A fiscal rule is a constraint on fiscal policy through numerical limits on deficits. Indian fiscal rules as per FRBM envisions fiscal deficit to GDP at 3 per cent. However in the post pandemic fiscal strategy, the fiscal glide path is envisioned at 4.5 percent by 2025-26.
Why fiscal consolidation ?
The fiscal rules ( section 4) envisions general government debt to be 60 per cent of GDP with 20 per cent threshold ratio for States. The golden rule of fiscal rules is to reach zero revenue deficit. However the clauses related to revenue deficit was eliminated in 2018 and noted in the Finance Bill 2018. At State level, right now the fiscal deficit to GDP ratio is kept at 3.5 percent , with extra borrowing powers of 0.5 percent is tied to State level power sector reforms. Why 3 percent ? As per Maastricht treaty, the fiscal deficit to GDP was kept at 3 percent . In case of India, we kept the same threshold ratio, though the country specific macroeconomic considerations might differ. There is no consensus why should a fiscal deficit - GDP ratio be kept at 3 percent scientifically . The present fiscal glide path towards 4.5 percent fiscal deficit GDP ratio - instead of 3 % - might be to incorporate budget transparency by including off budget liabilities. Including the off budget liabilities, the new fiscal deficit GDP ratio might be articulated at 4.5 percent by 2025-26.
The financing pattern of deficits:
The financing pattern of deficits can be broadly threefold - seigniorage financing ( monetary financing) , internal bond financing and external financing.
Excessive use of any mode of financing can result in macroeconomic consequences. However in India, the predominance of internal bond financing exists, in contrast to Sri Lanka where external financing of deficits was predominant . The role of government in emerging economies is very crucial as a counter cyclical policy tool in case of business cycles, especially through pump priming when economy is in down turn.
Deficit targeting and debt path surveillance:
The debt path surveillance towards fiscal consolidation is equally important as deficit-debt targeting at threshold ratios. The fiscal consolidation can be attained either through increased revenue buoyancy or through cuts in public spending. The latter can affect the quality of fiscal consolidation as expenditure compression has negative consequences on economic growth.
Equally important is the maturity profile of the debt . The refinancing risks can be postponed if the maturity structure of the public debt is elongated. Given the high interest rate regime, public debt management is becoming costlier. However the public debt is sustainable if the real rate of interest is lower than the real growth of economy.
Tax- GDP ratio:
The responsiveness of taxes to increase in GDP is termed as tax buoyancy. Increasing the Tax-GDP ratio is crucial for revenue generation and to contain mounting deficits. However increasing the tax rates always do not result in increase in tax revenue if Laffer curve operates. In the context of an emerging economy , 'tax administration is tax policy' . Therefore stregthening the digital infrastructure in tax administration in raising taxes is crucial.
The N K Singh FRBM panel:
N K Singh was the chairman of the FRBM panel which suggested the above mentioned debt deficit targets. N K Singh panel also suggested an "escape clause" in FRBM , on the basis of national security, war, national calamity, the collapse of agriculture affects output and incomes and structural reforms in the economy resulting in fiscal implications. The escape clause can also be applied if the decline in real output growth of at least 3% below the average of the previous four quarters.
There is a dissent note in the FRBM panel by former CEA about the possibility of making primary deficit ( instead of fiscal deficit) as the operational parameter of fiscal policy. Primary deficit is fiscal deficit minus interest payments. Primary deficit reflects the current fiscal stance of the government . However , in India , fiscal deficit continues to be the operational parameter .
A broader concept of deficit to measure the real resource gap is Public Sector Borrowing Requirement ( PSBR). PSBR captures the general government deficit plus the borrowing incurred through public sector entities . That's why PSBR is a better measure of deficit as it incorporates the 'hidden debt' or the off budget borrowings incurred through the public sector entities. However, we have data constraints in constructing time series data on PSBR.
The fiscal rules are predominantly of two types. One, fiscal rules are designed on the basis of absolute figures of debt . Two, fiscal rules are articulated as a ratio of GDP. US fiscal rules is of former category, while EU and India follows the latter.
While decomposing the public debt, we can understand that debt can increase due to several reasons including (a) rise in interest rates (b) increase in past debt servicing liability (c) if the GDP growth is lower , ( d) if there is huge primary deficit . There normalising the public debt threshold ratio to GDP is a better measure than absolute debt targeting/ceiling. The rise in GDP can decrease the public debt-GDP ratio.
This article was first published in The Financial Express, July 30, 2024.
Lekha Chakraborty is Professor, NIPFP and Research Associate of Levy Economics Institute of Bard College, New York and Member, Governing Board of International Institute of Public Finance (IIPF) Munich.
The views expressed in the post are those of the authors only. No responsibility for them should be attributed to NIPFP.