From UPSC perspective, the following things are important :
Prelims level : Provisions of the FRBM Act
Mains level : Paper 3- Issues with the FRBM and alternative framework
The article highlights the failure of FRBM Act to contain India’s rising debt and suggests an alternative framework.
Issues with the FRBM Act
- Economic disruption caused by the COVID has prompted calls for a relook atthe Fiscal Responsibility and Budget Management Act (FRBM).
- The introduction of the FRBM in 2003 reflected the belief that setting strict limits on fiscal deficits, both for the centre and the states, was the solution.
- But this framework didn’t work.
- Apart from the initial period, when growth was booming, the deficit targets were largely honoured in the breach, leaving the primary balance [Revenue-Non-intrest expenditure] essentially unchanged (Figure 2, phase 2).
Debt has increased to record levels
- India’s general government debt has soared.
- It is now close to 90 per cent of GDP — the highest independent India has ever seen.
- The debt ratio will come down naturally as GDP normalises.
- Even so, on current policies, it is likely to exceed 80 per cent for the foreseeable future.
Would such a high level of debt be sustainable?
- Briefly, sustainability depends on two key factors:
- 1) The primary balance (PB), revenue less non-interest expenditures.
- 2) The difference between the cost of borrowing and the nominal growth rate (r-g).[interest-growth differential]
- Debt does not explode when the primary balance is greater than the interest-growth differential.
- In India’s case, PB has been negative as the government has run primary deficits.
- But this has been counterbalanced over the past decade by favourable differentials, as interest rates have been lower than growth.
- Hence, the broadly stable debt ratio.
- This equilibrium has now been upset by the sudden increase in debt.
- If the interest-growth differential consequently turns unfavourable, as occurred during the previous period of high debt in the early 2000s (Figure 2, phase 1), then debt sustainability could only be preserved by shifting the primary balance into surplus.
- And this would not be easy.
Why shifting primary balance intro surplus is not easy
- Primary deficit of the Centre and states combined is typically about 3 per cent of GDP. [say PB is -3% of GDP]
- So, shifting the primary balance into a modest surplus [i.e. turning PB from -ve to +ve] would require an adjustment of 4 percentage points of GDP.
- But non-interest expenditure is only roughly 20 per cent of GDP.
- If tax increases were ruled out, then a sudden adjustment would require non-interest spending to be cut by no less than 20 per cent (4 divided by 20 times 100).[20% of 20 is 4]
- Clearly, this would be politically impossible.
- But this would render India susceptible to panic and possibly even crises.
- The government needs to eliminate the tension, undertaking a pre-emptive consolidation to prevent the need for a sudden adjustment.
Strategy based on 4 principles
- The government should start by defining a clear objective, based not on arbitrary targets but on sound first principles: It should aim to ensure debt sustainability.
- To this end, the government could adopt a strategy based on four principles.
1) Abandon multiple fiscal criteria
- The current FRBM sets targets for the overall deficit, the revenue deficit and debt.
- Such multiple criteria impede the objective of ensuring sustainability since the targets can conflict with each other,
- This creates confusion about which one to follow and thereby obfuscating accountability.
2) Don’t get fixated on specific number
- Around the world, countries are realising that deficit targets of 3 per cent of GDP and debt targets of 60 per cent of GDP lack proper economic grounding.
- In India’s case, they take no account of the country’s own fiscal arithmetic or its strong political will to repay its debt.
- Any specific target, no matter how well-grounded, encouraging governments to transfer spending off-budget such as with the “oil bonds” in the mid-2000s and subsidies more recently.
3) Focus on one measure for guiding fiscal policy
- In this regard, Arvind Subramanian and Josh Felmanwe propose targeting the primary balance.
- This concept is new to India and will take time for the public to absorb and accept.
- But it is inherently simple and has the eminent virtue that it is closely linked to meeting the overall objective of ensuring debt sustainability.
4) Don’t set yearly target for the primary balance
- The Centre should not set out yearly targets for the primary balance.
- Instead, it should announce a plan to improve the primary balance gradually, by say half a percentage point of GDP per year on average.
- Doing so will make it clear that it will accelerate consolidation when times are good, moderate it when times are less buoyant, and end it when a small surplus has been achieved.
- This strategy is simple and easy to communicate; it is gradual and hence feasible.
Consider the question “Despite the FRBM framework India’s debt level have touched a historic high. In light of this, examine the reasons for the failure of FRBM in controlling the debt level and suggest the way forward to make India’s debt level sustainable.”
COVID has upended India’s public finances. It is time to learn from past experience and adapt. Adopting a simple new fiscal framework based on the primary balance could be the way forward.