Home / Opinion / Views /  Reform India's fiscal management law for counter-cyclical impact

Reams have been devoted to dispensing with India's current Fiscal Responsibility and Budget Management (FRBM) Act. Some critics question the Act’s efficacy in binding our fiscal policy to achieve debt sustainability. This laudable consideration apart, there is the first-principles approach to looking at fiscal-discipline legislation. Discussion of public finance usually begins with listing various functions of fiscal policy, one of the principal ones being the ‘stability objective’. The motivation for this often flows from Keynes’ oft-repeated quote, “In the long run we are all dead. Economists set themselves too easy, too useless a task, if, in tempestuous seasons they can only tell us that when the storm is long past, the ocean is flat again."

What Keynes essentially advocated was this: When output falls below the economy’s potential, the government must add to aggregate demand and stimulate economic activity. This is called a counter-cyclical fiscal policy, in that the size of government stimulus to the economy runs in the opposite direction to the movement of aggregate economic output. Vide this philosophy, which enjoys near-unanimous approval, more government spending in periods of inadequate demand and higher taxes in periods of faster demand growth are usually prescribed. (A scenario of inadequate economic activity is called a negative output gap, since actual output has dipped below the level of output that the economy would be able to produce given its stock of resources. For this discussion, the output gap is estimated with respect to a potential level of output, calculated vide the Hodrick-Prescott Filter approach.)

The FRBM legislation was enacted to rein in fiscal profligacy, which was, more often than not, driven by political expediency rather than any economic imperative, seeking to place our sovereign debt on a path more salubrious to macroeconomic stability. To achieve this, bounds were imposed on deficit measures (fiscal or revenue deficits and debt were capped at certain proportions of gross domestic product). While there has been much discussion on the impact of these bounds on debt figures of the government, it is worth inquiring whether the objective of counter-cyclicality in fiscal policy has been achieved.

We look at fiscal policy by means of a parameter often used by the International Monetary Fund (IMF) called the fiscal impulse.

The fiscal impulse measures the change in fiscal stance, which, in turn, is a measure of the fiscal balance adjusted for business cycles, and shows whether fiscal policy is expansionary (positive fiscal stance) or contractionary (negative fiscal stance).

(Note that the fiscal balance is the global equivalent of what we call the fiscal deficit – the gap between expenditure and revenues of the government. The IMF, unlike India, leaves out disinvestment proceeds and recovery of loans from its reckoning of revenues. In this discussion, we consider the Indian definition of fiscal balance.)

So, the fiscal impulse indicates the change in government’s fiscal stance: a positive impulse means a more expansionary fiscal stance vis-à-vis the previous fiscal, and vice-versa. Reading the fiscal impulse along with the output gap is a commentary on the conduct of the fiscal policy pursued. In any year when output gap is positive, the economy is in a boom and a positive fiscal impulse reflects pro-cyclicality in fiscal policy – more expansionary when the economy is already doing well. But if the fiscal impulse is negative in a period of boom, then there is a counter-cyclical trend in the fiscal policy, as it ought to be.

Fiscal policy generally responds a year after an economic slowdown, when the new annual budget has an opportunity to make a course correction in the light of the previous year's growth experience. Thus, we look at the output gap of the previous fiscal coupled with current fiscal impulse (both as a percentage of potential GDP), in the post-FRBM period.

We have data for 15 complete fiscal years since the FRBM Act came in. A negative fiscal impulse implies a contractionary fiscal policy, which when co-existing with a negative output gap implies pro-cyclical fiscal conduct. Only on four occasions has the fiscal policy been counter-cyclical since 2004-05. Fiscal policy could not be counter-cyclical in more than 70% of the time that the FRBM Act has been in operation.

Since 2016-17, expenditure financed through extra-budgetary resources also contributed to fiscal stimulus; accounting for this does not alter our findings much; it just adds one more episode of counter-cyclical fiscal policy. It is notable that placing a limit on fiscal deficit-as-a-share-of-GDP ipso facto biases the fiscal policy towards pro-cyclicality: it allows a larger absolute fiscal deficit in case of a higher GDP. This is a ripe area of reform if and when we legislate a new debt-deficit law.

There are ways to anneal counter-cyclicality into a debt law. While retaining the numerical bounds on our fiscal deficit, leeway can be granted to achieve the target averaged over a couple of years, instead of each year individually. Alternatively, some provision can be made to modulate growth of expenditure such that the constituent components coupled with their multiplier values cumulatively close the economy's output gap.

Admittedly, there are constraints in being able to implement a counter-cyclical fiscal policy when one doesn’t have a grip on the GDP figure of the fiscal year ahead. Even if we had estimates, techniques to calculate the output gap are very sensitive to the precision of these estimates. Also, counter-cyclical fiscal intervention must be pursued in consonance with ensuring debt-sustainability.

These issues aside, there is no countervailing thought to the imperative of baking the counter-cyclicity of fiscal policy into our debt-deficit law.

Anshuman Kamila and Ritika Bansal are assistant directors (IES officer trainees) and Rajiv Mishra is adviser in the department of economic affairs, Ministry of Finance. These are their personal views.

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