Shankar Acharya: Farewell fiscal responsibility?

A PIECE OF MY MIND

After three years of debate, Parliament passed the Fiscal Responsibility and Budget Management (FRBM) Bill into law in 2003 during the tenure of the NDA government.

The law became operational with the notification of the Act and statutory Rules by the UPA government in July 2004. At that time, Finance Minister Chidambaram also successfully moved an amendment to the Act to relax (postpone) by one year to 2008-09 the target year by which the Centre's revenue deficit had to be eliminated.

The FRBM law requires, amongst other benchmarks, a minimum reduction of the revenue deficit by 0.5 percentage point of GDP and of the fiscal deficit by 0.3 percentage point in each year up to 2008-09.

Scarcely eight months after the notification of the Act, Mr Chidambaram in his second UPA Budget has pressed the "pause button" on the FRBM Act. He has justified this early recourse to "pause" by pointing to the additional "burden" of centre-state transfers entailed by the government's acceptance of the Twelfth Finance Commission (TFC) recommendations.

This brief history of the FRBM Act raises some important issues. Does this early weakening of the FRBM law in two successive Budgets seriously weaken the underlying objectives of the Act?

Were the TFC recommendations adequate justification for hitting the pause button on FRBM? Are even the weakened ("paused") fiscal targets in Budget 2005-06 achievable? If fiscal consolidation has been shelved, does it really matter? Let's explore these issues.

The basic purpose of the FRBM Act was to help bring about a long overdue reduction in the central government's revenue and fiscal deficits and outstanding liabilities.

The logic of this kind of law is to establish an "external" restraint on the government of the day as it struggles to contain expenditures and raise revenues.

The theory is that when Parliament has solemnly committed itself to a programme of medium-term fiscal consolidation, finance ministers, making annual Budgets, can draw strength from the FRBM Act to beat off the perennial and vociferous demands for additional expenditure and tax reliefs.

He can point to the FRBM benchmark and say, "Look, I would have liked to provide more money for education (or rural development ... or any other worthy expenditure), but I can't without breaching the FRBM targets."

However, if in the first year of the new law, the benchmarks are twice relaxed in two successive Budgets, then the purpose of the Act is largely defeated.

The UPA and Mr Chidambaram have clearly preferred to amend the law to accommodate the exigencies of annual Budget-making, rather than the other way round. But then why have the law if its restraints are so readily loosened?

Actually, the damage to the cause of fiscal consolidation goes beyond the central government. In recent years the states have also been encouraged to pass similar laws to help repair their parlous finances.

By endorsing TFC recommendations to make debt relief to states conditional on such enactments, the UPA government has reiterated this advice to states.

But the Centre's actions contradict such advice and actions speak louder than words. The obvious lesson for the states is to pass the laws (necessary to qualify for debt relief) and then amend them at will!

But what about the "additional" Rs 26,000 crore of TFC-recommended transfers to the states in the form of tax devolution, grants, and debt relief? Doesn't that provide "just cause" to pause FRBM targets? Not if you think about it a bit.

First, the estimate of Rs 26,000 crore seems exaggerated on several counts, including the fact that the TFC-recommended increase in the tax devolution ratio from 29.5 to 30.5 per cent has been largely negated by this Budget's greater reliance on surcharges and cesses, which are not shared with states.

Second, in a Budget of more than Rs 500,000 crore, it is surely a trifle unreasonable to single out one item of additional expenditure to justify a legal amendment. What about the "additional" Rs 25,000 crore provided for "priority and flagship programmes falling under the NCMP"? Why not make that the culprit for FRBM amendment?

More importantly, TFC recommendations (as interpreted by Mr Chidambaram) actually "save" the Centre's fiscal deficit Rs 3,000 crore! How so? Well, against the Rs 26,000 crore noted above has to be weighed the Rs 29,003 crore of central loan assistance to state plans, which has now been shunted from the Centre's Budget to states to seek directly from market, apparently "in accordance with the recommendations of the TFC". (The last bit is not strictly correct, since the TFC recommended this shift be "phased" in "over time". It rightly foresaw problems with an overnight shift in financing pattern; more on this later.)

Even the weak ("paused") deficit targets in the 2005-06 Budget look unattainable. More than most Budgets, this one suffers from optimistic revenue targets and a certain coyness in stating expenditures transparently. Consider the following.

Personal income tax revenues are projected to grow by 30 per cent despite sizable reductions in real tax rates at all income levels, engineered through widened tax brackets.

Last time (1997-98) Mr Chidambaram reduced tax rates, income tax revenues fell by 6 per cent. So, achieving even 10 per cent growth may not be easy. A shortfall of around Rs 10,000 crore on this item seems a safe bet. Similarly, excise revenues are expected to increase by 21 per cent, when the historical record justifies only 10 to 11 percent (see table).

Another Rs 10,000 crore of likely shortfall here. Company taxes are projected to grow by 33 per cent on top of last year's 31 per cent and against a historical average closer to 20 per cent. I anticipate a shortfall of about Rs 6,000 crore. Allowing for sharing with states, the Centre's Budget estimates for net tax revenue could be undershot by Rs 20,000 crore.

Turning to expenditure, it is most unlikely that all the Rs 29,003 crore of plan assistance shifted to the states for direct borrowing will actually be raised successfully from the market at reasonable rates.

Instead, many states will come knocking at the Centre's door to make up the balance. A reasonable guess is that the Centre will have to extend loans for about half the amount (say, Rs 15,000 crore).

Similarly, perhaps half the indicated Rs 10,000 crore for the infrastructure special purpose vehicle will end up as Budget expenditure. Possibly, there could be offsetting saving on plan expenditure of that order.

So, taking revenues and expenditure together, the fiscal deficit could be overshot by about Rs 35,000 crore (say, 1 per cent of GDP) and the revenue deficit by Rs 17,000 crore (say, 0.5 per cent of GDP).

If these guesstimates transpire, Budget 2005-06 will have hit the "reverse" button on fiscal correction quite hard! And just compare these estimates for deficits with those that Mr Chidambaram presented in his "Medium Term Fiscal Policy Statement" in July 2004 (see table). The possibility of reducing a 3 per cent of GDP revenue deficit to zero in three years is remote. Farewell to fiscal responsibility?

So what's a little fiscal irresponsibility between friends? Especially when the world economy is steaming ahead and dollars are pouring into India as global funds diversify into non-dollar equities. Exactly.

The going is good right now and India's economy is likely to grow at 7 per cent in 2005-06. But the global tide will turn one day. When it does, there could be a nasty reckoning for India's current fiscal profligacy.

As the Budget speech solemnly intones, "The current phase of high growth provides us an opportunity that should not be frittered away. We must use this opportunity to improve the fiscal health of the country."

Alas, the actual Budget promises less of improvement and more of frittering.

The author is a Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views expressed are personal.