The pandemic-flagged need for a new fiscal framework
4 min read 11 Jul 2022, 10:34 PM ISTLet’s adopt principles that allow counter cyclical action instead of using rigid numerical fiscal targets
PremiumThe challenges of the covid pandemic necessitated the suspension of fiscal rules across the globe. The costs of dealing with the pandemic—well beyond the stimuli imparted during the global financial crisis (GFC)—raised global government and private debt to record-high levels. This crisis has been compounded by the Russia-Ukraine conflict. Looking ahead, better managed public finances across levels of government is a crucial lynchpin of any growth strategy in a post-pandemic framework.
Fiscal architecture: This is the framework that supports fiscal sustainability. It comprises a fiscal strategy, as specified in numerical rules or qualitative standards, supported by fiscal institutions such as an accountable and efficient public financial management system (PFM). Should countries, including India, reset their fiscal rules?
Fiscal rules: Until recently, international experience supported the view that well designed and implemented numerical fiscal rules helped strengthen the credibility of an administration’s commitment to fiscal sustainability. However, these outcomes were hard to achieve even before the pandemic. The gains achieved were increasingly at the cost of fiscal rules becoming pro-cyclically biased. Importantly, the pre-covid evidence demonstrated that numerical fiscal rules did not prevent a large debt build-up over time.
Numerical fiscal rules were tested during the pandemic, which showed that overly rigid numerical measures of fiscal stability can do more harm than good. This prompted the modification of existing rules and revamping of escape clauses.
India was an early adopter of numerical fiscal rules. The government adopted them first in 2003, before they were mirrored by all states. In 2018, the Centre updated the Fiscal Responsibility and Budget Management (FRBM) Act, adopted multiple fiscal indicators as targets, and tried to operate under the second generation of these rules. However, in practice at the Centre as well as in states, the rules were effectively circumvented by off-budget fiscal operations, inconsistent budget classification and accounting standards and the improper use of public accounts for budgetary purposes. Definitions of key targets, such as ‘fiscal deficit’ or ‘public debt’, vary across state governments and the Centre, making them non-comparable in aggregate. Effectively, this is because the underlying PFM system meets only a fraction of best practice standards and cannot check misclassification of accounts for compliance.
For all these reasons, numerical fiscal rules need a rethink, rather than a reinstatement of the FRBM Act, accompanied by a strengthening of public financial management in close collaboration with states.
The case for a new framework: Countries need to consider a system that integrates prescriptions of fiscal sustainability with an institutional framework that leaves room for judgement, as well as a process to decide whether the standards are met. In particular, fiscal responsibility principles should not be time-bound, but must allow the government to manage shocks.
That would involve three key steps:
•Moving from numerical fiscal rules to principles of fiscal responsibility, as set out in the principal fiscal strategy, to ensure a high probability of public debt sustainability.
•Setting criteria and procedures to decide whether the standards are met.
•Specifying the institutions that would be responsible for its surveillance and determine ex-post compliance with the fiscal responsibility principle.
As part of the process of establishing standards, the criteria, procedures and methods of how to apply those standards should be developed and explained. In the case of federations, this framework can equally be applied to states, which also need flexibility in responding to unexpected shocks.
India could learn from the experience of New Zealand in adopting principle-based fiscal standards. The evidence suggests that a principles-based framework, rather than enforcing legislated numerical rules, is more likely to provide effective incentives for governments to conduct responsible fiscal policy. Australia and the UK are among the growing number of countries moving toward fiscal responsibility principles.
Going by New Zealand’s experience, a principles-based fiscal strategy would require India to adopt certain practices to make them credible:
•First, political commitment to the standards and principles of responsible fiscal management in a ‘fiscal strategy act’ that would include a medium-to-long-term fiscal sustainability report as well as elements like an investment statement and prioritized medium-term programmes and projects,
•Second, publication of an annual fiscal strategy explaining how its annual fiscal plan is consistent with the standards set out in the law and backed up by comprehensive medium-term budgets consistent with objectives.
•Transparent public reporting at regular frequency and a periodic public review of the government’s fiscal plans by Parliament and independent fiscal institutions, which would be another source of information to markets.
Overall, for India to achieve its full potential for economic growth and development, the country needs to improve the quality and efficiency of public spending and financial management across all levels of government. In doing this, India should consider moving toward a new principles-based fiscal strategy, rather than returning to a fiscal framework based on rigid numerical fiscal targets.
Anoop Singh is a distinguished fellow at the Centre for Social and Economic Progress, and a former member of the 15th Finance Commission
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