Time to re-frame fiscal prudence norms

| Updated on September 13, 2020 Published on September 13, 2020

Rigid fiscal deficit targets normally lead to the govt cutting back on discretionary spending, which is not good for the economy

An interesting discussion that has been going on of late is on whether there should be flexible norms for fiscal targets. This has assumed a practical aspect today considering that there is a pandemic and all fiscal targets are going to be breached. The MPC (Monetary Policy Committee), for instance, targets 4 per cent inflation with a tolerance limit of +/- 2 per cent. Can we think of such an approach?

The discussion is timely because of the controversy ignited by the recent GST episode. The challenge for India is that there is a federal structure with seemingly unequal financial powers. The Centre can run deficits and debt and not adhere to the FRBM (Fiscal Responsibility and Budget Management) targets, while States perforce have the fiscal deficit ratio as a binding norm with limited flexibility.

Also, there are several transfers from the Centre to the States with any shortfall causing disruptions. Further, grants from the Centre for certain centrally-sponsored schemes run the risk of the States having to put in their money in case there are shortfalls from the Centre as schemes once started are hard to cut back on.

To begin with, is there a rationale for the fiscal deficit ratio to be 3 per cent of GDP? There is no reason why it should be 3 per cent and not 4 per cent or 2 per cent. The number appears to be borrowed from Western experiences, especially during the formation of the Euro zone. For a developing economy like ours, where governments must perforce be more focussed on delivering welfare programmes, a higher number can be justified.

The problem with the fiscal deficit number is that it is a ratio where a higher denominator of GDP will justify a higher deficit. The GDP in nominal terms can explode in case of high inflation and justify a higher fiscal deficit in nominal terms even with a constant ratio. Hence, ironically, governments can run higher deficits by allowing for higher inflation which results when there is too much expansion.

No flexibility

It is true that fiscal deficit does put pressure on the financial system. In fact, too much borrowing becomes a blessing for banks which prefer to invest rather than lend. Therefore, there needs to be limits set. But having a fixed norm also means that the government normally ends up cutting back on discretionary expenditure to meet this target which is not good for the economy.

This has happened in the past and will recur especially at the State level when there is no flexibility. Alternatively, States often target a much lower fiscal deficit number of 2 per cent or so and create buffers and, in the process, restrain themselves from spending on capex.

The idea of a band has its problems. It cannot have something on the lower end like an inflation target as some States are by their volition pursuing this policy. The stretching of the band must be only in the upward direction. Again, there is a problem of by how much should this be permitted, and no number can be sacrosanct.

In fact, curiously, even the MPC target has become debatable because the number of 4 per cent looks unreasonable for an economy like ours which is subject to supply shocks. Further, the action of the MPC has not been consistent when inflation crosses 6 per cent, which should lead to an increase in repo rate but is not the case.

A way out is to fix the quantum of borrowing as a multiple of capex which is discretionary expenditure. For FY21, for instance, a capex size of ₹4.1 lakh crore for the Centre can have a multiple of two as fiscal deficit. This will ensure that at least a minimum amount of gross borrowing goes for capex. An alternative would be to look at borrowings as a proportion of total size of the Budget.

For FY21, a size of ₹30.4 lakh crore can have a proportion of 25 per cent being the fiscal deficit. This way the deficits are dovetailed to the content of the Budget which leaves scope for higher investment. This can address the issue of States too, which have better last-mile-connectivity but are often unable to meet the capex targets due to fiscal responsibility constraints.

Debt-GDP ratio

The issue of debt-to-GDP ratio also requires debate. The Finance Commission is talking of a ratio of 60 per cent, with the Centre and States meeting targets of 40 per cent and 20 per cent, respectively. The problem for States is that such ratios tend to come in the way of reforms which may have to be undertaken to correct systems.

For example, the UDAY scheme requires that a part of the debt of DISCOMs would be taken on by States. Adding such a liability would be dead-wood debt for the States, making them reluctant to go in for such schemes.

The more contemporary clash of ideology between the Centre and States has been on GST compensation (which hopefully will be amicably resolved). States have been given the option of borrowing from the RBI or market, which would not be agreeable as their debt ratios get impacted. They would find it disagreeable to borrow as the funds should be coming from the Centre, which the latter is not able to mobilise. Therefore, this can lead to a turf war where neither arm of the administration would like to take on debt on their books.

Re-framing guidelines on fiscal prudence is quite timely. Mimicking the West is not advisable and linking deficit to GDP runs the risk of slippage when the economy is weak — the denominator falls, collections slide and borrowings automatically increase.

The deficit should be linked with the size of the Budget or its components. The debt-to-GDP ratio should be clearly defined so that the Centre and States do not get into the ideological duel of not borrowing to protect these numbers. Budgeting is not an accounting but growth-inducing exercise.

The writer is Chief Economist, CARE Ratings. Views are personal

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Published on September 13, 2020
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