Still a Mental Fiscal Exercise

FRBM-2 has good ideas but isn’t tough enough to enforce financial discipline
The N K Singh Committee has suggested a new Fiscal Responsibility and Budget Management (FRBM) Act to replace the old one. It has many eminently sensible proposals. Its most obvious shortcoming is that its recommendations have no teeth, and rely on good sense and fiscal rules that can easily be broken -as often happened in the past. This asks a lot of Indian politicians who love spending sprees.FRBM-1called for the Centre’s fiscal deficit to be cut to 3% by 2008. That target is finally going to be achieved a good 10 years later. It highlights how often finance ministers can push the `pause’ and `reverse’ buttons. State governments have used many gimmicks to evade fiscal rules.

FRBM Not Quite ICBM

This problem will not go away because a new committee has suggested new norms. However, despite many deviations, FRBM-1 did make fiscal prudence a serious issue in framing central and state budgets. FRBM-2 can build on that.

The main change in FRBM-2 is to make the public debt-GDP ratio the anchor for fiscal policy. Fiscal deficits will be adjusted annually to achieve an anchor rate of 61%, down from around 70% today . This will be achieved by lowering the Centre’s ratio from 49.4% to 40%, while leaving the states’ ratio at today’s 21%. The glide path for the central fiscal deficit will be from 3.0% during 2018-20 down to 2.5% in 2022-23 and thereafter. The revenue deficit is to slide 0.25% every year, from 2.3% in 2016-17 to 0.8% by 2022-23. The states will follow a more complicated fiscal deficit glide path, from almost 3% today to 1.7% by 2025.

Far from being excessively tough, the targets are rather weak. The original FRBM-1targets implicitly aimed to cut the debt-GDP ratio to just 50%. The new target is far laxer, at 61%. The combined fiscal deficits of the Centre and states will be 4.2% of GDP even if all goes well, and fiscal deficits of this size have been enough to bust many countries in Latin America and Africa.

India can afford much higher fiscal deficits and debt-GDP ratios than other countries since it has high rates of savings and growth, both of which make debt more sustainable. Keynesians seek a more activist role for governments, spurring growth through massive public investment. But the record of public investment is, with honourable exceptions, substandard.

Besides, history suggests that fiscal laxity will typically fund freebies rather than efficient investment. The government should focus on public goods like justice, security, health and education, while the private sector progressively takes the lead in investment. The lower the fiscal deficit, the more bank finance will be available for financing private investment.

A debt-GDP ratio of 60% can be sustainable at reasonably low interest rates, and quite unsustainable at high interest rates. The committee takes at face value the RBI inflation target of 4%, +­2%. But history suggests that the RBI’s weapons -mainly the repo rate -cannot deal with in flation caused by drought or a global commodity boom. Hence, an anchor rate of 50% may have been more pru dent. That may be the battle to be fo ught by a future FRBM committee a decade hence.

The committee has suggested esca pe clauses from the fiscal path in the event of unexpected disasters. In such cases, fiscal deviation of no more than 0.5% for one year will be allowed, af ter which the normal glide path will resume. This rule may be politically acceptable during minor setbacks.

Spender at Any Speed

But the Great Recession of 2008 would have slashed revenue and increased welfare spending by at least 1.5% of GDP even without Pranab Mukher jee’s additional stimulus. Realistical ly, we can expect politicians to run much bigger deficits in really bad ye ars. Politics will trump FRBM-2, just as it often trumped FRBM-1.

The revenue boom of the 2000s was frittered away without building sur pluses for a rainy day. The committee has suggested that if GDP growth is 3% above the norm, the fiscal deficit should be an additional 0.5% of GDP lower than the glide path. This is a ridiculously high threshold that will rarely be met.

The proposed reduction of the fiscal deficit by just 0.5% in a huge boom cannot be called significant saving for a rainy day . Cynics will say even this tweak will be ignored for finance ministers being urged to use revenue windfalls for freebies.

The committee has suggested the creation of a technocratic Fiscal Council to prepare annual and long-term forecasts, raise alarm bells, highlight deviations and suggest ways to reduce these.

Such a council will not -and politically cannot -have teeth for enforcement. Yet, it can play a useful role as an honest research and advice outfit -like the Congressional Budget Office in the US. India needs such strong, capable institutions without political bias.

In sum, the N K Singh Committee has produced some good ideas for new fiscal rules, but not been tough enough. Whether the new rules will be followed strictly by politicians trying to buy vote banks is doubtful. But the climate for prudence should improve.

What do you think?