The finance minister, in his budget speech, announced that a committee would be set up to review the implementation of the Fiscal Responsibility and Budget Management Act (FRBM Act) and suggest modifications for the future. The FRBM Act, 2003, has many flaws and we need to reflect on five issues and produce a truly modern act.

Charles Wyplosz, reviewing global experience with fiscal rules (NBER Working Paper No. 1788), concludes they are neither necessary nor sufficient to ensure good behaviour, but they can be potentially helpful. Our experience bears out this assessment. The FRBM Act succeeded in disciplining the states, because the states cannot borrow without the permission of the centre, but it was spectacularly ineffective in disciplining the centre.

The centre’s deficit declined initially—from 3.9% of gross domestic product (GDP) in 2004-05 to 3.1% in 2007-08 (including unpaid subsidy bills), but in 2008-09, it exploded to 6% of GDP (8%, if unpaid subsidy bills are included). Fiscal expansion was justified initially on the grounds that it was necessary to counter the impact of the global financial crisis, and, indeed, all Group of 20 (G20) countries did something similar. However, it was not reversed in time, and the FRBM targets were just suspended.

Sovereign governments are not easily disciplined by fiscal rules unless Parliament is an effective watchdog. This is possible in a presidential system but not in a parliamentary system, where the government can have its way because it commands a majority in the legislature. Nevertheless, well-designed fiscal rules can at least help encourage a spirited discussion in Parliament on the consequences of departing from the rules and could have an impact on public opinion and market expectations. Unfortunately, our Parliament has not played this role, perhaps because of insufficient realization that fiscal indiscipline will lead, sooner or later, to higher inflation, higher interest rates or lower growth. Members of Parliament (MPs) are quick to criticize these developments when they surface, but they don’t raise an alarm in advance, when the deficit starts going off track.

Notwithstanding these problems, there is merit in having transparent and credible fiscal rules, even if they can be flouted.

The existing FRBM Act prescribes a target fiscal deficit of 3% of GDP for the centre but with no explicit justification for the number. Since there is also a separate limit for the states (although not specified in the Act), the combined fiscal deficit (general government deficit in International Monetary Fund terminology) is much larger. The Fourteenth Finance Commission (chaired by Y.V. Reddy), for example, has explicitly recommended a 3% fiscal deficit for the centre and another 3% for the states, yielding a combined limit of 6% per year for the period 2015-16 to 2019-20.

Is a combined deficit of 6% reasonable? This is best answered by looking at two criteria: does it “crowd out" private investment and does it worsen debt sustainability? The implications for crowding out can be seen by comparing the deficit with the net financial saving of households, which is the common pool of financial saving for which the government and the corporate sector (including public sector undertakings) must compete. In 2007-08, the net financial saving of households was about 11.6% of GDP and the combined fiscal deficit of the centre and states together was only 4.1%. This meant that 7.5% of GDP was left for the corporate sector. We know that private investment boomed at that time.

Net financial saving of the household sector has declined considerably since then, to about 7.3% of GDP. This probably reflects higher levels of inflation, prompting households to shift from financial assets to real estate and gold. If the combined fiscal deficit is fixed at 6% of GDP, it would leave only 1.3% of the GDP for the corporate sector! The resulting squeeze on finance for corporate investment would be excessive. Moreover, as the table shows, India’s government deficit is much higher than for all the other countries, except Brazil, which is going through a crisis. The combined deficit should therefore be lower than 6%.

What about debt sustainability? Since fiscal deficit is equal to the increase in total government debt at the end of the year, the size of the deficit in successive years determines what happens to the government debt-to-GDP ratio. India’s ratio is 65%, which is much higher than that of most other countries in the Table. Fortunately, India’s government debt is largely in domestic currency, which justifies a somewhat higher debt ratio without risking a loss in investor confidence, but even so, a lowering of the ratio is clearly desirable.

If the economy grows at 7.5% over the next 10 years and inflation is 4%, a combined fiscal deficit of 6% year after year would reduce the government debt-to-GDP ratio from 65% to 59.5% at the end of 10 years. This is still very high. If instead the combined fiscal deficit is contained at 4% of GDP, the debt ratio would decline to 47% in 10 years’ time—still higher than most other developing countries, but in the right ball park.

Ideally, the FRBM Act should not prescribe specific numbers. Instead it should require the government to present every year an explicit analysis of the crowding-out implications and government debt-to-GDP ratio implications of the proposed fiscal deficit trajectory of the combined deficit over the next five years based on explicit assumptions about GDP growth, household savings and inflation. This would bring out more clearly the rationale for the target and would guide discussions of departures. The trajectory itself could be modified by going back to Parliament if circumstances change. For example, if the feasible GDP growth rate proves to be lower than 7.5%, the fiscal deficit will need to be lowered to attain any given debt-to-GDP ratio target.

The total deficit as determined above has to be apportioned between the centre and the states. Since the states have been given a large increase in their share of the centre’s tax revenues, it is reasonable to divide the total combined deficit of, say, 4% of GDP into 3% for the centre and 1% for the states. A higher allocation for the states implies a lower allocation for the centre. The proposed division and its rationale should be reported to Parliament under the FRBM Act.

The 1% limit for the states as a whole also has to be converted into entitlements for individual states. Past practice would allow each state to borrow up to 1% of its gross state domestic product (GSDP). This seems fair, but it can be argued that states with high debt ratios should borrow less and states with a low growth potential should also borrow less. This may seem unfair, but financially weak states should be helped with more grant funds and not more borrowings.

The finance minister specifically mentioned the need for flexibility in the fiscal deficit target and in this context spoke of a band. This has the danger that the upper end of the band will become the effective ceiling. The most important reason for flexibility is the need to deal with cyclical shocks. The fiscal deficit in the budget is the gap between explicit expenditure and revenue projections, which, in turn, are based on reasonable expectations regarding growth of GDP. If for some reason there is a temporary shock, such as a fall in export demand, or a temporary choking of investment, or poor rains, revenues could turn out to be lower than expected. Expenditures could also be higher for cyclical reasons, for example a drought leading to higher expenditures under the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA). These could increase the fiscal deficit in absolute terms, and if GDP is also lowered, the deficit as a percentage of GDP would be even higher.

In a cyclical downturn, it doesn’t make sense to adhere to the earlier deficit target by cutting expenditures or raising taxes. Instead, we should allow the deficit to exceed the target as a contra-cyclical measure. However, it should not be an open-ended departure from the target, but one which ensures that the “structurally adjusted" deficit remains on track. The structurally adjusted deficit is what the deficit would have been if the cyclical shocks had not occurred. And the approach must be symmetric—when positive shocks produce an unexpected gain in revenue, the observed fiscal deficit should be lower than the target. Calculating the structurally adjusted deficit is a complex exercise, but several templates are available which can be drawn upon to devise an approach suitable for India. The quality of our national accounts also needs to be improved to support such quantification.

Flexibility may also be needed because of non-cyclical shocks, for example a permanent increase in oil prices. In such a situation the correct approach is to go back to the drawing board, work out the implications for GDP growth and revenues, and determine a new fiscal trajectory, which takes appropriate account of crowding out and the debt/GDP ratio. The pace of fiscal adjustment can always be slowed temporarily without affecting the end period debt-to-GDP ratio target by ensuring sharper reductions in the fiscal deficit in later years. However, the harmful impact on crowding out by going for higher fiscal deficits in earlier years needs to be carefully examined.

Both the Thirteenth Finance Commission and the Fourteenth Finance Commission recommended the establishment of an autonomous body to review fiscal performance under the FRBM Act. This could evolve into a statutory Fiscal Council, reporting to Parliament through the finance ministry. Such institutions have been set up in several countries, with somewhat varying mandates.

A Fiscal Council, with technical expertise, would help generate better understanding of the consistency of fiscal stance of each budget with the longer-term fiscal trajectory envisaged under the FRBM Act. It would certainly improve the quality of Parliamentary oversight and also contribute to a more informed public debate. The Council would actually strengthen the hands of the finance ministry, which is otherwise the lone guardian of fiscal prudence, battling other ministries typically keen on expanding expenditure.

The move would certainly be viewed as a major structural reform and would be widely welcomed in international markets. A major restructuring of the FRBM Act, taking account of these considerations, would produce a truly modern legislation in this important area.

Montek Singh Ahluwalia is the former deputy chairman of the Planning Commission.