Cafe Economics | A new fiscal framework

The move to a flexible fiscal target based on potential output will be welcome, but it will suffer from a major credibility problem unless there is an independent fiscal council that does its own analysis of the budget numbers


Graphic by Paras Jain/Mint
Graphic by Paras Jain/Mint

It is no secret that Indian fiscal policy suffers from a serious deficit bias. The consolidated fiscal deficit in India has been far higher than the comparable budgetary gap in other emerging markets (see chart).

One important reason why fiscal profligacy is more of a rule than an exception is the underlying political economy that creates incentives for spending far more than tax collections. The only reason persistently high deficits have not led to a fiscal crisis for the Indian State is that successive governments have inflated away the public debt.

Hence the need for a fiscal law that will impose legal restrictions on the ability of governments to borrow. The first such discussion is to be found in the constituent assembly debates on Article 292, with B.R. Ambedkar going so far as to say that he would be surprised if future Indian Parliaments do not impose legislative restrictions on government borrowing to fund the budgetary gap. The landmark Fiscal Responsibility and Budget Management (FRBM) Act of 2003 had the same underlying logic, but it is now time for a fresh look at what fiscal rule India should follow. The Narendra Modi government has now appointed a committee headed by veteran policymaker N.K. Singh to recommend a new fiscal rule for India.

I have argued on several occasions that India needs a new fiscal policy framework to complement the new monetary policy framework that has been put in place (http://goo.gl/s4Mjcc ). One problem that a new policy rule should address is the perverse nature of Indian fiscal policy.

This column had noted in February 2015, a few days before finance minister Arun Jaitley had presented his second budget: “The standard economics textbooks propagate a simple principle: net government spending should pick up when private spending is weak but should retreat when private spending is strong. India usually does the opposite. We tend to have pro-cyclical rather than anti-cyclical budgets. In other words, fiscal deficits are first too high during economic booms; governments then struggle to cut spending when the private sector is struggling during downturns.”

The N.K. Singh committee may look at replacing the simple fiscal rule imposed by the original FRBM with a more flexible one that sets moving targets based on the stage of the business cycle. This is in tune with contemporary thinking about fiscal laws the world over, especially since the economic collapse after the 2008 financial crisis made economists realize that counter-cyclical fiscal policy can become ineffective when there is a rigid fiscal rule.

The move to a cyclically adjusted fiscal balance—or the fiscal deficit as a percentage of potential output rather than actual output—seems an attractive one, but there are significant challenges in making a credible transition to the new framework.

There are two important issues. First, it assumes that policymakers have a very good understanding about the nature of the Indian business cycle. Second, the estimates of potential output need to be credible if the financial markets are not to assume that the government of the day is manipulating its fiscal targets. Remember that potential output is not directly observed but can be a contentious statistical estimate. And that the business cycle tends to change with time.

These are key problems the N.K. Singh committee will have to deal with if India has to move to a new system of flexible fiscal targets based on potential output. The most potent solution to this problem is the creation of an independent fiscal council on the lines of the bipartisan Congressional Budget Office in the US, which is now being replicated in many countries. Such a fiscal council will not have the powers to take policy decisions as the new monetary policy committee will, but it will act as an independent analyst of the fiscal numbers.

As economists Roel Beetsma and Xavier Debrun say in a recent paper, fiscal councils can bark but not bite. They can also help anchor fiscal expectations.

If a new fiscal rule and an independent fiscal council can hopefully impose institutional constraints on perverse fiscal policy, some sort of market discipline can also be added if there is a large reduction in the statutory liquidity ratio that allows the Indian government to automatically access a quarter of household savings in the banking system. A significant reduction in this captive market will lead to more market discipline on the part of the government, in the sense that sovereign borrowing costs will increase in tandem with high fiscal deficits.

So, a short memo to the N. K. Singh committee: The move to a flexible fiscal target based on potential output will be welcome, but it will suffer from a major credibility problem unless there is an independent fiscal council that does its own analysis of the budget numbers.

Niranjan Rajadhyaksha is executive editor of Mint.

More From Livemint