The Fiscal Responsibility and Budget Management (FRBM) committee will shortly submit its report to the government. Its report will presumably lead to version two of the earlier FRBM Act of 2003. The aim is to legislate fiscal discipline, rather than depend on the government’s own prudence and discretion. The law will a specify the upper limit, a sort of lakshman rekha that cannot be crossed by the fiscal deficit. That our lawmakers need to bind their hands with laws that they themselves enact may sound strange. But such is the power of spending temptations, and such is the force of vested interests, that a legal ceiling is the best way to control deficit spending.
In Homer’s epic Odyssey, the war hero Odysseus on his return journey is warned about the serenading Sirens. They lure sailors with their enchanting music and singing, only to cause shipwrecks, destruction and death. So the captain plugs the ears of all his sailors, and instructs them that he be tied to the mast, so that he would not succumb to the temptation, even after hearing the melodies.
The FRBM law too seeks to tie up our lawmakers to the mast of a fiscal deficit limit. It worked for Odysseus, but will it work for our lawmakers? When they are passing the Sirens that beckon more spending and more subsidies, will the lawmakers control themselves? Our recent history is not very encouraging. The 2003 FRBM law was promptly abandoned during the crisis of 2008. What the lawmakers can do, they can also undo.
But let us not blame only Indian lawmakers. Even the sacrosanct limit imposed by the Maastricht Treaty of 1992 was breached by the Europeans. The first ones to breach it were the big boys Germany and France. There was virtually no penalty for that breach. Hence to ensure that version two of the FRBM law is more effective and stands a better chance of being enforced, it may help to establish an autonomous body outside of Parliament. Just as we recently formed the monetary policy committee, which will now be accountable for monetary policy, we also need a fiscal policy council. This can be set up to act as a watchdog for the FRBM Act.
As Montek Singh Ahluwalia wrote in these pages, such a council will strengthen the hands of the finance ministry, which otherwise is the sole guardian of fiscal prudence. It would also enhance coordination between monetary and fiscal policies, which otherwise tend to be confrontational. Building on our earlier FRBM experience, it would be helpful if the new proposal specifies a range rather than just a number for an upper cap. The maximum deficit should remain in this range over the business cycle rather than annually.
In addition, the FRBM committee could consider the following four points. Firstly, India has one of the lowest tax-to-GDP (gross domestic product) ratios in the world. Hence, tax collection necessarily has to be supplemented by borrowing to feed the growth-oriented spending of the government. The importance of borrowing will diminish only when the tax net widens, and collection is buoyant. This may well happen with the rollout of the goods and services tax (GST). But until then we must make an allowance for more borrowing, and hence a bias towards a higher FRBM ceiling.
Secondly, much of the government’s spending is going to be for building infrastructure. In India’s current state of development, the backlog is anywhere between $1-2 trillion of new spending. The roads, railway, airports, bridges and waterways are all public goods that will outlive the current generation. Their benefit will accrue mostly to future generations. To that extent debt financing, that is, taxes levied in the future or on the unborn, is better than taxing the present.
Thirdly, it is pointless to differentiate between capital and revenue expenses, as far as the government is concerned. Expenditure on public infrastructure is surely capital in nature, since it leads to asset creation. Even spending on education and health ultimately enhances human capital, and in that sense can be argued as a capital expense. Stretching our imagination, even spending on mid-day meals could be called capital expense, since that too helps children’s nutrition and development. All capital expense is an investment in future growth that will benefit the yet-unborn generation. This implies that public finance be biased towards borrowing. The metric used to assess the sustainability of the deficit should then be the primary deficit only. This is fiscal deficit minus interest obligation.
Fourthly, India’s young demography too suggests a bias toward debt financed spending for today. A rupee borrowed and spent today has a lower per-capita burden in the future. That’s because (a) the tax net of tomorrow is wider; and (b) tomorrow’s generation will be three times richer in per capita terms. For instance, see the NITI Aayog’s projection for a $10 trillion economy by 2032.
The importance of fiscal discipline cannot be overemphasized. It gets us better sovereign rating (and hence saves interest cost on foreign borrowing). Even though almost all of the public debt is in domestic currency, the discipline also helps curtail inflationary forces. It frees up more capital for the private sector at a lower cost. Yet at our current state of development, demography and tax administration, a bias towards a higher fiscal deficit may be justified. The future unborn generations will thank us, and also pay the bill.
Ajit Ranade is chief economist at Aditya Birla Group.
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