Fiscal Responsibility and Budget

Management Centre and States in India

March 2017
 Post-Independence fiscal history
Till 60s mixed economy, major public investments in certain sectors, wars, famines,
green revolution, highly concentrated Tax system and Financial system not conducive
to growth, almost no debt and deficit; average 3% p.a. Hindu rate of growth
Decade of 70s nationalization wave, 1971 war, post-war inflation, oil shock, aversion
to debt and deficit continues
Decade of 80s liberalization and move to higher growth trajectory, rapid build-up of
debt and deficit; Balance of Payments crisis 1990-91 forex reserves dip below US$1
b
1990-91 to 2002-03 reforms and liberalization initiated in trade, investment, taxation,
public debt, capital markets, financial sector, power, telecom; SE Asian crisis, liquidity
crunch; high interest rates and wage revision cause fiscal stress, reforms pushed
2003-08 Reforms bear fruit, Service sector boom, oil shock, international push and
pull lead to surge in forex reserves; tax buoyancy and liquidity glut bring relief in
fiscal stress
2008-09 to 2012-13 - Impact of global food /energy/financial crisis on exports,
ballooning fiscal deficit, rising interest rates and inflation, fiscal stress at critical
point, savings diverted to gold, crude oil price fall brings relief but concerns remain
due to legacy issues
2013-14 onwards Attempts to return to fiscal consolidation path, governance and
public finance reforms to push financial inclusion, improvement in tax collection,
investment promotion, Make In India, JAM Trinity and the ongoing Remonetization
lesscash economy
 Budgetary Concerns: Past and present
Low Tax : GDP ratio (about 10% Centre, 7% States)
Central Tax:GDP peaked to 12% in 2007-08 as reforms bear fruit
coupled with economic upturn; State taxes more buoyant with VAT
Stagnant non-tax revenues and low financial return on public
investments (about 3%), under-recovery of costs an enduring concern
Increasing balkanization of Consolidated Fund with reserve funds,
earmarked revenues and sectoral ploughback
Increasing commitments of debt service, subsidies, defence and internal
security, and establishment costs, support to parastatal sap budget
maneuverability
Huge backlog of physical and social infrastructure
Preponderance of revenue expenditure in the overall public
expenditure implying slower creation of productive assets
Grants for financing Capital expenditure substitution or real
increase in asset stock. Quality and income aspects of assets
 Major planks of budgetary reforms:
Areas of concern and responses
Legislative control of debt and deficit, Institutional reforms through
FRBM Act, 2003
Tax reforms - reduce tax rates and increase tax base
Parastatal reforms -minimize Governments role as financial
intermediary
Performance / Outcome Budget
Increased transparency in budget preparation and in-depth
examination; Legislative Committee system;
Zero-Based budgeting for portfolio consolidation
Oversight by civil society (RTI Act) on budget implementation
Budgets have more transfers to parastatal and less direct expenditure,
less and less capital expenditure
Standardization of Budget formats and accounting reforms
Fiscal consolidation on course in many States, reaching revenue surplus,
with/without Central aid [Splurge or consolidate? Debt redemption?]
Why is Fiscal Responsibility so important?

Governments Fiscal Policies affect the economy through

Taxation
Expenditure

Financing of deficit

Fiscal responsibility is crucial for sustainable growth,

for moderate inflation and
for cost-competitiveness of the national economy.
Measures of indebtedness and other imbalances
in government accounts
Total outstanding liabilities is the simplest measure of indebtedness. Then
Debt/ GDP ratio indicates size of debt relative to the size of economy. But
measuring just size is not enough.
We have to look at structural composition, maturity profile, cost of
borrowing profile of debt.
No single measure is sufficient for all purposes of analysis of the general
government sector. In GFS 1986, emphasis was placed on the overall
deficit/surplus, which essentially measured cash deficit/surplus in the bank
account requiring overdraft from the banker.
Since then new deficit measures have come into practice, viz. revenue, fiscal
and primary deficits, of which the first two have dominated public discourse.
Monetised Deficit was also used for some time but given up. It indicated
Central bank financing of government deficit, which in popular perception
meant printing money to meet the deficit.
Finance Act 2012 has introduced a new concept Effective Revenue Deficit
 Definitions of key deficit indicators

Gross Fiscal Deficit, commonly referred simply as Fiscal Deficit,

measures net borrowing required to finance all expenditures
excluding debt repayment. [Debt repayments netted against debt
receipts). It should be equal to net increase in liabilities minus
accretion to cash balances.
Revenue Deficit is the gap between revenue receipts and Revenue
Expenditure.
Effective Revenue Deficit is the Revenue Deficit minus grants-in-
aid to finance capital expenditure of grantee entities.
Primary Deficit is the Gross Fiscal Deficit minus Interest Payment.
 Government borrowing is deferred taxation

How does an individual householder repays debts? 1. Paying some

installments of principal/interest every month out of regular income 2.
Using some windfall receipts, say from asset sale or lottery, to retire
debts 3. Seldom, seeking debt waiver.
Governments generally behave differently. General trend is for
governments to keep accumulating debt stocks by refinancing/rolling
over their liabilities repayments made out of fresh borrowings from
the same or some other lender. If there is no dearth of gullible lenders,
this game can go on endlessly.
Even if governments have some windfall receipts, they splurge on
expenses rather than repaying debts as if they would never be called
upon to pay debts.
 Risks in endless rollover of debt

Governments seldom go bankrupt but their continued debt addiction

can make all other economic agents within their country bankrupt!
If the government is indebted to its own citizens, banks and
companies, it can legally meet debt repayment obligations by printing
money or by extortionate taxation.
Postponing debt repayments by constant rollover, governments keep
shifting the liability to repay debts to future governments/ generations
while themselves enjoying the benefits of borrowed funds.
Let us review linkages of government borrowings with key macro-
economic variables of inflation, foreign currency exchange rates and
interest rates.
 Demand and supply of funds

Demand Supply

General Government Commercial banks

Household Non-bank financial market
Corporate sector Central bank
Rest of the world
 Methods of financing fiscal deficit

External
financing

Governments
Deficit

Domestic Central Bank

Market Monetization
 Implications of deficit financing strategy

Financing of deficit: External debt

Balance of Payments scenario, Exchange rate, Level of forex
reserves, Exports, imports, trade balance, Invisibles, Trade and
Investment links with the rest of the world
Financing of deficit Central bank financing
Inflation risk from deficit monetization, Reduces the financial
strength of the Central bank cost of financing, Increases money
supply
Financing of deficit : Pre-emption of investible funds
Investment controls Banks, FIs, CPSUs, Parastatal, SLR/CRR,
Insurance, Long term contractual savings - pension and
provident funds
 Implications of deficit financing strategy (contd)

Financing of deficit: Market borrowings

Crowding out effect
Impact on interest rates
Availability of bank finance

Financing of deficit: Treasury banking

Financial sector distortions
Tax benefits and returns offered

Overall impact of fiscal deficit

Different ways of financing fiscal deficit seem to affect the economy

differently but ultimate impact is the same:

reducing cost competitiveness and growth prospects of the economy
 Financing of deficit
External debt
Central bank financing
Market borrowing; Pre-emption
of investible funds through
Investment controls on Banks,
FIs, CPSUs, Parastatals;
Treasury banking
Balance of Payments scenario
(Exports, imports, trade
balance, Invisibles); Exchange
rate, Level of forex reserves;
Trade and Investment links with
the rest of the world; affects
inflation through money supply
Increases money supply; affects
interest rates, Inflation risk
from deficit monetization
Financial strength of the Central
bank cost of financing
Jacks up interest rates, crowds
out private investment; Asset-
Liability mismatch for Long
term contractual savings like
Insurance, pension and
provident funds
 The Central FRBM Act - chronology
The Act and the Rules were brought into force on 5th July 2004, by the
new government, a day before presenting the regular budget 2004-05.
Elimination of Revenue Deficit by 2008-09 was part of NCMP and in
Budget 2004-05 itself, the FRBM Act was amended to shift the target year
for Elimination of Revenue Deficit from 2007-08 to 2008-09. The target
year was postponed to 2009-10 through Finance Act 2008 and finally
abandoned through Finance Act 2012. The new target was to cap Revenue
Deficit to 2% of GDP by 2014-15.
A new measure, Effective Revenue Deficit, i.e., Revenue Deficit minus
grants-in-aid for financing capital expenditure, was targeted for
elimination by 2014-15. Medium Term Expenditure Framework
Statement, and role of C&AG to review periodically were also introduced.
In Budget05-06, FM pressed Pause button FRBM implementation and
during 2008-09, fiscal stimulus packages supposedly to deal with the
impact of global financial crisis wiped out the gains made earlier.
(Whether the stimulus was well-targeted remains unexplored).
 Three major objectives of the FRBM Act
to make the Government responsible to ensure inter
generational equity in fiscal management implying that
borrowings are nothing but deferred taxation and the
governments living beyond their means leave a burden of debt
on future generations.
to make the Government responsible for ensuring long term
macro economic stability because reckless borrowings by
government crowds out private investment or fuels inflation or
leads to balance of payment crises eventually leading to macro-
economic instability.
to make the Government responsible for removing fiscal
impediments to the effective conduct of monetary policy
because unsustainable increase in deficit constrains the RBIs
ability to control money supply as the RBI also happens to be
the debt manager of the government.
 The three planks of FRBM strategy

Limits on government borrowing under a time bound

programme to altogether eliminate revenue deficit and bring
down fiscal deficit to prudent limits.

Bringing a medium term perspective in Budget planning

through the introduction of certain statements to accompany the
budget document.

Improving transparency in the fiscal operations of the

government in order to avoid any window dressing in meeting
the deficit targets as well as improving fiscal discipline.
 Government original obligations under FRBM
To eliminate the revenue deficit by 2008-09, with a minimum
annual reduction by 0.5% of GDP (revenue deficit was 3.6% in RE
2003-04).
To reduce the fiscal deficit by an amount by at least 0.3% of the
GDP, so that fiscal deficit is less than 3 per cent of GDP by the end
of 2008-2009 ( fiscal deficit was 4.5% in RE 2003-04). The GFD
target is linked to Household Financial Savings.
To limit guarantees within 0.5 per cent of the GDP in a financial
year.
To limit additional liabilities (including external debt at current
exchange rate) to 9% of GDP in 2004-05. , 8% of GDP in 2005-
2006, 7% of GDP in 2006-2007 etc
Not to borrow directly from the RBI w.e.f. 1/4/2006
Finance Act 2012 New Deficit Targets
Finance Act 2012 New Disclosure Targets
Fiscal consolidation roadmap recommended by
the 14th Finance Commission

After reviewing the progress made in fiscal consolidation so far, the

Fourteenth Finance Commission has recommended as follows for the
period 2015-16 to 2019-20:-
The Central government should strive to eliminate revenue deficit by
2019-20, as against the original FRBM Act target of elimination by
2008-09.
The Central government should strive to restrict fiscal deficit to 3 per
cent of GDP from 2016-17 onwards up to the end of award period.
This was also the original target set in 2004 under the Act to be
achieved by 2008-09.
The monitoring of effective revenue deficit should be discontinued.
 Progress in fiscal consolidation
by the Central government
Year Fiscal Deficit as % of GDP Revenue Deficit as % of GDP Outstanding liabilities as % of GDP
2003-04 4.3 3.5
61.2
2004-05 3.9 2.4
61.5
2005-06 4.0 2.5
61.2
2006-07 3.3 1.9
59.1
2007-08 2.5 1.1
56.9
2008-09 6.0 4.5
56.1
2009-10 6.5 5.2
54.5
2010-11 4.8 3.2
50.5
2011-12 5.7 4.4
51.1
2012-13 4.9 3.6
50.8
2013-14 4.6 3.3
50.1
2014-15 4.1 2.9
49.8
2015-16 3.9 2.5
50.8
2016- 3.2 2.1
17(RE) 49.4
2017- 3.2 1.9
18(BE)
47.3
 Fiscal Responsibility Legislation by States

Some States enacted laws similar to Central FRBM Act, beginning

with Karnataka in 2002, Kerala, Tamil Nadu and Punjab in 2003 and
Uttar Pradesh in 2004.
The process was accelerated by 12th Finance Commission which made
certain debt relief contingent upon enacting such laws. West Bengal
and Sikkim did so in 2010, covering all States.
A Group of State Finance Secretaries with a JS from MoF prepared a
Report (Jan 2005) on Model Fiscal Responsibility Legislation at State
Level with technical support of RBI as per decision in a Conference
of the State Finance Secretaries (August 1, 2003)
 Fiscal Responsibility Legislation by States

The Group considered it desirable to allow individual States to take a

view on sequencing the adoption of the various provisions, fixing the
actual targets and time frame thereof for implementation and allocate
the provisions between the Act and the Rules depending on their
fiscal capabilities and further refine the provisions in the model bill.
Their objective was to design a template on the basis of "workability"
and enforceability taking into account the diverse requirements of
various States.
The Group recommended that the actual path of fiscal correction
could be left to the individual States depending upon their initial
conditions and capability.
Essential elements of the FRA recommended by the
12th Finance Commission

The Commission has recommend that each State should enact fiscal
responsibility legislation. This legislation should, at a minimum,
provide for
(a) eliminating revenue deficit by 2008-09;

(b) reducing fiscal deficit to 3 per cent of GSDP or its equivalent

defined as ratio of interest payment to revenue receipts;

(c) bringing out annual reduction targets of revenue and fiscal

deficits;
(d) bringing out annual statement giving prospects for the state

economy and related fiscal strategy;

(e) bringing out special statements along with the budget giving in

detail number of employees in government, public sector, and aided

institutions and related salaries.
 Cooperative federalism
With the economy being decontrolled and having increasing role of free,
prudentially regarded market for provision of goods and services, with
concomitant reduction in the role of Government in the economy, is it really
necessary to continue with Soviet styled centralized planning?
Contrary to popular belief, the role of government in the economy has not
diminished calling for an end to Soviet style centralized planning.
Governments impact on economy has not diminished even though
Governments role in direct provision of goods and services may have
declined. The combined expenditure of Centre and State Governments
continues to be around 27 per cent to 28 per cent of GDP and in many States,
the Government expenditure is more than 50 per cent of the State's GSDP.
So government including PSUs size and impact on the economy has not
really changed much. In areas like civil aviation, telecom, power, roads and
transport, automobiles, there is an increasing participation of private sector
suppliers of goods and services.
 Cooperative federalism
One may be tempted to conclude that centralized planning may be dispensed
with but there is a continuing and severe competition for the limited national
resources between the Governments, public sector entities and the private
sector entities, whether for manpower or funds or natural resources, the key
factors of production.
Of particular concern is the competition for funds because the increasing
levels of Government borrowings are driving out private sector from the
domestic financial market. They are increasing being forced to resort to bring
capital from abroad.
An important role for the Policy Commission is expected to be planning the
desirable size of public expenditure / investment as a whole and in particular
sectors, irrespective whether it is plan or non-plan, good or bad, revenue or
capital, developmental or non-developmental expenditure. It is problematic to
leave spending plans totally to individual governments.
 Individual States fiscal responsibility
Pursuit of uncoordinated fiscal policy by different State governments may
lead to fiscal crisis.
State governments should have greater autonomy in spending their own non-
debt resources with due regard to national benchmarks
However, resorting to populist policies, living beyond means and transferring
the States problems to the Central public exchequer amounts to being
irresponsible member of the family.
The national resource pool (household financial savings] is limited and all
governments have to compete for a share in it not just among themselves but
also with non-government competitors.
Any aggressive elbowing out may be disastrous for the economy.
To wield moral authority, the Centre must be fiscally prudent, practice before
preach.