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Column: Fine-tune the FRBM framework

The FRBM mechanism must be given the flexibility to withstand the vagaries of the business cycle

The primary objective of fiscal policy, i.e., macroeconomic stabilisation is achieved by reducing the volatility of the business cycle through counter-cyclical policies. The recent mid-year economic analysis of the ministry of finance advocates not only a counter-cyclical fiscal push, but “counter-structural” fiscal measures to revive medium-term growth by boosting public investment. Such stabilisation efforts require adequate fiscal space. However, the government is enfeebled by its commitment to adhere to the 4.1% fiscal deficit target, raising doubts about its medium-term fiscal capacity for large capital expenditure. Unfortunately, the social sector is a soft target in such times, as is evident from the recent cuts in budgets for higher education and health by R3,900 crore and R5,000 crore, respectively.

This scenario raises fundamental questions about our preparedness for economic slowdown and the lessons we have learnt. The answers lie in the anachronistic fiscal policies of the pre-crisis heydays of the Indian economy, which stemmed mainly from the failures of the well-intentioned fiscal rule framework entrenched in the Fiscal Responsibility Budget Management (FRBM) Act. However, unlike the Left, which argues for dilutions to the FRBM framework, I believe that the solution lies in strengthening it. The FRBM Act aims at containing the government’s temptation to over-spend due to political and distributive conflicts. Thus, ceilings for fiscal and revenue deficits were established to promote counter-cyclical policies by keeping a check on deficit bias. However, these measures proved to be insufficient in two key respects.

First, cross-country experience shows that ceilings on deficits, on their own, have been an ineffective tool to induce fiscal discipline, especially during economic upswings. The accompanying figure shows how India’s compliance with its annual fiscal deficit targets in the pre-crisis boom gave a false impression of fiscal discipline. Significant increases in public expenditure, implying a pro-cyclical fiscal stance, were veiled by a temporary spurt in windfall revenue due to tax buoyancy. As the crisis approached, there was a quick correction in revenue collections but expenditure, being less elastic, remained stubbornly high. These dynamics left little fiscal space for the unavoidable stabilisation efforts that followed in the form of three fiscal stimuli in FY09, causing the fiscal deficit to jump sharply from 2.5% in FY08 to 6.46% of GDP in FY10. Subsequently, the FRBM Act was suspended as both revenue and fiscal deficits far exceeded their target. Thus, in economic upswings, when windfall revenue receipts are temporarily high, deficit targets are easy to comply with, and lack adequate deterrence to disincentivise exuberant spending by governments.

According to increasingly popular conventional wisdom, expenditure rules must complement deficit rules, which explicitly set limits on current spending. Since such rules are not undermined by revenue windfalls, they remain forceful when the economy is healthy. This promotes counter-cyclical policy and improves the government’s preparedness to face potential macro-stabilisation challenges in times of distress. Also, unlike deficit rules, expenditure rules do not constrain the government’s macro-stabilisation efforts during downturns since they do not limit the use of revenue-side expansionary policies such as tax cuts or reductions in tariff rates.

Actual-Fiscal-Deficit

The second cause of concern was the rigid structure of the FRBM Act. Since fiscal policy can have profound distributional effects, the government must retain sufficient flexibility to face situations of economic anomalism effectively. In a rule-based fiscal scheme, this is achieved by providing for a well-specified escape clause. However, if defined vaguely, escape clauses may weaken the enforceability of such legislation.
For instance, the FRBM Act specifies that the government may breach the deficit targets on grounds of “national security, national calamity or such other exceptional grounds as the Central Government may specify”. Moreover, in the event of a breach, the Act does not specify any time-bound transition path back to target. Using this clause, the government suspended the FRBM Act in the aftermath of the financial crisis in 2009 to make way for the stimulus package. Though the stimulus was unavoidable, the nebulous drafting of the FRBM escape clause caused much confusion and kept the law in abeyance for almost five years until it was reintroduced in 2013.

A well-defined escape clause is a key lesson from cross-country experience. For instance, Brazil and Peru have bolstered the credibility of their fiscal rules by requiring parliamentary approval prior to the invocation of the escape clause. EU fiscal laws lay down specific deadlines for excessive deficit corrections whereas the German and Swiss fiscal rules impose automatic correction mechanisms within a pre-defined timeframe if deviations cross a certain threshold.

Recent events have exposed the deep links between efficient fiscal management on one hand and the sustainability of social spending on the other. Exuberant spending during economic booms may reap electoral rewards in the short run but come back to bite the social sector in the long run. In this light, the FRBM should not be reduced to an ad hoc and artful signaling device that is switched on when convenient and withdrawn during crises. Instead, efforts should be made to enthuse it with sufficient flexibility to withstand the vagaries of the business cycle. A multi-rule framework comprising “second generation” rules such as expenditure rules and a transparent and systematic escape clause are the key design elements of successful fiscal responsibility legislation. Given the weakness of deficit rules during economic booms, such reform must be expedited and brought in place before the economy takes off on its next upswing.

By Ananya Kotia

The author is a MPhil candidate at Oxford University

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First published on: 21-02-2015 at 00:27 IST
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