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Budget 2019: India has a law to cap fiscal deficit but UPA and NDA couldn’t care less

No matter what the specific deficits caps, debt limits or escape clauses are, a stronger rule of law in fiscal policy is in public interest.

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The budget is such a big deal because it combines the exercise of many powers. Among them, the power to run deficits is special. In a competitive democracy, the pressures to spend always exceed the willingness to tax. This creates a fertile ground for excessive deficits, whose consequences are suffered by future generations.

The legal framework for fiscal discipline is provided under the Fiscal Responsibility and Budget Management (FRBM) Act. Passed in 2003 when the NDA was in power, and notified in 2004 by the UPA government, the FRBM law sets deficit caps (fiscal deficit of 3 per cent of the GDP and elimination of revenue deficit) and limits on debt and guarantees, among other requirements.

Rapid growth in tax collection helped the government restrict the fiscal deficit to 2.6 per cent of the GDP in 2007-08, and also create a primary surplus (in other words, it did not borrow to pay interest on loans).

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In 2008-09, the central government suspended the Act to provide fiscal stimulus in response to the global crisis. Since then, the government has repeatedly promised to bring fiscal deficit down to below 3 per cent of the GDP, but this has not happened. In 2014, the NDA government said that it would bring the fiscal deficit to 3 per cent of the GDP by 2016-17. The expected year of achieving the target has been changed, and is now 2020-21.

The government has also run primary deficits for each year since 2008-09. This is in spite of the fact that a lot of borrowing has become off-budget. Entities promoted by the government are borrowing more, helping the government limit budget deficit. The bank recapitalisation bonds were “below the line”, and did not get counted in the deficit.

Adding up the additional spending over and above the 3 per cent deficit cap, excluding the off-budget items, the cumulative fiscal stimulus, so far, has been worth about 18.2 per cent of the GDP (14.9 per cent of the GDP between 2008-09 and 2013-14). This equals about two years of revenue collection. However, this did not lead to a sharp increase in the debt to GDP ratio because between 2008-09 and 2013-14 the inflation was very high.

Why governments ignore the law

This experience begs the question: why is it so easy for the government to ignore the FRBM law?

The legal answer is straightforward: a money bill can amend the FRBM Act, and since such a bill only requires the Lok Sabha’s approval, the government can easily get the targets changed.

The economic answer is also relatively clear: much of the government borrowing is financed by institutions that have no choice but to lend to the government.

In recent years, about two-thirds of fiscal deficit is financed by market borrowings against securities. About three-quarters of central government securities are held by institutions that are required to hold them (banks, insurance companies and provident funds), and about 12 per cent are held by the RBI, which needs to hold these securities for its operations.

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Further, in a reversal of trends, an increasing portion of the deficit (about 20 per cent in 2018-19) is now financed by the national small savings fund, which is also controlled by the government, but with an increasing unfunded shortfall. This system of financial repression is not conducive for market discipline vis-à-vis government borrowing.

The political answer is more complicated. Under the Westminster system, Parliament can hold the government accountable, but it depends on the way Parliament functions. Our Parliament does not properly perform its function of holding the government accountable. Further, it seems that the government does not incur a significant reputational cost for neglecting its own promises on fiscal discipline.

The FRBM framework has been recently amended, based on recommendations of a committee. Its content has changed, and it now includes a reasonably clear list of escape clauses, but the legal structure remains the same. It will be equally easy for the government to ignore the new framework. The fact is that in spite of a fiscal responsibility law, the government has considerable discretion in choosing the level of deficit in any year.

Reasons for structural deficit

This points to a basic problem in fiscal policy in India – weakness of rule of law in fiscal policy. Rule of law is essentially about predictable use of powers – government’s power should be used for the purposes defined in advance. Deficits should be run only for specific purposes, and deficit caps should be breached only on well-defined grounds.

Borrowing is moving resources from the future to spend in the present. If this is done excessively, it is unfair to the future generations. Fiscal discipline is about ensuring that each generation pays for what it spends on, with certain exceptions.

Also read: This is how Modi govt managed to keep 2018-19 fiscal deficit ‘artificially low’

First, government can borrow to make productivity-enhancing investments. Since every rupee that the government borrows makes it more expensive for the private sector to borrow, the question is whether government can invest the resources better than the private sector. The general principle is that government needs to invest in creation of public goods and infrastructure, and the private sector is better at making investments in other sectors.

Second, in a low-income country, one can justify transferring resources from the future generations to the present generation for financing gaps in basic consumption. This is a redistribution from a more prosperous future to a less prosperous present. However, this is unfair to the future generations if it creates a significant burden on them, especially because they are not here to object.

These are the reasons for structural deficits. In addition, fiscal stimulus may be required to stabilise an economy in crisis. In such times, the borrowing may be so high that the government runs a primary deficit – borrowing even to pay interest on existing debt. Such a stimulus is justified if there is a sharp decline in economic growth. However, such a deficit should be paid for in the good times.

Parliament needs to step up

To put such theoretical justifications into practice, simple fiscal rules, with clear escape clauses can be effective, but only if they are really enforceable. Further, financial markets often work to discipline the government by pushing up the interest rates in response to fiscal profligacy.

In India, the FRBM framework has not been really enforceable, and works more as a source of directional guidance for the government. An effective alternative in the law is to place the constraints and escape clauses in the Constitution. Further, to ensure market discipline, Parliament can implement legislative reforms to limit the powers of financial repression, free up the bond markets, and ensure market discipline works on government borrowing.

Also read: Modi’s election handouts threaten plan to curb fiscal deficit

Both these paths are difficult, because the incentives to choose them are weak. However, politics is not just about responding to incentives. Once in a while, leaders transcend short-term thinking, and put in place systems that work in the long run. No matter what the specific deficits caps, debt limits or escape clauses are, stronger rule of law in fiscal policy is in public interest, and is worth investing political capital in.

The author is a Fellow at Carnegie India. Views are personal.

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  1. This article is bad in Spirit, it intentionally avoids to say why in UPA 2 why and how much fiscal deficit it reached and the burdon of clearing was left to NDA and massive bungling in PSU bank loans again left for NDA to settle…. please read Urjit Patel’s statement in one of the business schools in US . I would appreciate if such articles disclose all issues before drawing conclusions.

  2. Running a primary deficit, ie, borrowing to pay interest on borrowings is the classic definition of a debt trap. A private company – plantations of teak, chit funds, etc – doing this would be called a Ponzi scheme. 2. The only justification required to breach the FRBM mandated ceiling is that there is an election to be fought, which is now the perpetual state India finds itself in. A general election comes in several notches higher than Assembly elections. Parliamentary oversight is meaningless when there is such an impressive majority. With deferential Speakers, everything is now a Money Bill. 3. That leaves the markets. The sanctity of official data is now gone. That makes the rating agencies more apprehensive. Some years ago, Goldman Sachs cooperated with the Greek government to cook its books. That story had a sad ending. Sincere efforts are imperative to avoid a Junk rating.

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