An insider's take on FRBM report

Extant FRBM legislation focusses on two operational targets, the fiscal deficit and revenue deficit

The government has placed the report of the Fiscal Responsibility and Budget Management (FRBM) review committee (of which I was a member) in the public domain for discussion. This is commendable. It is important that the recommendations of the report, and the grounds on which these are based, be debated and understood by all stakeholders. Fiscal responsibility is a public good; successful implementation of any framework requires consensus on its objectives, and collaboration in its implementation. In this column, I offer my personal take on the reasoning behind the main recommendations.

The report specifies a debt anchor for general government — 60 per cent of gross domestic product (GDP), which limits central government debt to 40 per cent and collective state governments’ debt of 20 per cent of GDP respectively. It presents many arguments on why such an anchor is necessary. For me, the most important is that the Indian Constitution (Articles 292 and 293) enjoined the government to fix limits on its borrowing. In fixing such a debt ceiling, we have finally implemented this constitutional exhortation. We also address international concerns (misplaced or otherwise) with the debt-GDP ratio, which is currently higher than that of any emerging economy or the BRICS. Rating agencies, too, place great importance on the debt-GDP ratio and a debt anchor sends favourable signals to the global investor community.

India’s extant FRBM legislation focusses on two operational targets, the fiscal deficit and the revenue deficit. The majority view on the committee is to continue to use these operational targets. There have to be good reasons to abandon these targets, as policy continuity is an important virtue. There is evidence presented in the report that markets punish India when governments miss the fiscal deficit target. Further, the fiscal deficit for general government also specifies what percentage of total financial savings the government is using to finance its consumption and investment and how much is therefore left for firms and households to borrow. This is especially significant now, when financial savings are declining as a percentage of GDP.

The distinction between revenue and capital spending is one recognised by the Constitution, with good reason. Revenue expenditure is recurrent in nature and should ideally be financed out of taxation, not borrowing. The revenue deficit should be zero; ideally, there should be a revenue surplus which can be used to finance public investment.

The states, taken collectively do not incur a revenue deficit and have not done so for some time. But the Centre’s revenue deficit has increased sharply and consistently over the past 37 years; the ratio of the central government’s revenue to fiscal deficit has risen from 1.3 per cent in 1980-81 to 66 per cent last year. This is a structural shift in the balance of government spending and runs counter to government’s declared policy, which is to increase capital spending to maximise growth. 

I have previously explained the anatomy of the problem in this newspaper (1).

A combination of the legacy burden of high levels of expenditure on interest on debt and the need to maintain expenditure on the core functions of government, especially national security, make it difficult to resolve a 37-year-old structural problem and eliminate the revenue deficit in the medium term. The report recommends a sizeable reduction in the revenue-fiscal deficit ratio to 28 per cent from 66 per cent. This will involve drastic cuts in subsidies, and will require much increased efficiency in revenue expenditure. It will be arduous, but achievable. Trying to do more would be irresponsible, as it would require government to reduce spending on its core functions. 

The current FRBM Act allows the government to deviate from its fiscal path on fairly broad grounds, liable to expeditious interpretation. We paid a heavy price for this in the post-crisis years. The report, therefore, has specified three circumstances when deviations may be permitted, two of which (extreme events, and a sharp growth downturn) are unexceptional (though there may be different views on how much fiscal room the government should be allowed for a growth downturn). The third allows relaxation when there are “far-reaching structural reforms in the economy with unanticipated fiscal implications”. Unease with this clause is understandable, but I think there is an inbuilt check. 

It is the responsibility of the government to assess the fiscal consequences of policy actions and to take account of them when planning the future macro-fiscal envelope. It is only if these plans are “shocked” (a) by events outside the government's control, or (b) by developments that government could not reasonably anticipate, and (c) are of a magnitude that cannot be corrected while remaining on the FRBM path, that such an escape clause should be invoked. If the government does not satisfactorily explain that deviations are due to such unforeseen events or exogenous shocks, then this would imply that it had not done its job of crafting these reforms adequately in the first place (for instance, if this clause is invoked citing the goods and services tax, or demonetisation). This should act as a check on the government’s use of this clause. The fiscal council will also serve a useful purpose in ensuring that this clause is invoked with demonstrable cause. 

The review has proposed a fiscal council. I expect pushback from some government circles. The fiscal council will make it necessary to explain the rationale underlying the government’s fiscal policy actions. In a secretive governance culture like ours, where peripatetic decisions are commonplace, this is a desirable reform, which those used to ruling by discretion will obviously not like.

At the same time, it is important to understand that the fiscal council will not be the fiscal counterpart of the Reserve Bank of India’s (RBI’s) monetary policy committee, in that no powers currently exercised by the government will be transferred to the council. The report specifies three sets of functions. (1) Empirical: Preparing multiyear fiscal forecasts, improving quality of fiscal data and undertaking a fiscal sustainability analysis. (2) Analytical: Ensuring consistency of the annual financial statement with debt targets, producing a fiscal strategy report and preparing the macroeconomic frameworks statement. (3) Advisory: Providing policy guidance to central government at its request, advising on invoking escape clauses, returning to the FRBM path and taking corrective steps to ensure compliance. It will have no regulatory, policy making or auditing function. The idea is to create an institution that works with government to deliver better fiscal outcomes and makes the analytical basis for fiscal decisions clear. 

As a co-author of the report, I look forward to engagement with stakeholders on the recommendations of the report which, I think, presents a credible framework for growth oriented, responsible, fiscal policy making.

(1). “Anatomy of the revenue deficit”, Business Standard, February 4, 2016