There is a debate on changes to India’s Fiscal Responsibility and Budget Management (FRBM) Act after the submission of the FRBM Review Committee Report this year. The arguments made are illuminating but illustrate the complexity of the issues involved.
We suggest two criteria to cut through the Gordian Knot. One, that India is well established on a catch-up growth path and is expected to sustain high growth rates over the next few years. Second, it is more open to foreign inflows, and therefore assessment by rating agencies, which would like India to commit to reducing debt ratios.
Perhaps that is why the Committee wants a debt ratio target. But is it possible to use the first criteria to moderate the second even while satisfying rating agencies?
Which deficit criterion?
Deficits add to debt. Is the primary, the revenue or the fiscal deficit the relevant criterion? The primary deficit (PD) or the excess of real government expenditure, net of interest payment, over taxation goes with focus on debt, since the real debt as a ratio to output rises with the excess of the real interest rate over growth rates plus the PD ratio. If the real interest rate equals the growth rate then the real debt ratio changes only with the pd ratio. The dissent note to the committee report prefers this. But since nominal interest rates, inflation and growth are all volatile, committing to a path of reducing the PD ratio may not by itself be adequate to reduce debt.
The fiscal deficit (FD) includes interest payments and is the total government-borrowing requirement to finance current and capital expenditure net of tax and non-tax revenue. This is a highly watched statistic. Markets are interested in this as an indicator of pressure on market yields, and crowding out of private investment. It is the focus of most fiscal rules as it caps government expenditure in excess of revenue and possible crowding out of private expenditure. But it both rises with and raises interest rates, and it can raise output growth even as it falls with growth. Since its impact on public debt depends on what happens to interest and growth rates, it cannot be made precise in relation to long-term debt targets.
Moreover, capping the FD ratio in order to distribute an assumed fixed ratio of household savings between the private and the public sector as the committee wants is also not precise because both the absolute amount and the ratio of savings can rise with income. A critical issue over the last several decades is the falling quality of public expenditure. Experience with the FRBM shows targets were met by cutting capital expenditure rather than sustainable reform. Moreover, they were reset when convenient, as after the Great Financial Crisis.
The revenue deficit (RD), or deficit on current account, which is the amount the government needs to borrow to finance consumption expenditure, therefore becomes important. A falling RD will raise the share of investment in government expenditure. It is necessary to protect such asset creating expenditure. Research shows this has a higher and more persistent effect in raising GDP, reducing inflation and decreasing the current account deficit. So it is the RD that should gradually be reduced towards zero, in line with facilitating high feasible transitional growth.
The Committee wants a debt target of 60 per cent by 2023, and gives a path of reduction for both RD and FD ratios. There is an issue of over-determination with debt, FD, and RD targets.
Fiscal policy is procyclical since higher revenues are spent in boom times and capital expenditures are cut in lean times. Expenditure caps can reduce disincentives creating procyclicality. Since restraints only cover spending, deficits can increase as revenues fall in a slowdown. Caps can enforce small reductions in discretionary spending with escape clauses provided for emergencies. Escape clauses improve credibility. ‘Pay-as-you-go’ rules can restrain new transfer payments since assured funding has to be demonstrated so that they do not increase future deficits. State level FRBMs that had incentives built in for compliance, worked better.
The Committee, however, feels the country is not ready for caps or cyclical adjustments because of difficulties in defining potential output. It suggests a relook in these issues in the future. It does, however, include an escape clause, allowing the FD ratio to rise (fall) 0.5 in response to a sharp 3 per cent rise fall (rise) in output growth. Changing this to a 0.2 rise (fall) in response to a 1 per cent growth deviation can build in counter-cyclicality now when it is needed instead of waiting for a future likely to be distant.
The Committee also wants an independent fiscal council to discipline the Centre. A fiscal institution does improve fiscal management and expenditure quality, and reduces the discretion to cut capital expenditure. But the fiscal council should also be allowed to use its computing capabilities and set a yearly FD target consistent with RD and debt targets, and budget predictions of expected growth, interest and inflation rates.
The debt ratio target should be moderated to a downward direction only and removed after it reaches 60, although higher growth and improved fiscal institutions would probably reduce it further. Bank of International Settlements reports the core government debt ratio for India to be 68.2 in Q3 2016. The comparable figure for all economies is 82.6; advanced economies 103.1; emerging markets 47.5. It is arguable East Asian economies have low debt ratios because of past high growth — a process beginning for India.
Such a framework would raise productive expenditures and favourably affect belief in Indian prospects as gaps in public services and infrastructure fall. To reduce country risk that affects inflows, policy needs to stop excess demand that does not expand supply over time—RD is relevant for this, not debt or FD. Growth that raises per capita incomes is more likely to get a rating upgrade than reducing debt ratios at the expense of growth.