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The Fiscal Responsibility and Budget Management (FRBM) Act of 2003 was unceremoniously buried in 2009. That Act mandated the government of India to meet quantifiable targets for fiscal deficit (as a percentage of GDP), in a time bound fashion. Why did our lawmakers in Parliament pass such a binding law in the first place? Our democracy is fractious, noisy and chaotic. The spending pressure on governments is compounded by significant poverty, by backlog of infrastructure and by populism. Governments are also not immune to bad ideas. But government is often unable to constrain its own spendthrift ways. Hence lawmakers decided that we will bind ourselves by law. It is somewhat like the hero and captain Odysseus asking to be tied down, to prevent him from succumbing to temptation. India’s fiscal ratios had deteriorated to such an extent, that it was dangerously close to a debt trap. This is the situation of borrowing fresh to pay for interest on the already high debt mountain. The fresh loan keeps growing the debt mountain, causing interest obligations to rise, causing the deficit to go out of control. So an FRBM Act put a legal upper limit that could not be crossed.
The most remarkable recommendation of the committee is an institutional reform, in the creation of the Fiscal Policy Council. This will be a constitutional body, outside the government, not swayed by electoral or populist consideration, and will be focused on adhering to the fiscal discipline imposed by a new FRBM Act.
But the 2008 global financial crisis led to an emergency need to inject a huge fiscal stimulus. So, fiscal deficit ratios again went for a toss. No wonder by next year, the Act got a burial, the blame going mainly to the external financial crisis. It’s a different story that even after a V-shaped recovery took place, and fiscal revenues improved, there was no spending restraint. The deficit ratios continued to remain high.
Last year the government appointed an expert committee to review the FRBM Act, under the chairmanship of former finance ministry bureaucrat N. K. Singh. The committee submitted its report about three months ago, but it was made public only recently. The report is in four volumes and very comprehensive, based on scholarly analysis. The Chief Economic Adviser, who was a member of the committee, has a dissenting note on the recommendations. That note itself adds immense value to the report, which is now open for public feedback.
The committee has recommended that the focus should be on the size of the debt in relation to national income, and not merely the fiscal deficit to GDP ratio. The overall debt to GDP ratio should come down to 60 percent, from its current 68 percent in the next five years. This is to be done by bringing down the fiscal deficit in two steps, first down from 3.5 per cent to 3 per cent for the next two years, and then down to 2.5 per cent for the remaining three years. The debt to GDP ratio of the central government will then fall from current 49.4 per cent to 38.7 per cent. For this to happen, the assumed nominal GDP growth rate is 11.5 per cent. The state governments’ collective debt to GDP ratio also has to stay at or below 20 per cent.
The most remarkable recommendation of the committee is an institutional reform, in the creation of the Fiscal Policy Council. This will be a constitutional body, outside the government, not swayed by electoral or populist consideration, and will be focused on adhering to the fiscal discipline imposed by a new FRBM Act. It will also consider the quality of expenditure, and hence the level of the revenue deficit as well. After all, if the fiscal deficit is high, mainly due to capital spending on roads, bridges and irrigation projects, then that is good quality spending. In such a case, so long as the revenue deficit is low, then a higher fiscal deficit can be tolerated. It remains to be seen if the government accepts the recommendation of forming the Fiscal Policy Council.
It’s interesting to note that while India gravitates to a debt ratio of 60 per cent, most countries in Europe already have a debt ratio well above 100 per cent. Japan’s debt to GDP ratio is the highest in the world, close to 300 per cent. Despite these very high levels of debt, the developed world has not experienced higher inflation of interest rates, as predicted by conventional economic theory. Indeed, the International Monetary Fund (IMF), which had advocated fiscal austerity during the East Asian crisis of 1997, and also to Greece in 2010, has admitted that it was an error. Fiscal austerity is no longer in vogue. But India is signing up to a new FRBM Act. This is not to deny the need of fiscal discipline in India, since its debt servicing ratios are among the worst in the world.
One important caveat is in order while considering fiscal discipline in the Indian context. It is true that every rupee spent by the government is collected from the taxpayer. If it is not from current taxes, then it is from borrowing, which is future tax. If the fiscal spending goes mainly to create infrastructure that will be used by future generations as well, then it is only fair that they too share the burden of that spending. In fact, given India’s advantageous demography, the per capita burden of future taxes will be lower, since the population will remain young for a long time. In such a scenario, a higher deficit and borrowing today, simply means a proportionately higher tax burden on tomorrow’s unborn generation. This is justified in the growth phase of a developing economy, with a young demography. Even the extra spending on “soft” infrastructure, i.e. health and education, is an investment into the future. These considerations of higher spending on physical and human capital should give a bigger leeway for fiscal deficit and borrowing. Unlike a human being or a family who have to repay all their loans in their own lifetime, governments are long-lived and can pass on their debts to the unborn. Indeed it may be justified if the spending is largely for the benefit of the future. It is as if they are paying for taxes before they are born.
(The writer is a senior economist based in Mumbai)