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Why India needs a new fiscal policy framework
There is scope for a new institutional matrix that alters the way fiscal policy is conducted in India
Mumbai: Arun Jaitley will announce the first full budget of the Narendra Modi government on Saturday. He has a unique opportunity to look beyond the immediate fiscal issues that will undoubtedly dominate the headlines over the weekend.
The finance minister has often spoken about the need to bring in a new monetary framework for India. There has been some progress here. The proposal to make consumer price inflation the formal nominal anchor of Indian monetary policy is a step in this direction. Jaitley would do well to begin a similar discussion on a new fiscal policy framework that will make Indian budgets more credible and less whimsical.
Why? The broad answer is as follows. The standard economics textbooks propagate a simple principle: net government spending should pick up when private spending is weak but should retreat when private spending is strong.
India usually does the opposite. We tend to have pro-cyclical rather than anti-cyclical budgets. In other words, fiscal deficits are first too high during economic booms; governments then struggle to cut spending when the private sector is struggling during downturns.
The mid-year review of the economy by the finance ministry has touched upon this issue as well, though in the context of the immediate need to cut the fiscal deficit when economic growth is below potential, rather than the broader issue of pro-cyclicality over the economic cycle.
The other problem is that the budget numbers are not credible. Finance ministers usually overestimate revenues and underestimate spending. Fiscal deficit targets are often met only with the help of clever accounting gimmicks. The impact of budget decisions on the economy over the longer run are rarely explained adequately. Most thinking on the impact of fiscal policy is terribly myopic.
Both these problems—of being on the wrong side of economic cycles as well as failing the credibility test—need to be addressed through a rethinking on the nature of Indian fiscal policy.
One solution is to bank on the good sense of the political class. But its incentives to be profligate are too strong in the midst of the perpetual election cycle. This harsh reality was evident during the tenure of the two Manmohan Singh governments.
The other solution is to design new institutional mechanisms that make Indian fiscal policy less perverse as well as more credible. There are four possible elements to a new fiscal policy framework.
1. A new fiscal rule to impose legal limits on fiscal deficits.
India abandoned the requirements of the landmark Fiscal Responsibility and Budget Management (FRBM) Act after the global financial crisis. Many other countries also chose to abandon similar fiscal rules because of the need to stimulate economic activity in the midst of an extraordinary downturn. A key requirement in the original law was that the government should aim for a zero revenue deficit. All public borrowing would be used only to create new assets. Hard fiscal rules can sometimes tie the hands of governments during crises, but there is still a compelling case to bring in a new bipartisan fiscal rule that restricts fiscal deficits.
2. An Indian CBO to provide an independent analysis of budget numbers.
The US Congressional Budget Office (CBO) is an independent agency that provides its own trenchant analysis of government budgets. It also delivers its own forecasts on the trajectory of several important economic variables such as public debt or future pension liabilities. The office also commissions its own reports on the prospects of the US economy. Several other countries have appointed similar fiscal councils after the 2008 crisis. India would benefit from a similar independent fiscal watchdog that is both alert about fiscal fudging as well as providing guidance on the effects of a budget over the medium term. Too much is currently left to the good sense of the finance ministry.
3. Less easy access to bank funds.
The Indian government is not exposed to the discipline of the bond markets because it has a captive market for its debt: the banks. Indian banks are by law expected to keep aside a quarter of their liabilities for investments in securities that the government floats to fund its fiscal deficit. What this means is that borrowing costs do not increase even when there is a surge in fiscal profligacy. The greater presence of foreign investors in the government bond market has begun to make an effect. Remember, it was the massive sell-off in Indian bonds by foreign investors that pushed the rupee down to record lows in the middle of 2013, as the record twin deficits began to bite. A steep cut in the statutory liquidity ratio will have a deeper effect in terms of exposing the Indian government to the harsh discipline of the bond markets.
4. Empowered fiscal councils that have a say in budget design.
One of the most radical ideas that has emerged since the 2008 crisis is whether budgets can be decided by independent fiscal councils, much as monetary policy is now decided by independent central banks with empowered monetary policy committees. The economist Simon Wren-Lewis has contentiously argued in a recent blog post that “demand management is basically a technical issue with political implications”. Five countries have recently set up independent fiscal councils to provide budgetary advice to governments, in Sweden, Canada, Hungary, Slovenia and the UK. The US CBO is also a fiscal council. But no fiscal council has formal power over policy, as Wren-Lewis has pointed out.
The shift to a new fiscal policy framework cannot happen overnight. And it is also useful to remember that budget making is a more political act than monetary policy is, so it has to be rooted in the political process. It cannot be outsourced to technical experts with the same ease as monetary policy is.
Yet, there is still scope for a new institutional matrix that alters the way fiscal policy is conducted in India.
Jaitley has several earlier examples to emulate. The Rajiv Gandhi government brought in a long-term fiscal policy as a first step towards a stable tax regime. The Sukhamoy Chakravarty committee on monetary policy argued in 1985 that yields on government bonds should be determined in the money market rather than fixed by officials. The United Front government signed a landmark deal with the Reserve Bank of India in 1997 so that the malign practice of automatically monetizing fiscal deficits through the issue of ad hoc treasury bills was ended. The 2003 FRBM not only imposed a fiscal rule but also ensured that the central bank would not participate in primary auctions of government securities.
Each of these moves involved political vision to reduce the deficit bias in Indian fiscal policy. Jaitley should take this process forward.
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First Published:24 Feb 2015, 12:04 AM IST
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