One of the persistent points made in this column is that India needs a new fiscal policy framework to complement the new monetary policy framework that has been adopted (for example, see ‘Why India needs a new fiscal policy framework’). A committee headed by veteran bureaucrat N.K. Singh is expected to recommend changes in Indian fiscal rules when it submits its report to the government in the coming weeks.
Here are five questions worth pondering over.
Should the fiscal rule be more flexible?
The landmark Fiscal Responsibility and Budget Management Act was a laudable effort by the Indian political system to impose on itself a legal limit on deficits. One of the main criticisms of the existing fiscal rule is that it is rigid, and delinked from the state of the underlying economy. Governments sometimes have to focus on cutting the fiscal deficit even when the economy is growing below its potential growth rate. Fiscal policy can be pro-cyclical rather than anti-cyclical in these circumstances.
One way to deal with this problem is to have a fiscal deficit target as a percentage of potential output rather than actual output. However, there are too many statistical problems in estimating potential output. The global consensus has also moved from hard to more flexible fiscal rules, although the context in the developed economies is quite different from what we have in India right now. It now seems likely that the N.K. Singh committee will recommend a fiscal deficit range rather than a fixed number, so that the government of the day has more flexibility. The tricky question is how much flexibility.
Should fiscal policy keep the inflation target in mind?
The inflation target has been set by the government. The Reserve Bank of India (RBI) has been given the freedom to pursue it as it thinks best. There is a distinct possibility that fiscal policy—either through the fiscal deficit target or decisions on the minimum support prices for food—may act as obstacles in the fight against inflation. The Indian central bank, RBI, technically has the freedom to slam the brakes when the finance ministry tries to press the accelerator too much. The Raghuram Rajan episode shows that such necessary action could lead to a political firestorm. It would be far better if there is more structured thinking on the impact of budgetary policy on prices—rather than habitually leave Mumbai to douse the inflationary fires lit by New Delhi.
What is the sustainable level of public debt in India?
Most economists will agree that the key question is whether the annual borrowing by the government to fund its fiscal deficit will lead to an unsustainable level of public debt in the medium term. Fiscal crises begin when public debt cannot be comfortably sustained from annual tax revenues, as was the case in 1991.
India has managed to keep its public debt under some control despite having one of the highest fiscal deficits in the world only because it has also had a rapid increase in nominal growth. A less polite way of saying this is as follows: Successive Indian governments have inflated away their past sins.
That may no longer be an option given the structural downward shift in our inflation trajectory. The N.K. Singh committee will hopefully provide us with an estimate of sustainable public debt. The Thirteenth Finance Commission had said that the stock of public debt should be 45% of gross domestic product. Will that be the target? Or something much higher, say around 60%?
Can the bond markets also help reduce fiscal profligacy?
Most of the public debt issued by the Indian government to finance the fiscal deficit is held by public sector banks. The statutory liquidity ratio (SLR) is the regulatory tool through which the government has created a captive market for its bonds. So the interest rates on sovereign bonds barely react to changes in public finances. It is always worth asking whether a new fiscal law needs to be complemented by a more active bond market, which will push up borrowing costs whenever fiscal policy goes out of control. The N.K. Singh committee would do well to revive the old calls for a sharp reduction in the SLR requirements of banks (even though the banks themselves currently prefer government bonds over commercial lending).
Does India need an independent fiscal council to assess budgets?
There is enough empirical proof to show that finance ministers massage budget numbers: Revenues are systematically overestimated while spending is systematically underestimated. The medium-term fiscal statements that are included in the budget documents are rarely credible. An independent fiscal council—something like the bipartisan Congressional Budget Office in the US—needs to be set up to deal with such information asymmetry. Unlike the monetary policy committee or the GST council—two recent institutional innovations—it will be an analytical unit rather than a policy-making one. And it can be made answerable to parliament. Many countries around the world now have fiscal councils.
The quest for a new fiscal law is absolutely fine as long as it does not become an excuse for abandoning fiscal discipline. It should be the centrepiece of a new fiscal policy framework rather than just an argument for flexible fiscal policy. Now, a lot depends on the eagerly awaited final report of the N.K. Singh committee.
Niranjan Rajadhyaksha is executive editor of Mint.
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