Fiscal deficit at 3%: A sensible target despite questions about its origin

The number wasn't imported from the Maastricht Treaty, but is a synthesis of the experiences of various countries within and outside the accord

From where did the authors of the original Fiscal Responsibility and Budget Management (FRBM) Act arrive at three per cent as the number for a prudent level of fiscal deficit of the Centre? It was not an import from the Maastricht Treaty, says Dr E A S Sarma, the then economic affairs secretary who principally authored the bill. “We did simulations around several numbers, principally to inform us at which levels the interest burden would become unsustainable,” he told Business Standard. 

The questions around the number are far more than academic ones, especially this year. To stick to it or not could determine the extent to which finance minister Nirmala Sitharaman can spend more liberally with, say, a normative five per cent rate as the accepted fiscal deficit level. That would impact how much the government would spend, the money which might flow to various sectors and, of course, how the recovery of the Indian economy would pan out. Industry chamber CII, for instance, has suggested a range spread around the three per cent rate rather than a fixed number to shoehorn government expenditure into. 

There are various theories of where this number came from, including that it was sourced from the Maastricht treaty which created the European Union. The treaty was signed in 1992. It asked member states to ensure their government deficits did not soar beyond three per cent of their respective GDP levels and also cap the debt to GDP level at 60 per cent. The IMF has also stuck to this number as a viable measure of government efficiency. 

Sarma said the authors, which included Y V Reddy and Ashok Lahiri, looked at the experience of other countries, including that the Maastrict Treaty embraced, to finally come up with this number. This position was also endorsed by the N K Singh committee to review the FRBM, which gave its report in 2017. “Importantly, the Act did not borrow the three per cent limit from the European Union’s fiscal rules as is commonly believed. The fiscal deficit target of three per cent was, in fact, adopted with two considerations in mind: a) consistency with the forecast trend of household financial savings and b) the target being considered sufficient for reducing the stock of outstanding government liabilities to the level of 50 per cent of the GDP within 10 years”. 

According to Sarma, there was a difference of views among the original authors about whether to pen a number or leave it to the government of the day. Reddy, for instance, preferred the latter course. In subsequent speeches, Reddy argued that while there is a need for a “nominal limit for fiscal deficit, what is even more important is the mode of financing the fiscal deficit and the use that the resources so raised are put to”. 

“Our rough calculations showed three per cent was reasonable, it was achievable. I agree that the number does not meet the test of an economist,” Sarma remarked. But it has done its job as a goal. “If you want any teeth for the report, you must mention a goal. Unless you mention it, the bill may not have had any impact.” 

As subsequent governments have found out, the three per cent fiscal deficit goal has stood the test of time. When writing the FRBM review, Singh had also asked Sarma to explain how the critical numbers were arrived at. “I told him our background papers were with the department of economic affairs. I am not aware if those are still there, but I have none with me now. My position remains that without a figure the entire policy would have been subjective.”