<b>Rathin Roy:</b> Delivering effective fiscal responsibility

The government intends to review the Fiscal Responsibility and Budget Management (FRBM) Act. Many commentators interpret this as a redefinition of fiscal and revenue targets - possibly a "range" rather than specific numbers - plus some exit clauses, and an unelected Fiscal Council.

This is unfit for the purpose. India's fiscal management is in urgent need of reform, the centrepiece being a fiscal responsibility framework (FRF) that improves the predictability of government macro-fiscal policy and maintains fiscal discipline, while allowing space to government to respond to internal and external volatilities.

There are six actions that government needs to take to put an effective FRF in place.
 

• Decide the long-term size of general government: Total tax revenues accruing to general government (GG = Centre + states) are approximately 17 per cent of gross domestic product or GDP. The total GG fiscal deficit is seven per cent. This means that GG accounts for about a quarter of GDP. Is this just right, too small or too big? The higher the tax-to-GDP ratio, the lower the amount available for firms and households to consume and save. The more GG borrows, the lower the savings available for private investment. This important policy question has been long ignored. It is time a clear policy stance on the size of GG is enunciated.
  

 

Commit to the 'golden rule' that governments should not borrow for consumption spending: In India, states as a whole now meet the golden rule, but not the Centre. The Centre must lay out a road map for the elimination of its revenue deficit or at least specify the maximum revenue deficit over the medium term.
 

Implement a functional medium-term fiscal framework: This would consist of (a) a multi-year macroeconomic framework that provides GDP and inflation forecasts (b) a revenue forecasting framework (MTRF) that predicts tax revenue on the basis of the relevant tax base (GDP, consumption, service sector growth etc.), and the impact of changes in tax rates, and (c) an expenditure framework that specifies the ministry/sector-wise allocable ceiling each year, which is total expenditure less committed expenditure on salaries, maintenance, pensions etc.

 

Decide fiscal targets: The macroeconomic framework will provide real and nominal GDP aggregates. The MTRF will fix the revenue-to-GDP ratio. Thus, for example, if nominal growth is forecast at 12 per cent, the revenue-to-GDP ratio is 18 per cent, and the size of GG is maintained at 25 per cent of GDP, then this means that (a) the GG fiscal deficit will be seven per cent; (b) if the golden rule is maintained then this implies a public investment-to-GDP ratio of seven per cent, or six per cent if the Centre's revenue deficit is one per cent of GDP.

Note that this does not mean that expenditures are frozen. Current expenditures, at 18 per cent of GDP, will grow at the same rate as nominal GDP, and by one per cent more if a revenue deficit-to-GDP ratio of one per cent is allowed for. This will then be the baseline scenario in a FRF common to the Centre and states.
 

Decide the allocation of fiscal deficit space between the Centre and the states: This can be the status quo (3.5 per cent of GDP for both) until incorporated into the terms of reference of the Fifteenth Finance Commission.

 

Specify exit clauses that address volatility: We simply do not have robust modelling of either the Indian business cycle or the "output gap" on which to any credible policy analytics can be based. The loose use of these terms in the Indian context is just economist's jargon being used to argue normatively held positions and confuse policy makers. The focus should be on adapting fiscal targets to address known volatilities which impact fiscal policy.

Agriculture is the most important internal source of volatility. Monsoon failures, floods, droughts, etc, can require governments to temporarily increase public spending, either nationally, or in specific states. An exit clause allowing increases in public spending on the basis of quantifiable evidence that such volatility has occurred, should be part of the fiscal responsibility framework.

The most important external volatility impacting the fisc is the oil price. Define a benchmark oil price, above which an exit clause would allow government to lower taxes on oil/provide subsidies. The maximum period for which this will be done should be specified in the FRF; thus, if the benchmark price is $70 per barrel, government can specify an increase in the fiscal deficit that will maintain this benchmark price up to two years. If prices persist at higher levels then the benchmark price will be raised. If prices stay below the benchmark price for more than two years then the government should deposit the resultant tax surpluses in a multiyear stabilisation fund, thereby reducing the need to deviate from fiscal deficit targets in future years.

These six actions will create a rules-based, flexible FRF common to the Centre and the states. The FRF will specify deficit targets on the basis of a comprehensive analytical macro-fiscal framework, and incorporate exit clauses based on quantifiable triggers that will specify the exact fiscal space available to government to respond to specific volatilities. The compliance framework will be common to both levels of government. There will be no need for vague "ranges," unelected fiscal councils, etc.

There are many contingent technical issues on which I will elaborate elsewhere, but the core vision in these six actions is what I believe is required to transform India's archaic fiscal management framework into one fit for contemporary purpose.

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The writer is director, National Institute of Public Finance and Policy
rr1@nipfp.org.in