Missing fiscal deficit target is in Budget DNA

Now that the din over the Union Budget has died down, it’s worth asking: Does the fiscal deficit target of 3 per cent of gross domestic product (GDP) make any sense at all?

The finance minister told us in her Budget speech that we will miss the targets for 2019-20 and 2020-21 by 0.5 per cent. Nirmala Sitharaman sounded prim and proper on the subject. The deviations, she said, were in accordance with the “trigger mechanism” provided by section 4(2) in the Fiscal Responsibility and Budget Management (FRBM) Act. 

The section allows the government to deviate from the FRBM target for any number of reasons: National security, act of war, national calamity, collapse of agriculture severely affecting farm output and incomes, structural reforms in the economy with unanticipated fiscal implications, and decline in real output growth of a quarter by atleast 3 per cent points below its average of the previous four quarters. 

From the above list, Ms Sitharaman invoked “structural reforms in the economy with unanticipated fiscal implications” to justify the present deviations. Now, structural reforms will be work-in-progress in the foreseeable future. Any finance minister could fall back on structural reforms to justify deviations. 

There’s no escaping the reality: Deviations from fiscal deficit targets have become the norm. The ultimate target of 3 per cent of GDP now appears to be something of a mirage.Here’s the story in brief.

Under the FRBM Act of 2003, the target of 3 per cent of  GDP for the fiscal deficit was to have been met by March 31, 2008. In 2004, the target was moved to March 31, 2009. In 2008, came the global financial crisis. In 2009, the fiscal deficit targets were suspended. 

In 2011-12, the government announced a return to the targets of the FRBM Act. The Finance Bill of 2012 introduced the concept of “effective revenue deficit” and proposed that this deficit be eliminated by March 31, 2015. The FRBM Act was amended accordingly in May 2013. The Act was amended again through the Finance Bill of 2015 and the deadline of March 31, 2015, was moved to March 31, 2018. The same Bill set 2017-18 as the year for reducing the fiscal deficit to 3 per cent of GDP.

The story doesn’t end there. In May 2016, the government constituted a committee headed by N K Singh to review the FRBM Act. It submitted its report in January 2017. The Singh committee proposed that the fiscal deficit target be reduced to 3 per cent by 2017-18 and further to 2.5 per cent by 2022-23. 

It was the Singh committee that proposed the “escape clause”, whereby a deviation of 0.5 per cent from the specified target was permitted. The committee had attached an important proviso to the escape clause: There must be a clear commitment to return to the original fiscal deficit target in the ensuing year. This proviso has fallen by the wayside.

In his Budget for 2017-18, Arun Jaitley referred to the recommendations of the Singh committee but chose to move the target date for the fiscal deficit of 3 per cent of GDP to 2018-19. In his Budget for 2018-19, Jaitley proposed a “glide path” under which the target of 3 per cent was now pushed out further to 2020-21. The Budget for 2020-21 envisages a target of 3.5 per cent of GDP for 2020-21 and 3.1 per cent of 2022-23. The target of 3 per cent is not even on the horizon! 

The picture should be clear enough. The government can propose a path towards the target of 3 per cent. It may deviate by up to 0.5 per cent from intermediate targets along the path. It may even propose a fresh path when it appears that the target date for 3 per cent will not be met. Missing the fiscal deficit target is now built into the Budget’s DNA.

What is the way out? How do we make fiscal deficit targets more credible? 

One possibility is to accept the reality of our fiscal position and simply set the target higher than 3 per cent. The danger in this approach should be obvious. Instead of fudging around deficits of 3 per cent or thereabouts, governments will end up fudging around higher targets. Getting governments to work notionally towards a 3 per cent target is better.

Some have proposed that the government aim at a target of 3 per cent over the entire business cycle. The deficit will be higher in years in which growth is weaker and lower when growth is stronger. The problem is that we don’t have a handle on the length of a business cycle in India, unlike in the advanced economies. So it’s hard to specify the period over which the fiscal deficit must average 3 per cent. 

Moreover, tenures of governments tend to be shorter than the business cycle. The government of the day won’t be able to resist the temptation to err on the side of expansion and leave it to its successors to pay for its excesses.

A third suggestion is to allow for a deviation that is larger than 0.5 per cent in a given year, say up to 1.5 per cent, so that the stimulus is truly meaningful. The date for returning to the committed targets can be specified. Again, governments will be tempted to avail of the large deviation when it suits them— and then fail to return to committed targets. The real check on the government, it seems, is not the FRBM Act but the fear of being downgraded by the rating agencies.

There seems to be no way out. Managing revenues and expenditure to get the numerator in the fiscal deficit-to-GDP ratio down seems a Herculean task. The best we can hope for is that the denominator, the GDP, gets a boost, either from a global recovery or a greatly improved export performance. 

The writer is a professor at IIM Ahmedabad