India needs new fiscal pact

India needs new fiscal pact
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First Published: Tue, Feb 26 2008. 11 25 PM IST
Updated: Tue, Feb 26 2008. 11 25 PM IST
Finance minister P. Chidambaram will stand in front of the nation on 29 February and deliver what could be the final Budget of this government. He will almost certainly announce that the government has met the fiscal deficit target that was announced a year ago. He is also likely to say that the government is on course to meet the deficit targets imposed upon it by the Fiscal Responsibility and Budget Management (FRBM) Act of 2003.
But the official deficit number will be misleading. The official Budget numbers will look impressive because of strong revenue growth rather than spending discipline. But the government has been running a parallel deficit that has been kept out of its books through accounting fudges. If we add these off-budget liabilities—including oil and food bonds worth close to 1% of gross domestic product, or GDP, that have been sold to offset the losses on fuel and food subsidies—to the official Budget figures, then the government’s finances will not seem as impressive as claimed by the finance ministry.
Several economists have already pointed this out. The International Monetary Fund (IMF) says in its latest staff report on India that if off-budget bond issuance and the deficits of state governments are added to the official government numbers, then India’s fiscal deficit is around 7.25% of GDP. That’s intolerably high. “Overall fiscal consolidation has…stalled. (The) general government deficit has hovered at just over 7% of GDP since 2004-05.”
The fiscal gains of the past few years are, thus, part illusion.
Even if one ignores the excursions into smart accounting, India’s fiscal record is not as impressive as it seems at first glance. True, the fiscal deficit for 2007-08 is far lower than what it was at the beginning of this decade. But India’s fiscal deficit is still far higher than the budget gap in most other emerging markets. China, for example, has a small budget surplus.
This government has frittered away a wonderful opportunity to put its finances in order and get rid of our most persistent macroeconomic problem. India has witnessed an economic boom that is unmatched in its history. Tax collections have soared. But so have expenditures. Other countries— notably the US in the 1990s—used strong economic growth to set their financial houses in order. We haven’t.
The recent record suggests that the Indian government—irrespective of the party in power—is incapable of being fiscally disciplined in even the most benign economic circumstances.
The only instances in the recent past when there have been serious attempts to control deficits were in the early 1990s and the early years of this decade. In the early 1990s, the stiff conditions attached to the IMF loan forced the government to slash its deficit. And then in the early years of this decade, the National Democratic Alliance government agreed to tie its own hands by passing the FRBM Act in 2003.
Other countries have also used fiscal responsibility laws to curb government profligacy. New Zealand introduced a Fiscal Responsibility Act in 1994. In the US, after the failure of the Gramm-Rudman-Hollings Act during the Reagan era, the Budget Enforcement Act of 1990 paved the way for a bipartisan push to balance the budget there. The European Union’s Growth and Stability Pact of 1997 is another exemplar legislation.
The most practical way to avoid such fiscal stress is to tie the government down with binding constraints. FRBM has been a welcome piece of legislation. In its original form, this law expected the Union government to bring down its fiscal deficit down to 3% of GDP and wipe out its revenue deficit by this year. The government later pushed the deadline to 2009.
Despite the burgeoning off-budget liabilities, there is little doubt that FRBM did help prevent worse fiscal excesses. The problem is that the FRBM law has given numerical targets till 2009—and targets that were impressive at a time when the deficit was close to 6% of GDP and economic growth was sluggish. But these targets now look quite modest.
And there are no numerical targets for the years beyond 2009. Given the economic boom and strong growth in tax collections, India now needs a fresh set of stiff and binding deficit reduction targets. Or a new fiscal pact that will force the government to further cut its deficit over the next five years.
High deficits are not an economist’s irrelevant obsession. The Reserve Bank of India (RBI) is under immense pressure to cut interest rates, despite resurgent inflation. But what the central bank’s critics often do not say is that India cannot run a slack monetary policy when it also has such a loose fiscal policy. One of the two policy screws has to be tightened at this juncture—to keep effective demand and inflation under control.
In other words, the high government deficit restricts RBI’s ability to cut interest rates.
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First Published: Tue, Feb 26 2008. 11 25 PM IST
More Topics: Fiscal Policy | Budget | Economy | Revenue Growth | IMF |