A rule-based deviation from fiscal path

Govt ability to reverse any deviation from long-term fiscal path depends on nature of expenditure

An important innovation of the FRBM (Fiscal Responsibility and Budget Management Act) Review Committee Report is its introduction of a rule-based deviation from the fiscal path during times of large swings in the economy. The absence of such a provision in the existing FRBM was a serious weakness, which resulted in the government of the day “pressing the pause button” on multiple occasions. Once the pause button is pressed, the government can do as it pleases, including when and how to get back on to the FRBM path.
 
Arvind Subramanian and the committee agree that the best approach would be by “cyclically adjusting the deficit targets” and that “calculating such adjustments is not possible at the present time”. However, Subramanian criticises the committee’s proposal for triggering the “escape clause” only in exceptional circumstances — when growth diverges by three percentage points or more from the latest four quarters’ average. He points out that until the clause is triggered, the government’s behaviour is likely to be “dramatically pro-cyclical, aggravating the slumps and booms”. He is correct, but stops short of providing an alternative formulation.
 
The committee justifies their proposal for allowing deviations only when conditions are “large” and “rare” on the grounds that it preserves “the sanctity and credibility of the framework recommended by the Committee”. They recommend that this issue “should be looked into seriously by future reviews of the fiscal framework”. What do we do until then?
 
This round, and therefore the debate, is a draw.
 
The starting point for making any progress from here is the recognition that:

• “Pro-cyclicality” is the inevitable outcome of any binding constraint on public borrowing.
• Centre and states should have different rules.
• Shocks and cycles are very different, and separate provisions need to be made for each.
• Return paths to the fiscal rule are sensitive to the nature of deviation; the escape clause should reflect this.

 
In what follows, I will confine myself to the fiscal deficit rule recommended by the committee and stay as true as I can to the substance of the report.
 

Illustration: Ajaya Mohanty

Most of our states have experienced the pro-cyclicality of binding borrowing limits in recent years. While all of them have curtailed expenditures during slumps, many haven’t fully utilised the available fiscal space during booms. Nevertheless, given the heterogeneity of state-level behaviour and the difficulty of inter-state coordination, it may be wise to not provide an escape clause for states and let the entire burden of adjustment be borne by the Centre, which has more policy options. An immediate implication is that the Centre will have to take into account the pro-cyclical behaviour of states while framing counter-cyclical interventions.
 
As the committee points out, the recommended triggers are shocks, which have three characteristics: (a) asymmetric, almost all shocks are negative; (b) sharp and sudden, with usually slow recovery; and (c) monetary policy is ineffective. To prevent prolonged disruption, the response must be equally large and sharp. The committee’s recommendation of a 0.5 percentage point relaxation of fiscal deficit simply isn’t enough. However it is calculated, the expenditure multiplier in India is no more than three, which means that if a three percentage point decline in gross domestic product (GDP) is to be countered, fiscal deficit will have to rise by at least one percentage point of GDP, and probably more to take into account the contraction in expenditures by states. The reversal of such a deviation will depend upon the duration of the shock and pace of recovery.
 
In contrast, cyclical movements are gradual, usually symmetric, and more amenable to monetary policy. However, they can be equally pernicious, especially if the government is committed to a pro-cyclical fiscal stance. Not providing for such eventualities can expose the economy to unintended instability. In its response to the dissent note, the committee indicates that it had considered deviations of two percentage points from the four-quarter average, but rejected it in favour of the three percentage point trigger. I would suggest considering a trigger at 1.5 percentage point deviation in both directions with a flexibility of 0.3 percentage point in fiscal deficit. This may not entirely take care of the cyclical issue, but would contribute to limiting potential damage.

 

Finally, the ability of the government to reverse any deviations from the long-term fiscal path depends crucially on the nature of expenditure commitments. The problem occurs when increase in expenditures is on activities which are difficult to roll back for political reasons. These mostly fall into the category of revenue expenditures, while capital expenditures can be turned on and off with greater ease. It is, therefore, important to clarify in the escape clause that only the fiscal deficit target is being relaxed, not the revenue deficit target.
 
Recommendations for the FRBM
 
The open disagreement within the committee calls for inputs into the final decision that the government will have to take. My advice is as follows:
 

• Accept the 2.5 per cent fiscal deficit operational target for 2022-23 with a realisation that it can be relaxed up to four per cent without compromising the 40 per cent debt/GDP objective. Retain the limits for states as specified.
• Provide two escape triggers — one at 1.5 per cent change in growth rate with a 0.3 per cent flexibility in fiscal deficit; the other at three per cent change in growth rate with 1.5 per cent fiscal deficit flexibility.
• Don’t permit any flexibility in the revenue deficit target.
• Set up a committee to examine: (a) how far debt/GDP ratio and fiscal deficit can be allowed to fall without serious systemic repercussions; and (b) transition path to a zero primary deficit regime.

(Series concluded; you can read the first part here)

The author is country director for IGC’s India Central Programme. He was chief statistician, Government of India

Published with permission from Ideas For India, an economics and policy portal. You can read the full version here