India has made yet another brave attempt at getting its public finances in order. The 13th Finance Commission and the Union Budget have laid out a road map to cut the fiscal deficit and public debt over the next five years. Both are needed to maintain economic stability and create more space for private investment.
These are laudable first steps, but the more difficult challenge lies in the implementation. The politicians who run the national budget have strong incentives to think short-term while a credible fiscal correction needs long-term thinking. We have already seen how the Manmohan Singh government myopically wasted the opportunities offered by the economic boom between 2004 and 2008, when soaring tax revenue and a buoyant stock market should have put India’s public finances in better shape before the downturn came. India thus entered the downturn with very high levels of public debt and fiscal deficits, as a result of which it did not have the headroom to go in for a huge fiscal stimulus as China could.
How can politicians be disciplined? India has tried to temper the usual political tendency to spend to win votes by going in for hard fiscal rules that commit the government to low deficits. The landmark Fiscal Responsibility and Budget Management Act of 2003 (FRBM) is the best known example and emerged from a broad consensus that cut across party lines, no mean feat. It was quite another matter that the first Manmohan Singh government used some of the loopholes in the legislation to not account for oil and fertilizer subsidies in the deficit numbers, a sorry case of fudging. The FRBM rules were finally buried when the fiscal deficit shot up in the wake of the global downturn.
India needs a new and improved set of legislative rules to bind the government to its medium-term fiscal plan while at the same time providing enough discretion for the government to act quickly in times of trouble. But will FRBM 2.0 be enough? Perhaps not. It is time some thought was given to other forms of restraint on government profligacy.
The financial markets may not have much role to play right now. We see in the case of countries such as Greece and Spain that the bond markets can act as independent watchdogs that bite when public finances go awry. India is unlikely to face the heat from bond vigilantes for the simple reason that most public debt is owned by domestic investors, especially banks controlled by the government.
A more useful option would be to set up autonomous fiscal authorities to either help the government design fiscal policy or provide independent analysis of the budget numbers and forecasts. In a fascinating paper, Independent Fiscal Agencies, Xavier Debrun, David Hauner and Manmohan Kumar of the International Monetary Fund provide an excellent overview of why and how such agencies can complement fiscal rules in disciplining governments.
The three economists identify two types of institutions in their research. One, fiscal authorities that conduct fiscal policy on behalf of the government just as independent central banks conduct monetary policy in some countries. Two, fiscal councils that make the budget more transparent and credible, by providing independent analysis of the budget numbers, assessing the consistency of budgetary policies with long-term objectives or advising governments on “specific fiscal adjustment measures in the context of established fiscal rules”.
A country such as India that does not have an independent central bank is hardly likely to get an independent fiscal authority anytime in the near future. But a fiscal council of the sort that Debrun, Hauner and Kumar recommend is worth considering.
Many countries have such fiscal councils. One of the best known examples is the US Congressional Budget Office (CBO), which analyses the federal budget, provides its own forecasts about how various economic variables will move in the years ahead and commissions several independent economic reports. Just take a look at its trenchant analysis of the Obama administration’s tax and spend policies. That is the sort of institution that India now needs. We depend too heavily on what the finance ministry tells us right now.
India is now perhaps a year away from a system of low and stable taxes that finance ministers will find difficult to fiddle with. The spending budget will be the only remaining ground for discretionary policies meant to buy votes and placate lobbies. The fiscal rules provided by a new FRBM law will be useful, but we also need an Indian version of CBO to keep the government on its toes. One can guess what an Indian CBO would have said about the fiscal fudging that was done in 2007 and 2008, or about the fact that the so-called fiscal stimulus was less an economic recovery plan, and more a politically convenient attempt to buy votes ahead of the 2009 general election.
Niranjan Rajadhyaksha is managing editor of Mint.
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