Insights into Issues: FRBM Act – Need for a paradigm shift

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Insights into Issues: FRBM Act – Need for a paradigm shift


 

 

FRBM act

The Fiscal Responsibility and Budget Management Act, 2003 (FRBMA) is an Act of the Parliament of India to institutionalize financial discipline, reduce India’s fiscal deficit, improve macroeconomic management and the overall management of the public funds by moving towards a balanced budget.

frbm act

Source: The Hindu

Objectives

  • to introduce transparent fiscal management systems in the country
  • to introduce a more equitable and manageable distribution of the country’s debts over the years
  • to aim for fiscal stability for India in the long run

Why the debate:

  • Union Minister has recently commented that fiscal expansion or contraction should be aligned with credit contraction or expansion respectively of the economy.
  • This suggests that there should be an inverse correlation between fiscal deficit (fiscal expansion) and bank credit (monetary expansion).
  • This is to ensure adequate money supply to the economy in all the cycles
  • The finance minister, in his budget speech, announced that a committee would be set up to review the implementation of the Fiscal Responsibility and Budget Management Act (FRBM Act) and suggest modifications for the future

 

Assessment of FRBM Act:

 

  1. FRBM Act is neither necessary nor sufficient to ensure that fiscal discipline is maintained. They have the potential to help, definitely. Under the FRBM Act, the state requires centre’s permission to borrow but similar check is not imposed on the centre. Due to this, the centre’s FD declined from 3.9% in 2004-05 to 3.1% in 2007-08. However, at the time of recession, like many other countries of the G20, the centre decided to go for counter cyclical measures to allay the affect of 2008 recession on the economy. The FD increased to 6% of GDP in 2008-09. It is important to understand that sovereign governments in Parliamentary System are not easily reined in by controls of FRBM Act, unlike a Presidential System where there is a clear separation of power between the executive and the legislature. The Parliament can exercise a check through discussions. One of the amendments to FRBM Act in 2012 allowed the centre to change FRBM targets but only after providing reasons to the Parliament. This has been done to ensure continuous control of Parliament over the Fiscal policies of the government.
  2. The existing FRBM Act prescribes a target fiscal deficit of 3% of GDP for the centre but with no explicit justification for the number. Since there is also a separate limit for the states (although not specified in the Act), the combined fiscal deficit (general government deficit in International Monetary Fund terminology) is much larger. The Fourteen Finance Commission, under the Chairmanship of YV Reddy, suggested a combined deficit of 6% (3% respectively for centre and states) for the period of 2015-16 to 2019-20. However, the reasonability of such a target should be based upon two criteria
    • Crowding out of private investment – This is to be determined by looking at the deficit versus the net financial savings of household, which is the common pool of savings for which the government and corporate sector vie for. In 2007-08, the net financial saving of households was about 11.6% of GDP and the combined fiscal deficit of the centre and states together was only 4.1%. This meant that 7.5% of GDP was left for the corporate sector. We know that private investment boomed at that time. Net financial saving of the household sector has declined considerably since then, to about 7.3% of GDP. This probably reflects higher levels of inflation, prompting households to shift from financial assets to real estate and gold. If the combined fiscal deficit is fixed at 6% of GDP, it would leave only 1.3% of the GDP for the corporate sector. This would mean that there is a crowding out of corporate investment.
    • Debt Sustainability – Since fiscal deficit is equal to the increase in total government debt at the end of the year, the size of the deficit in successive years determines what happens to the government debt-to-GDP ratio. India’s ratio is 65%, which is much higher than that of most other countries. The saving grace is that most of the debt is serviceable in domestic currency which is still a comfortable position to be in.
    • Ideally, the FRBM Act should not prescribe specific numbers. Instead it should require the government to present every year an explicit analysis of the crowding-out implications and government debt-to-GDP ratio implications of the proposed fiscal deficit trajectory of the combined deficit over the next five years based on explicit assumptions about GDP growth, household savings and inflation. This would bring out more clearly the rationale for the target and would guide discussions of departures.
  3. The third issue is with regards to apportioning the debt between centre and states. The 14th Finance Commission has gone for greater devolution of taxes to the states which should mean that the fiscal capacity of the central government, ideally needs to be enhanced through liberal limit on the FD of central government vis a vis the states. For distribution of deficit targets among the various states, we must ensure that states with greater debt burden and lower growth potential should be allowed to borrow less. These states should be helped through greater grants instead of allowing them greater borrowing limits in light of sustainability of debt
  4. It is also argued that the current FD targets are not flexible which makes it difficult for the government to adhere to it when the going gets tough. This can happen, for instance, when there is widespread drought, or when exports go down.
    • In a cyclical downturn, it doesn’t make sense to be rigid with FRBM targets. Instead, we should allow the deficit to exceed the target in a structurally adjusted manner as a counter cyclical measure. The structurally adjusted deficit is what the deficit would have been if the cyclical shocks had not occurred. And the approach must be symmetric—when positive shocks produce an unexpected gain in revenue, the observed fiscal deficit should be lower than the target
    • Flexibility may also be needed because of non-cyclical shocks, for example a permanent increase in oil prices. In such a situation the correct approach is to go back to the drawing board, work out the implications for GDP growth and revenues, and determine a new fiscal trajectory, which takes appropriate account of crowding out and the debt/GDP ratio.
  5. Both the Thirteenth Finance Commission and the Fourteenth Finance Commission recommended the establishment of an autonomous body to review fiscal performance under the FRBM Act. This could evolve into a statutory Fiscal Council, reporting to Parliament through the finance ministry. Such institutions have been set up in several countries, with somewhat varying mandates. Advantages would be:
    • A Fiscal Council, with technical expertise, would help generate better understanding of the consistency of fiscal stance of each budget with the longer-term fiscal trajectory envisaged under the FRBM Act
    • improve the quality of Parliamentary oversight
    • contribute to a more informed public debate

 

Logic of linking credit expansion and FD limits:

 

This is because of following reasons –

  • Money is the blood of economic growth
  • Money that fuels the economy is created by banks, not by government. Banks and financial institutions fund business and others, and it is that credit money which drives the economy
  • If bank credit to the economy does not adequately grow, like it did not in the last few years, economic growth will suffer for want of adequate money, like it has happened in the past 2 years. It is then that the Budget needs to step in, to pump money into the economy by incurring deficit, and, for the purpose, borrow the money lying with banks or even by printing more money, if that is needed. This ensures that growth does not decelerate for want of enough money circulating in the economy. The FRBM law has ignored this logic and fixed the 3 per cent fiscal deficit as inviolable

Steps taken by the government:

The government thus formed a five-member committee under former revenue secretary N K Singh to review the working of the 12-year old FRBM Act and examine the feasibility of a fiscal deficit range instead of a fixed target. The committee will look into various aspects, factors, considerations which go into determining the FRBM targets. The committee will also examine the need and feasibility of aligning fiscal ‘expansion or contraction’ with ‘credit contraction or expansion’ in the economy

Way forward:

  • Transition to a cyclically adjusted fiscal deficit framework. Under this arrangement, government spending would increase during economic downturns to shore up aggregate demand, only to recede when private spending strengths. The policy stance would thus be counter cyclical- increase government spending during times of distress as opposed to a pro-cyclical policy and increase government spending when the going is good. Theoretically sound but difficult to implement practically as it involved making forecasts which are not always reliable.
  • Another idea is of having a range or a band in terms of target. The problem in this however is that automatically the upper end of the band would be followed. Thus prudent step would be to link the range for fiscal deficit to a number of indicators such as the government’s debt level, its interest service obligations and its revenue deficit which gauge the fiscal health of the government. This step however would ignore the supply side issues