Home / Opinion / What sort of new FRBM do we need

The N.K. Singh committee to review the Fiscal Responsibility and Budget Management Act (FRBMA), 2003, has produced an excellent report on future reforms in this important area. The report has been made public to elicit comments, so here are my thoughts on some of the key issues.

Do we really need a new Act?

We definitely need a new Act because the existing FRBMA has proved ineffective. It was suspended with impunity in 2009, for several years, during which the fiscal deficit went out of control. There was also non-transparency which allowed the deficit to be seriously understated. The lesson is not that fiscal rules are useless, but that the old Act was flawed, and we need something better.

What fiscal targets should we adopt?

Fiscal rules should focus on macroeconomic stability and the relevant targets for this are the fiscal deficit, the primary deficit, and the debt/GDP (gross domestic product) ratio. The committee has focused on the fiscal deficit, the debt ratio, and also the revenue deficit, which in my view is not relevant.

Our fiscal deficit and debt ratio are much higher than those of other comparable emerging market countries. This doesn’t matter when things are going well, because markets are notoriously forgiving when growth is robust. It is when things go poorly that all hell breaks loose. Since the fiscal deficit and debt ratio are our weak points, our fiscal rules should try to correct both.

Are the proposed targets reasonable?

The committee has recommended reducing the Centre’s debt to GDP ratio from 49.4% in 2016-17 to 40% by 2022-23. The states’ debt ratio is targeted to remain at around 20%. The combined debt of the Centre and the states is targeted to go down from 68% in 2016-17 to 60% by 2022-23.

There is no hard rule to determine what the debt ratio should be. What matters is that it should be viewed as “sustainable" by rating agencies and investors. The 60% debt target for the Centre and the states combined is an improvement from 68% in 2016-17, but it is still much above the average of about 40% for similarly rated emerging market countries. However, since our growth rate is also much higher, a 60% debt ratio may be accepted as a reasonable target.

The committee had recommended a fiscal deficit trajectory which is a step function, with the deficit coming down from 3.5% in 2016-17 to 3% in 2017-18 and staying at that level for the next two years, and then declining steadily to 2.5% by 2022-23, yielding a debt ratio of 38.7%. The chief economic adviser in his dissent note had favoured a more gradual decline (using the primary deficit as the instrument) which would take the fiscal deficit down to 2% in 2022-23 and reduce the debt ratio more sharply to 35.7%. The finance ministry has clearly chosen a more gradual decline because the deficit in the budget is set at 3.2%, which is as recommended in the chief economic adviser’s note.

There are many different trajectories that will yield roughly the same result. However, the outcome depends critically upon the rate of growth. Both the committee and the chief economic adviser have assumed nominal GDP growth of 11.5% (7% real plus 4.5% inflation). If growth decelerates, the fiscal deficit will have to be reduced to achieve the debt target. Fiscal rules that signal that fiscal targets will be modified in the light of actual growth performance will add to credibility. Perhaps the new Act should explicitly allow adjustment of the medium-term fiscal deficit targets once every two years, to reflect revisions in the expected medium-term growth rate.

Flexibility and escape clauses

The committee has considered the need for flexibility in fiscal targets. This is important because a fixed deficit target can pose problems if there is a cyclical downturn in GDP. Lower growth means lower revenue, which means expenditure has to be reduced to keep the absolute level of the deficit on target. The lower GDP will also reduce the denominator in the fiscal deficit ratio, which means the absolute size of the fiscal deficit will have to be lower than originally projected to keep the deficit as a percentage of GDP at the targeted level. Both factors will force a contraction in expenditure, which would worsen the cyclical downturn.

We could overcome this problem by using a “cyclically adjusted" fiscal deficit to measure performance, but such measures are difficult to calculate in a situation where quarterly data is highly unreliable. The committee has therefore recommended an “escape clause" which would enable departure from the fiscal deficit target in specific circumstances. These are (a) overriding considerations of national security, acts of war, calamities of national proportions, etc., (b) far-reaching structural reforms, with unanticipated fiscal implications, and (c) a decline in output growth of at least 3 percentage points below the average of the last four quarters.

The proposal clearly improves over past practice because the escape will be possible only on the recommendation of the Fiscal Council (on which more below) combined with some assurance of a planned return to the original target. However, a shortfall of 3 percentage points is too large. It means growth must fall below 4% in real terms before the target is adjusted. There is a case for triggering the escape clause if there is a
2 percentage points fall in growth in two quarters, below the average of the previous four quarters. The extent of the departure from the fiscal target should be appropriately calibrated. Equally, if growth exceeds expectations, the fiscal target should be reduced to moderate the upswing, but the government may not seek an escape. The Fiscal Council could be tasked with recommending it suo motu.

Should we worry about the revenue deficit?

The revenue deficit has nothing to do with debt and macro stability. It figures in the committee’s recommendations only because of the belief that it will help improve the quality of expenditure. However, the implicit assumption that capital expenditure is always good is an oversimplification, and equally, revenue expenditure incurred in providing health and education services cannot be viewed as bad. The revenue deficit could be dropped from the Act, if only to keep the fiscal rules fixed on macro stability. Concerns about improving the quality of expenditure are best handled through more detailed sectoral evaluations and not by an aggregate indicator.

There is a good case for adding the primary deficit/surplus in the fiscal rules. It is actually a subcomponent of the fiscal deficit, excluding interest payments, and is universally regarded as the real measure of fiscal discipline because it focuses on those items of expenditure which the government controls. Interest payments can go up if interest rates rise, but this does not imply fiscal profligacy. Interest rates on government debt have not been as variable as they are elsewhere, because of financial repression, but as the system becomes more market-driven, they will become more variable. We should devise an architecture of fiscal rules that looks ahead.

The new Fiscal Council

The recommendation to create an independent Fiscal Council is a major institutional reform. The council would be responsible for preparing the usual macroeconomic sustainability documents that are presented with the budget, based on transparent guidelines that would avoid the non-transparency that arose in the past. It would also have the weighty responsibility of advising the government on whether recourse to the escape clause is justifiable, specifying the extent of permissible deviation from the target, and also recommending a time path for returning to the fiscal targets.

Many countries have established such councils and our doing so will add to the credibility of the new system.

Fiscal targets for the states

The committee has not spelt out any state-specific fiscal deficit trajectory, consistent with the aggregate target of keeping the total states’ debt at the present level of around 20% of GDP. They have recommended referring this to the next Finance Commission, which will in any case decide the extent of transfers from the Centre to the states.

The difficult issue here is whether fiscal deficit targets for individual states (which determine the extent of borrowing they are allowed) will be set equal to the average for all states, as has been the case thus far, or whether each state will have its own target reflecting (a) its initial debt/GDP ratio and (b) its growth potential. A state-specific target is more rational, and creates incentives for good behaviour, but it does mean that states with relatively high debt/GDP ratios, and those that have lower growth prospects, will have to accept sharper reductions in their fiscal deficit. This will be a politically sensitive issue and the Finance Commission, being a constitutional body, is best equipped to handle it.

Will all these changes guarantee fiscal discipline? No set of rules can guarantee fiscal discipline since Parliament is supreme, and can sanctify any course of action. However, the new Act will certainly provide the basis for a more informed debate, both in Parliament and outside, and also increase transparency about fiscal reporting. Hopefully, it will sensitize the political class more broadly about the importance of fiscal rectitude and this in turn will put pressure on the government to live up to its promises. In other words, it will create conditions conducive to more responsible behaviour. In a democracy, you can’t expect more.

Montek Singh Ahluwalia was the deputy chairman of the erstwhile Planning Commission.

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