissent. Further, if and when fiscal action is initiated, an extra fiscal deficit of only 0.5 per cent of GDP may prove to be ineffective in correcting a fall of more than 3 percentage points.

In any case, this clause will have relevance only up to FY23, since the departure is defined only in relation to a fiscal deficit target, and there is no fiscal deficit target beyond FY23 in the proposed Bill. We refer to these only to point out how difficult it is to specify the conditions.

Implementation teeth

The main problem is that the existing FRBM Act lacks implementation teeth. The targets for fiscal and revenue deficit reduction in the present Act and Rules have proved to be malleable.

The CAG’s Report (no 27, 2016) on the Centre’s compliance of the FRBM Act refers to “continuous deferment of targets”, several instances of understatement of expenditures, and an extensive list of transparency issues. In fact, the Government has failed to keep to the targets even when the economy was growing strongly.

Without implementation teeth, faced with political economy compulsions, the proposed Act may meet the same fate.

The proposed Fiscal Council may improve the quality of analysis, but it would not have any effective instrument to ensure compliance. In fact, if the Government feels the need to deviate from the path specified, it should go before Parliament and get a specific endorsement.

Need for political will

Ultimately, if there is no strong political will, no act can be effective. However, building it in the Constitution as some have suggested may not necessarily be the appropriate way.

Since for three years, the fiscal deficit target of 3 per cent is to be continued according to the FRBM Act 2003, we have time to ensure that the reference values of debt and deficit are made analytically consistent and brought in line with their sustainable values, a more effective counter-cyclical strategy is designed, and effective teeth are built-in by providing for an explicit parliamentary debate and voting for departures from the targets, outside of the normal process of budgetary approval.

Rangarajan is a former chairman of the Economic Advisory Council to the Prime Minister and former governor of the RBI; Srivastava was a member of the Twelfth Finance Commission and director of the Madras School of Economics

Published on May 15, 2017

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