Amaresh Bagchi: Fixing the fisc by fiat

Like its predecessor, the Twelfth Finance Commission (TFC) was mandated inter alia to suggest a plan for restructuring the public finances of the country so as to restore budgetary balance, achieve macro-economic stability and, additionally, debt reduction along with equitable growth.

Accordingly, the TFC has come out with an elaborate restructuring plan which, if it materialises, will eliminate the revenue deficits (RD) of the Centre and the states, which taken together stood at 4.5 per cent of GDP in 2004-05, by 2009-10, and reduce the fiscal deficit (FD) from 8.9 to 6 per cent (3 per cent at each level). With this, the TFC avers, domestic savings will increase as the government will no longer dissave, and investment and growth will go up.

The debt level will come down from 81per cent of GDP to 75 per cent. In the TFC's plan, all this will entail only modest effort: revenue receipts have to increase by 2.9 percentage points in five years, tax revenue by 2 points and revenue expenditure has to contract by 1.7 points. Governments' capital spending will increase from 5.5 per cent of GDP to 6.6 per cent. The burden of adjustment will fall on both the Centre and the states.

Fiscal adjustment on the part of the states is considered imperative as deficits in state budgets have been a major contributory factor in the resurgence of deficits in the late nineties. But how will these desirable outcomes be achieved? The TFC prescribes a multi-dimensional reform programme to this end backed by legislation committing the governments at the two levels to abide by deficit targets specified in the rules year to year.

The Union government has already made the required commitment with the Fiscal Responsibility and Budget Management (FRBM) Act of 2003. The TFC has held out substantial inducements to get the states too to have similar laws.

The inducements are twofold: one, a benefit in terms of relief in debt servicing via consolidation of outstanding loans to the government of India and reduction in the rate of interest payable from some 12 per cent at present to 7.5 per cent; and two, waiver of interest and principal of the debt payable in the five years of the TFC's award.

For availing itself of the first, a state has only to get a Fiscal Responsibility Law (FRL) enacted with, however, some minimum features, viz. obligation to eliminate RD and reduce FD to 3 per cent by a stipulated date, furnishing annual statements setting out prospects for the state's economy and fiscal strategy over the medium term, and so on.

The benefit of debt waiver on the other hand is conditional on the state not only enacting an FRL but actually reducing RD annually leading to its total elimination by 2009-10 and containing its FD at the 2004-05 level in absolute terms.

The debt reduction will be proportional to the extent of RD reduction. The benefits the states can avail themselves of under the two schemes are substantial, Rs 33,000 crore or so on FRL enactment and about Rs 32,000 crore on actual RD reduction. This contrasts with a mere Rs 10,000 crore held put under the Fiscal Reform Facility Fund set up under the (majority) recommendation of the Eleventh Finance Commission.

While some states already have their FRL on board all are now in the process of getting their FRL in place soon to get at least the benefit of debt consolidation and interest rate reduction. But how sound is the strategy of the TFC for getting the fiscs of the Centre and the states fixed by fiat in five years by eliminating all RD and capping FD at 3 per cent for each level?

The pertinent questions are: Do FRLs work? What will be the consequences for the public sector if they do, and what are the preconditions for their success? What is more, will the expectation of sustained 7 per cent growth be realised once the targets of the FRLs are met?

In an instructive paper presented at a conference held at the Administrative Staff College of India in Hyderabad last month, George Kopits, a former IMF hand and a leading expert in the field, explained the rationale of fiscal rules especially in decentralised fiscal systems, and surveyed the practices in this regard across the world.

Legislated rules to secure prudent fiscal behaviour are not new. In the US, they date back to the 1860s and in Switzerland to the 1920s. The crop of FRLs now in operation in other countries is of more recent origin, the Stability and Growth Pact of the EU being a prime example.

Kopits' survey shows the experience so far is mixed and the "jury is still out". Even so, country after country has gone in for FRL to rein in the deficit bias and time inconsistency of periodically elected governments in democracies.

Like in most other countries, FRLs in India focus primarily on achieving revenue balance""the "golden rule"""but go further in laying down borrowing limits even for capital spending.

However, unlike in federations like Brazil where fiscal discipline is sought to be imposed on subnational governments in a "coordinated top-down" fashion, India has been following a "bottom-up, autonomous" approach adopted in advanced countries like the US with the states themselves coming up with FRLs to be in a position to access the capital market for borrowing.

An important feature of the successful bottom-up models is the absence of bailouts from the Centre. In a way the TFC's scheme combines elements of both. Hereafter there will be no onlending from the Centre and the states will need to go to the market for borrowing.

Since the transition may take time, the TFC proposes a Loan Council to take the responsibility of assessing the debt sustainability of individual states and laying down caps on their borrowing. The success of the scheme and of the FRLs will depend crucially on the Centre's commitment to a no-bailout policy and a fair assessment of the states' borrowing capacity by the Loan Council.

For fiscal rules to work, Kopits mentions the need for flexibility in meeting the targets over a cycle rather than year to year and also supportive institutional arrangements comprising the budget process such as in a rolling medium-term budget framework, transparent accounting conventions, periodic reporting and projection requirement and penalties for non-compliance.

Not all of these figure in India's FRLs. Multi-year budgeting is yet to come and a review of the planning process, recommended by the TFC, is not yet on the policy agenda. Nevertheless, the campaign for fiscal discipline is already yielding results.

States' FD for 2004-05 has come down to 3.6 per cent. Some states have achieved revenue surplus. Maybe the targets of the FRBM and the FRLs of most states will be met. But will that help achieve the mandate of larger spending on social sectors and faster, equitable growth?

Macro-theorist Mihir Rakshit is sceptical. While acknowledging the need for fiscal consolidation, he argues in a forthcoming paper that the strategy of the TFC for reducing the deficits is not optimal, indeed flawed.

The major weakness of the strategy lies in not dovetailing demand management policies in a development programme, and ignoring the savings-generating impact of investment in an economy marked by huge infrastructure gap and considerable underutilisation of resources in the rural and informal sectors.

Given these gaps, he argues, a heavy dose of public investment financed by a moderate recourse to seignorage would crowd in private investment, generate growth and augment revenues, and that would by itself reduce the deficits. Given the prevailing orthodoxies, such views may find few takers. However, in our situation the golden rule alone requiring borrowing only for investment as in the UK may be superior to pre-stipulated targets for fiscal deficit.