 "Ajay Chhibber: Redoing the fiscal math")
The latest IMF advice to India is to continue with fiscal consolidation. Nothing wrong with that per se, but India needs a more sophisticated approach to its fiscal policy. Given the politician's penchant for fiscal profligacy, the Fiscal Responsibility and Budget Management Act, 2003 (or FRBM Act) was seen as a way of constraining excessive public spending, reducing the fiscal deficit and eliminating the revenue deficit. It has had a mixed history and the government has constituted a new panel to review the Act and suggest improvements.
The government rigorously followed the Act between 2003-04 and 2007-08, when the fiscal deficit was brought down sharply and the revenue deficit declined below two per cent of GDP. But then, in the run-up to the 2009 general elections and subsequently, in response to the global economic crisis, the Act was significantly breached and the fiscal deficit exceeded six per cent of GDP, and high fiscal deficits persisted unnecessarily, for another two years. The FRBM Act was suspended and revived only in 2011-12.
The NDA government wisely persisted with fiscal responsibility, but deviated from the target in 2014-15 to delay fiscal adjustment to increase public investment by 0.4 per cent of GDP. The fiscal deficit in 2015-16 went up from 3.5 per cent of GDP to 3.9 per cent of GDP. But even with the increase, the central government's public investment, at less than two per cent of GDP, remains too low. Even if investment by public enterprises and state and local government are included, public investment adds up to around eight to nine per cent of GDP, compared to around 15 per cent of GDP in countries like China. Moreover, more than half of it is re-investment by public sector undertakings (PSUs), not service-providing public investment.
There are three key problems with the Act, which needs to be reviewed.
First, the Act focuses only on the Union budget, whereas India must focus on the consolidated public sector borrowing requirement (PSBR) of the Centre, the states and the PSUs. The PSBR is much higher than the fiscal deficit and lately, the two have moved in different directions - the fiscal deficit has been falling but the PSBR has been rising.
Second, the revenue deficit of the central government has been high and the FRBM Act targets its elimination, but the consolidated public sector has had a revenue surplus for much of the last 25 years - except for a brief period from 1998 to 2003 - and remained in surplus even through and after the global economic crisis. In effect, the central government has been running a revenue deficit - meaning that it has been borrowing to finance consumption expenditure, but the public sector as a whole has been running a revenue surplus.
This means the PSUs are financing larger investments from internal resources - but these need not be the kind of public infrastructure investments that have wider benefits for the economy. One way forward would be for the central government to collect larger dividends from profit-making PSUs and redeploy these towards service-providing public infrastructure - roads, electricity, schools, health facilities, etc.
An FRBM Act that overly restricts public investment can be harmful to long-term growth. The composition of spending does matter. The UPA-II government increased spending on subsidies and other social programmes, but allowed public investment to decline excessively, leading to a high revenue deficit.
A higher PSBR where the money is borrowed for public investment leaves the consolidated revenue deficit unchanged. Our latest research findings suggest that more public investment increases GDP growth in two ways - directly by helping reduce business costs and indirectly by crowding-in private investment, which then leads to higher GDP growth. Our results show that a 10 per cent increase in the public capital stock increases GDP directly by two percent. But, in addition, it also crowds-in an additional five per cent of private investment, which further increases GDP by an additional three per cent.
This positive effect holds even when the higher public investment spending is financed not by internal resources but by borrowing from the banking sector, which in turn lowers credit available to the private sector. In this case the net increase in GDP is lower, but still positive.
Third, fiscal policy needs to be contra-cyclical, so the FRBM Act must build in automatic rules to guide the scale and scope of such cyclicality. The current Act has no such cyclical flexibility. This meant that when the global crisis hit, the government had no choice but to breach the FRBM rules. The fiscal deficit exceeded six per cent of GDP and the PSBR was over eight per cent of GDP.
This by itself may have been fine, but then the fiscal deficit persisted at very high levels for several years after that, as there were no rules for cyclical flexibility. In addition, if the fiscal stimuli in response to the global crisis had been targeted at public investment instead of higher subsidies, its growth effects would have been much more sustained and the revenue deficit would have been much smaller.
Given the size and complexity of India's economy, and the key role that the states and PSUs play in the fiscal mathematics, the FRBM panel must not just focus on a numerical target for the central budget for the fiscal and revenue deficits.
In the spirit of cooperative federalism, following the excellent work of the Finance Commission and the impending GST, it must take a look at the broader public sector's finances and suggest ways in which a more sophisticated approach to the consolidated public finances is pursued, to maximise returns on public spending and sustain growth, while maintaining macro-economic stability.
The author is Distinguished Visiting Professor at NIPFP and Visiting Scholar at IIEP, George Washington University
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
