Today's Editorial

26 April 2017

The long road to fiscal sanity



Source: By Jayachandran: Mint



It is no secret that fiscal adventurism has almost always been followed by macroeconomic crises. The most recent example is the reckless fiscal expansion by the second Manmohan Singh government—combined with loose monetary policy—that paved the way for a run on the rupee in 2013. Every crisis is followed by a brave attempt at fiscal discipline. Stability returns. And so does hubris. Then the next round of profligacy begins. The growing calls for farm-loan waivers are only the most obvious example of how India is drifting towards its bad old habits despite the ugly fact that India already has one of the highest fiscal deficits in the world.


The members of the constituent assembly were aware of these risks. It is for this reason they wrote a constitutional provision that allows Parliament to impose limits on the ability of a government to borrow. The landmark Fiscal Responsibility and Budget Management Act of 2003 was based on this constitutional provision. The committee headed by veteran bureaucrat N.K. Singh has now recommended a new fiscal architecture that will eventually replace the original fiscal rules introduced because of an enlightened bipartisan consensus at the turn of the century. The committee has suggested a glide path to reach the fiscal targets.


The new fiscal framework can best be understood in terms of four key components. First, the anchor of fiscal policy will be a public-debt target rather than a fiscal deficit target—a stock rather than a flow variable. Second, the annual fiscal deficit will continue to be the operating target for budget makers. Third, the new fiscal rule will be more flexible since there are clear escape clauses that allow the government to increase spending when faced with severe exogenous shocks. Fourth, an independent fiscal council will not only analyse the impact of fiscal decisions over the medium term but also give an opinion on whether the government of the day can use an escape clause to ramp up public spending.


The committee report is a wonderful example of fiscal economics at work. The fiscal deficit target has been derived from a simple analysis of financial flows. The annual financial savings of Indian households plus the international capital flows needed to fund the current account deficit create a borrowing capacity of 10% of gross domestic product (GDP). The committee assumes that this is shared equally between the private and public sectors. So the Indian government can run a combined fiscal deficit of 5% of GDP—or half the financial resources available in a given year. This gives a fiscal deficit target of 2.5% for the Central government and 2.5% for the states.


The public-debt calculations have been made using a range of standard forecasting models. The committee has concluded that India needs to keep its stock of public debt below 60% of GDP—40% will be the liabilities of New Delhi and the rest of the states. There were some important differences of opinion within the committee. Reserve Bank of India governor Urjit Patel has argued that the fiscal slippage allowed under the escape clauses should be lower than what the committee report suggests. Chief economic adviser Arvind Subramanian has written a full dissent note, including an argument that the government will be better off targeting the primary deficit rather than the fiscal deficit if public debt is to be the anchor of Indian budgetary policy.


This newspaper has earlier argued in favour of a new fiscal rule as well as a fiscal council. We thus welcome the main thrust of the recommendations. There are a few operational issues that still need to be sorted out. First, a fiscal deficit target derived from the flow of financial savings could be problematic given the fact that these fluctuate depending on the state of the economy; they are endogenous to economic growth.

Second, the dual targets of a stock of public debt as well as a flow of fiscal deficits can lead to complications in case the two do not move in tandem. The standard Tinbergen policy rule says that any policy system should have at least the same number of instruments as targets. Third, the interaction between the new fiscal policy framework and the new monetary policy framework needs to be worked out, though it is likely that the new fiscal rules will complement inflation targeting by the Indian central bank. Fourth, how the public debt targets will be assigned to specific states is a tricky collective action problem that is best sorted out by a federal institution such as the next Finance Commission. The N.K. Singh committee has done well to set tough fiscal policy goals for a country that is prone to high inflation as well as macroeconomic instability. India needs more fiscal realists—even though they are habitually denounced as fiscal hawks.