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Persistence of Fiscal Irresponsibility: Looking Deeper into Provisions of the FRBM Act

While the 2009-10 budget was branded as a lacklustre budget, there seems to be near consensus that it rightly pushed aside the issue of fiscal rules, as growth is the top-most priority at this moment and all else can follow. This paper argues that even if we were to accept this position, the direction and structure of expenditures since the passage of the Fiscal Responsibility and Budget Management Act has been far from "responsible" even when macro caps were being met. The structure of expenditure allocations in the 2009-10 budget appears to be inadequate for a "fiscal stimulus". The time is thus opportune to chalk out a set of "Second Generation Fiscal Rules", which will address the inadequacies that have surfaced during the four-year experience with fiscal rules at the central government level. Prioritising these second generation rules - thus following the gradualist approach - and strengthening enforcement via greater power to the Comptroller and Auditor General, which could play the role of a Fiscal Council, would facilitate greater success of the new rules.

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Persistence of Fiscal Irresponsibility: Looking Deeper into Provisions of the FRBM Act

Mala Lalvani

While the 2009-10 budget was branded as a lacklustre budget, there seems to be near consensus that it rightly pushed aside the issue of fiscal rules, as growth is the top-most priority at this moment and all else can follow. This paper argues that even if we were to accept this position, the direction and structure of expenditures since the passage of the Fiscal Responsibility and Budget Management Act has been far from “responsible” even when macro caps were being met. The structure of expenditure allocations in the 2009-10 budget appears to be inadequate for a “fiscal stimulus”. The time is thus opportune to chalk out a set of “Second Generation Fiscal Rules”, which will address the inadequacies that have surfaced during the four-year experience with fiscal rules at the central government level. Prioritising these second generation rules – thus following the gradualist approach – and strengthening enforcement via greater power to the Comptroller and Auditor General, which could play the role of a Fiscal Council, would facilitate greater success of the new rules.

Thanks to Abhay Pethe, Ajit Karnik and Romar Correa for their comments and suggestions, which made a vital difference to the final outcome. The usual disclaimer applies.

Mala Lalvani (mala.lalvani@gmail.com) is with the Department of Economics, University of Mumbai.

T
here seems to be near consensus on the issue that fiscal rules could not have been adhered to in the 2009-10 budget in the milieu of the global meltdown. The global meltdown seems to have legitimised slipping on the Fiscal Responsibility and Budget Management (FRBM) targets. However, we argue here that there is ample evidence to suggest that fiscal correction after the passage of the FRBM has been wrong headed and the 2009-10 budget is no different. We believe that the time is opportune to get back to the rule book and chalk out a set of second generation fiscal rules, which will address the inadequacies that have surfaced during the four-year experience with fiscal rules at the central government level. While the global crisis provides the immediate impetus to boost government spending, the issue of getting back to fiscal discipline at the earliest is of vital importance from the point of view of a long-term sustainable fiscal policy.

Section 1 presents the trends in major deficit indicators and expenditure composition, both pre and post the introduction of fiscal rules, draws special attention to expenditure composition in the 2009-10 budget and highlights the inadequacy of the fiscal stimulus. Section 2 discusses the issues to be addressed by the second generation fiscal policy rules. Section 3 focuses on institutional reforms that could help enforce the rules and finally Section 4 charts the way forward for the second generation rules.

1 Tracking Fiscal Indicators
Central Government

An evolution of key deficit indicators for the centre pre- and post-FRBM appears in Table 1.

Table 1: Deficit Indicators of Centre as % of GDP

Pre-FRBM Post-FRBM
1985-1990 1990-1995 1995-2000 2000-2004 (Average) (Average) (Average) (Average) 2004-2007 2007-08 2008-09 (RE) 2009-10 (BE) (Average)
GFD 7.7 6.3 5.5 5.5 3.9 2.7 6.0 6.8
RD 2.4 3.0 3.1 4.1 2.3 1.1 4.4 4.8
PD 4.5 2.2 1.1 0.9 0.1 0.9 2.5 3.0

GFD: Gross Fiscal Deficit, RD: Revenue Deficit, PD: Primary Deficit, RE: Revised Estimates, BE: Budgeted Estimates. Source: Budget Documents, various issues.

Clearly, since the passing of the FRBM Act by the centre in 2003, there has been some reduction in the major deficit indicators (barring the worsening of the deficit in 2008-09(RE) and 2009-10(BE). We will return to a discussion on this later.) However, for a complete and correct picture, it is essential to go a step further and look “below the line” at the structure or composition of the fiscal correction that has occurred on the expenditure side of the

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budget. Table 2 traces the shares of revenue and capital expenditures 2004-05 onwards, i e, post-FRBM.

The story that Table 2 and Figure 1 tell is that the structure of expenditure has worsened in the post-FRBM phase with a rising share of revenue expenditure and a falling share of capital expenditure. A look at the share of revenue and capital expenditure in total expenditure at the central government level indicates that the share of revenue expenditure in total expenditure has increased from 77% in 2004-05 to 89% in 2008-09 (RE), thus implying that the share of capital expenditure has declined from

Table 2: Composition of Expenditures of Central Government (in %)

Post-FRBM

2004-05 2005-06 2006-07 2007-08 2008-09(RE) 2009-10(BE)
Revenue exp/Total exp (RX/TX) 77.14 86.88 88.21 83.41 89.18 87.89
Capital exp/Total exp (KX/TX) 22.86 13.12 11.79 16.59 10.82 12.11
Revenue exp/GDP (RX/GDP) 12.31 12.32 12.63 12.65 14.76 15.22
Capital exp/GDP (KX/GDP 3.65 1.86 1.69 2.52 1.79 2.10

GDP: Gross Domestic Product. Source: Computed from Expenditure Budget, GOI various issues.

Figure 1: Shares of Revenue and Capital Expenditure (%) 90 80

RX/TX 70 60 50 40 30 20 10

KX/TX

0 2004-05 2005-06 2006-07 2007-08 2008-09(RE) 2009-10(BE)

23% to 11%. The requirement of FRBM is that GFD/GDP stabilise at 3% with zero revenue deficit thus implying that the share of capital expenditures in GDP (KX/GDP) stabilises at around 3%.

In 2004-05, the first year when FRBM targets were set, we started with KX/GDP at 3.65%, i e, better than the FRBM requirement. Since then KX/GDP dipped to 1.8% and 1.7% in 2005-06 and 2006-07, respectively. In 2007-08 the trend reversed and KX/GDP stood at 2.59% but once again a reduction to 1.79% in 2008-09 (RE) goes contrary to the desired trend. The 2009-10 budget, however, gives the right signal, as regards the direction, with the share of capital expenditures budgeted to rise to 2.1% of GDP.

A closer look at expenditure composition on some key expenditure categories like social and economic services is presented in Table 3.

Table 3 shows that expenditure on social services has indeed picked up in the post-FRBM phase but it still stands at a mere 1.2%

Table 3: Expenditure Components as Per Cent of GDP

Pre-FRBM Post-FRBM
1991-92 to 1994-95 to 1999-2000 to 2004-05 to 2009-10(BE)
1993-94 1998-99 2003-04 2008-09
Social services 0.55 0.70 0.73 1.20 1.73
Education 0.13 0.21 0.22 0.44 0.55
Health 0.06 0.07 0.08 0.11 0.15
Economic services 7.09 6.45 6.41 6.73 7.06
Agri and allied services 0.93 0.83 0.94 1.49 1.83
Rural development 0.10 0.36 0.32 0.54 0.74
Irrig and flood control 0.02 0.01 0.02 0.01 0.01
Subsidies 1.54 1.35 1.40 1.62 1.89

Source: Annual Financial Statement, Budget Documents, various issues.

of GDP, well below the desired level. Education stands at a mere 0.44% of GDP and health at 0.11%. Undoubtedly, these are state subjects and hence the share of central government expenditure will not be very high. Still, the share of the central government expenditure on education and health put together not being even close to 1% of GDP is certainly hard to accept. However, given the history, the hike appears to be large. For instance, social services which constitute a mere 1.7% of GDP in the 2009-10 budget is a hike of 60% as compared to the budget of 2008-09.

The share of expenditure on economic services in GDP in the post-FRBM phase at 6.73% is, in fact, lower than that in the first half of the 1990s. The share of expenditure on agriculture and allied activities in GDP has picked up from 0.94% to a mere 1.5% and that of rural development from 0.32% to only 0.54%. The share of irrigation and flood control has fallen from 0.02% to 0.01%. Thus, it would appear that in the phase of post fiscal responsibility rules, expenditure composition has suffered in terms of not providing a “big push” to developmental expenditure. The 2009-10 budget also vindicates this proposition.

In his budget speech the finance minister, defending the missing of the FRBM target on fiscal and revenue deficits said, “Fiscal expansion would go a long way in reversing the impact of the economic slowdown and accelerate our growth revival in the medium term”. The question that we explore here is – what is the direction of this fiscal expansion? Does it look like it would translate into reversing the impact of the economic slowdown? Table 4 helps answer these questions by juxtaposing the figures of 2007-08 (actuals), 2008-09(BE), 2008-09(RE) and 2009-10(BE). Computing the variation of BE of 2009-10 from the others gives us a fairly good picture of how the 2009-10 budget fares on these expenditures.

Table 4 indicates that non-plan expenditure on social services in the 2009-10 budget does better than the RE and BE of 2008-09 but worse than the actual of 2007-08 by almost one percentage point. As regards non-plan expenditure on education and health specifically, the 2009-10 budget has indeed increased the expenditure, although the hike in its share is hardly of a magnitude that one could feel ecstatic about. As regards non-plan expenditure on economic services in general and agriculture and allied activities

Table 4: Share of Expenditure Components in Plan and Non-Plan Expenditure (in %)

Variations 2007-08 2008-09 2008-09 2009-10 2009-10 2009-10 2009-10 Actual BE RE BE (BE) minus (BE) minus (BE) minus 2008-09 2008-09 2007-08 (RE) (BE) (Actuals)

Share in non-plan expenditure
Social Services 3.63 2.05 2.12 2.66 0.53 0.61 -0.97
Education 0.88 0.84 0.96 1.12 0.16 0.28 0.24
Health 0.34 0.31 0.32 0.39 0.07 0.09 0.06
Eco Services 3.23 3.11 3.18 2.63 -0.55 -0.48 -0.60
Agri and allied activities 0.96 0.98 0.95 0.35 -0.60 -0.63 -0.61
Share in plan expenditure
Agri and allied activities 4.32 2.68 2.57 2.37 -0.20 -0.31 -1.95
Rural development 9.70 5.05 10.56 9.79 -0.77 4.74 0.09
Irrig and flood control 0.23 0.11 0.09 0.10 0.00 -0.01 -0.14
Social services 29.45 26.84 25.15 24.95 -0.20 -1.89 -4.49
Gen education 11.79 7.52 6.62 6.56 -0.06 -0.96 -5.23
Medical and public health 6.80 1.39 1.29 1.38 0.09 -0.01 -5.42

Source: Budget Documents, various issues. Expenditure Budget, Vol 1.

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in particular, the budget fares poorly as the expenditure shares are lower than the actuals of 2007-08, RE and BE of 2008-09.

On the plan expenditure front, the budgetary allocation for agriculture and allied services as per cent of GDP is once again lower than all three comparable years, i e, actual of 2007-08, RE and BE of 2008-09. In fact it is lower than the actual of 2007-08 by almost 2 percentage points. The allocation for irrigation and flood control is also lower than the BE of 2008-09 and actual of 2007-08. What comes as the biggest surprise, however, is the allocation for rural development, under which we have the National Rural Employment Guarantee programme, which is being touted as a success story of the United Progressive Alliance (UPA) government. The share of expenditure on rural development in GDP in the 2009-10 budget is seen to be higher than the actual of 2007-08 by a mere 0.09 percentage points. The expenditure shares for social services and education in plan expenditure is lower in the BE of 2009-10 as compared to all three comparable allocations. Clearly the expenditure composition proposed in the 2009-10 budget does not show any marked hike in expenditure on social and economic services. Given the small base of expenditure in these areas, small hikes here and there are unlikely to make any major dent.

Table 5 lists the allocations announced by the FM, and which occupied a large part of the finance ministers’ budget speech for 2009-10

– the proportion of the allocation as a whole is disappointing.

Table 5: Allocation for Flagship Programmes of Central Government (Rs crore)

Schemes 2009-10 (BE)
NREGS 39,100
Pradhan Mantri Gram Sadak Yojana (PMGSY) 12,000
Rajiv Gandhi Grameen Vidyutikaran Yojana (RGGVY) 7,000
Indira Awas Yojana (IAY) 8,800
National Housing Bank (NHB) 2,000
Pradhan Mantri Adarsh Gram Yojana (PMAGY) 100
Rashtriya Mahila Kosh 500
Welfare of minorities 1,740
National Rural Health Mission (NRHM) 14,127
Rashtriya Swastha Bima Yojna 350
National Ganga River Bima Authority (NGRBA) 562
Exp on various schemes pertaining to education 4,335
Total amount allocated for various schemes announced
in budget speech 90,614
Total Expenditure 10,20,838
Share of allocation for schemes in total exp 8.88

Source: Expenditure Budget, Vol I, Budget Document 2009-10.

The sum total of the allocations in budget 2009-10 on welfare improving programmes constitute a mere 8.88% of the total expenditures of the government. Clearly, interest payments and the higher pay scales on account of the Sixth Pay Commission recommendations and not higher developmental expenditures are the two primary causes of higher fiscal deficit.

With higher fiscal and revenue deficits (funded by borrowings which are bound to put pressure on interest rates and adversely affect private investment) and lagging capital expenditure by the government, investments are bound to suffer. With lagging i nvestments especially in the agricultural sector (coupled with relatively poor monsoons) the rising demand for foodgrains would be difficult to cope with. With foodgrain and vegetable prices set to further rise, the poorest sections of society are sure to

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be the worst hit as they are not beneficiaries of the Sixth Pay Commission salary hikes. Thus the 2009-10 budget has neither kept the deficit indicators under check nor has it given any big push to c apital expenditures. The developmental expenditures on social and economic services have also lagged behind. One cannot help but say that the 2009-10 budget does not come across as being fiscally “responsible” or indeed irresponsible for the right reason!

State Governments

For state governments, no single year can be considered as the d ividing line to take stock of the states’ fiscal positions post-FRBM. A broad picture, however, can be obtained by considering 2006-07 and 2007-08 as post-FRBM years as 22 of the 28 states had passed the Fiscal Responsibility Legislation (FRLs) by then. Table 6 points out that the GFD/GDP target of 3% has been bettered and the r evenue deficit has turned to revenue surplus. Thus, the situation of the states as a whole is similar to that of the centre where aggregate targets under FRBM have by and large been conformed with.

Having seen that aggregate targets in the post-FRBM phase have been adhered to by the states as with the centre, we turn our attention to the composition of expenditure in Table 7.

Table 7 shows that the share of revenue expenditure in total expenditure for states has risen from 72% in 2004-05 to 77% in 2008-09 (BE) thus implying that the share of capital expenditure has declined from 27% to 22% for the same period. As per cent of GDP, the share of revenue expenditure has been more or less stable with the share of capital expenditure having declined from 4.8% in 2004-05 to 3.8% in 2007-08(RE). The budget estimate of 2008-09, in fact, showed a further decline to 3.7%.

A look at the expenditure composition for states as a whole (revenue and capital) in Table 8 reveals that the expenditure for

Table 6: Key Fiscal Indicators – State Governments

1985-90 1990-95 1995-2000 2000-04 2004-07 2007-08 2008-09 2009-10
(Average) (Average) (Average) (Average) (Average) (RE) (BE)
States* GFD 3.0 2.8 3.4 4.3 2.9 2.3 2.1 n a
RD 0.2 0.7 1.6 2.4 0.5 -0.5 -0.6 n a
PD 1.6 1.1 1.4 1.5 0.4 0.1 0.1 n a

* Data for the last three years pertain to 27 state governments. Sources: (1) Handbook of Statistics on the Indian Economy, 2006, RBI.

(2) Budget documents of government of India and state governments.

Table 7: Post-FRBM Structure of Expenditure – State Governments (in%)

Post-FRBM

2004-05 2005-06 2006-07 2007-08(RE) 2008-09(BE)

Revenue exp/Total exp (RX/TX) 72.76 77.99 76.94 76.98 77.44

Capital exp/Total exp (KX/TX) 27.24 22.01 23.06 23.02 22.56

Revenue exp/GDP (RX/GDP) 12.90 12.28 12.41 12.90 12.61

Capital exp/GDP (KX/GDP) 4.83 3.47 3.72 3.86 3.67

Source: Budget at a Glance, Budget Documents, various issues. Table 8: Components of Developmental Expenditure of States (as % of GDP)

Item 2005-06 2006-07 2007-08 (RE) 2008-09 (BE)

1 Developmental expenditure (revenue and capital) (A + B) 8.86 9.30 10.16 9.88

A Social Services (a to l) 4.56 4.71 5.19 5.19

  • (a) Education, sports, art and culture 2.24 2.26 2.36 2.31
  • (b) Medical and public health 0.54 0.55 0.60 0.59
  • B Economic services (1 to 9) 4.30 4.59 4.97 4.69

    1 Agriculture and allied activities 0.64 0.68 0.80 0.74

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    “developmental” purposes (as defined by the RBI – comprising expenditure on social services, economic services and loans for social and economic services), has shown signs of improvement in the recent years but is still lower than the levels achieved in the early 1990s. We must remember that this is out of a significantly higher GDP. The total developmental expenditure (revenue and capital) as a ratio to GDP, which was 9.84% during 1990-91 to 1994-95 on an average, has declined to 9.14% in 2006-07 and was, in fact, budgeted to decline to 5.23% in 2008-09. These statistics appear to take away the argument that the growth dividend provides an opportunity for giving a fillip to the lagging social sector. If the pro-growth argument is to be upheld then the additional revenues obtained must be directed towards developmental activities.

    Thus, clearly the structure of expenditure has shown a worsening trend in the process of attempting to comply with the macro caps imposed by the FRBM. In fact, much of the fiscal correction and consolidation which has occurred at the central and state levels can be largely attributed to robust economic growth and macroeconomic stability coupled with a tax structure based on reasonable rates, fewer exemptions and better compliance. The focus on expenditure restructuring has clearly lagged behind.

    The issue of contingent liabilities of the states is yet another area of concern that has come to the fore since the mid-1990s when borrowings by state-owned public enterprises were removed from coverage under the ceiling established for states’ market and statutory liquidity ratio (SLR) borrowings. Prior to 1994-95, state enterprises were given separate borrowing allocations each year as part of state-specific global ceilings for SLR and market borrowings. Their SLR qualification status permitted state-controlled enterprises to mobilise funds at relatively low rates of interest. At the same time, the allocation of a specific limit on the amount that could be raised meant there was some control on the extent to which state governments could issue guarantees.

    The outstanding guarantees of state governments have increased from 4.4% of GDP as of end-March 1996 to 8% of GDP as of end-March 2001, and were placed at 7.5% of GDP as of end-March 2003.

    A snapshot picture of how the

    Table 9: Position of State Government states are placed with respect Guarantees

    Outstanding Guarantees % No of States

    to guarantees is indicated in

    of Revenue Receipts

    Table 9. Himachal Pradesh and

    ≤ 25 5

    Maharashtra are two states which

    25 to 50 3

    have guarantees exceeding 100%

    50 to 100 6 of revenue receipts. ≥ 100 2 Howes and Jha (2001) have Total 16 Source: Computed from State Finances

    drawn attention to three techni

    2007-08, RBI.

    cal issues that arise when extending fiscal policy rules to cover off-budget liabilities: (a) one should be concerned with off-budget capital expenditure rather than off-budget borrowing per se, (b) the rules would need to clarify if guarantees would be included in off-budget liabilities, and (c) other debt equivalent financing devices such as leasing should also be covered by fiscal policy rules.

    In fact, even the Model Fiscal Responsibility Legislation of state finance secretaries published by the RBI (2005) decided to extend the definition of liabilities to include not only the total liabilities under the Consolidated Fund of the state but also all the items under the Public Account of the state. It pointed out that given the need to comply with budgetary targets in terms of the prescribed debt rule, state governments might have the tendency to go for off-budget borrowings. The group of finance secretaries of states felt that in order to bring such borrowings “above board”, fiscal rules should also cover off-budget borrowings. Accordingly, it was felt that borrowings by the public sector undertakings and the special purpose vehicles and other equivalent instruments including guarantees, where the liability for repayment of principal and/or interest is on the state government should also be treated as borrowings of the government for the purpose of computation of total liabilities.

    Another issue associated with state guarantees relates to borrowings of state public enterprises, especially State Electricity Boards (SEBs), which are incurring losses and show negative returns on capital. Attracting private sector investment for power generation projects in the absence of tariff reform has required granting of rate of return guarantees by many states with counter-guarantees extended by the government of India. Past guarantees for SEBs and other public enterprises have proved to be an obstacle to future reform. If the SEB has raised a large amount of loan guaranteed by the state government, then the cost of unwinding these commitments as part of privatisation is formidable.

    The above-mentioned channels have regularly been used by various state governments to flout norms and soften the hard budget constraints that the FRBM Act was expected to impose. Based on this experience we feel that it is time to move ahead to charting the second generation fiscal rules which will spell out the details of micro design. Undoubtedly, such detailing of fiscal rules would curb the flexibility available to the government of the day (both centre due to its own initiative and states by compulsion) – which, theoretically speaking, is not desirable. However, given the intrinsic and observed tendency of governments to behave opportunistically, we believe that stringent fiscal policy rules would initiate a culture of fiscal discipline. Some of the issues that the second generation fiscal rules would need to address have been listed out in Section 2 below.

    2 Second Generation Fiscal Rules: Issues of Concern

    With four years of experience of the FRA at the central government, some loopholes in the existing FRLs of the states and the central government that need to be plugged are:

    (a) Expenditure Composition: The rising share of revenue expenditure as noticed in Table 4 provides a warning signal. International experience suggests that capital expenditure falls disproportionately in times of fiscal stringency. Hicks (1991) shows this for developing economies in a cross-regional context, Easterly and Serven (2003) for Latin America and Estache (2005) for Sub-Saharan Africa. Roubini and Sachs (1989) and De Haan et al (1996) show the same for industrial countries.

    It is also important to address the issue that expenditure on social services is largely revenue expenditure. Karnik (2002) expressed the fear that in the absence of any lobby for this expenditure category there was a danger that in the endeavour to attain the target of zero revenue deficit the government may

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    squeeze social sector spending still further. Thus expenditure on social sector categories needs to be considered in totality (i e, revenue and capital) and needs to be protected from being drastically cut in the fiscal disciplining exercise.

  • (a) Maintenance Expenditure: This falls under the current expenditure category and is a vital expenditure component that bears the brunt of any expenditure pruning exercise – thus such expenditures must be given special attention and protected in our fiscal policy rules. Serven (2007) draws attention to the key role of maintenance expenditure and to the fact that they tend to be compressed even more sharply than investment at times of fiscal retrenchment.
  • (b) Contingent Liabilities: Off-budget borrowings of states have come to the fore since the mid-1990s. Guarantees have become a convenient means for States to circumvent the ceiling on the quantum of their market borrowings. In addition to use of guarantees for large infrastructure projects, some states have used bonds, financed through special purpose vehicles or corporations with little or no credit records, but with borrowing guarantees from state governments to raise debt financing for direct budgetary support (McCarten 2000). More recently, oil bonds (offbudget) have been floated by the central government to lend a helping hand to loss-making oil marketing companies.
  • Although contingent liabilities prima facie do not form a part of the debt burden of states, in the event of default by the borrowing agency, the debt service obligations will fall on the state governments. The outstanding guarantees of state governments showed a rising trend during the 1990s. The outstanding guarantees rose from Rs 40,159 crore (6.1% of GDP) as of end-March 1992 to about Rs 1,84,294 crore (7.5% of GDP) as of end-March 2003. The provisional figures show some improvement on this count with guarantees placed at 5.5% of GDP as of end-March 2006. The additional contingent liabilities were only 0.07% of GDP and in 2006-07 additional contingent liabilities have not been assumed and the amount has actually declined from 2005-06 levels. An interesting observation made by Agarwal (2008) is that the FRBM of the central government has put a cap on fresh liabilities at 0.5% of GDP pa, but has not put a cap on total liabilities (which are cumulative).

    As stated earlier, one important reason for the upsurge in guarantees is the borrowings of state public enterprises, especially the SEBs. Thus the consolidated deficit to be targeted could also include these power sector deficits.

    Apart from the magnitude of contingent liabilities, an important dimension which has implications for the stability of fiscal operations of the state governments is the quality of guarantees extended and the element of risk embedded in such guarantees arising from a lack of, or poor risk assessment of, guaranteed advances and bonds.

    An introduction of the concept of such a “consolidated deficit” to be targeted would take away the incentives for the states to make use of various accounting tactics to push various expenditure items off-budget and also renege on their subsidy obligations in the power sector. It will undoubtedly require sacrificing the

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    p rinciple of “simplicity” in some measure. We believe that the advantage of targeting a consolidated deficit measure, which reduces the incentive for accounting gimmickry, far outweighs the cost.

    (c) Penal Clause: There is no penal clause in the existing FRBM for failing to comply with fiscal rules. For fiscal rules to have credibility, credible sanctions are needed against violations. An escape or exclusion clause, in a contract, allows non-performance of the contract if a certain specified condition occurs. In the FRBM Act 2003 of the government of India, it is provided that the revenue deficit and fiscal deficit could exceed the target on grounds of national security or natural calamity or such other exceptional grounds as the central government may specify. In the case of state governments, these could cover internal disturbance and natural disasters. In case of special category states, the exclusion clause may also cover the shortfall in the current transfers from centre in excess of certain percentage, say 10% of the trend growth rate of such transfer for the last three years.

    The escape clause of unforeseen circumstances needs to be tightened and spelt out in detail so that governments do not misuse this clause as a cover-up for their failure. Howes and Jha (2001) recommend explicit incorporation of a contingency fund to take care of natural disasters and specification of the extent to which the missing of targets is permissible. Undoubtedly, no exact amount can be estimated for a natural disaster but some guesstimate is certainly possible.

    To take some lesson from the EU, their fiscal rules state that if any country fails to meet the target, it would pay penalties in the form of deposit, ranging from 0.2 to 0.5% of GDP, depending on the deficit size. The deposit of the countries that failed to meet this target would be returned if they manage to reduce the budget deficit within the limits within two years. Otherwise, it would become definite penalty. However, such rules do not apply in “exceptional circumstances” caused by natural disasters or severe recessions. Exceptional circumstances mean that the economic activity of a country declines by more than 2% on an annual level. If the decline of GDP is between 0.5% and 2%, the penalties would be paid subject to approval by the Council of Europe. Thus the EU not only imposes a penal clause for missing targets but also specifies in detail what is meant by the “exceptional circumstances” under which all targets could be set aside.

  • (d) Reporting Requirements: The consensus view of the Model Act Group of finance secretaries (RBI 2005) was that state governments should have quarterly reviews and corrective measures, if required, should be taken only after taking into account the outcome of the trends in receipts and expenditure at the end of the second quarter. This would also be in line with the approach adopted in the fiscal rules framed by the central government. This would be demanding on the states but a binding commitment to spell out in detail the targets and achievements necessarily imposes a discipline.
  • (e) Budgetary Accounting: There is no economic rationale for what in budgetary accounting is referred to as public investment. Education is classified as public consumption expenditure whilst
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    the building of new government offices is considered an investment. However, public spending on education is likely to be far more socially productive than building a new government building (D’Souza 2006). Such issues are crucial and will need to be addressed by the fiscal policy rules if they are to attain fiscal discipline of the right variety.

    A recent welcome step towards improvement in accounting practices is the announcement that the centre has decided to gradually move from a cash-based to an accrual-based system of accounting, under which revenue and expenditure are shown in the books even when they are realised later. Under the fresh accounting system, the government will have to account for all the future liabilities such as oil, fertiliser and food bonds in its books of accounts, which could have major implications on the fiscal deficit numbers.

    With the accrual-based accounting system the decision-makers can know the full cost of services they are providing, and this will result in better resource allocation and better management of assets and liabilities. Cash-basis accounting is a method of book-keeping that records financial events based on cash flows and cash position. Revenue is shown in the books when cash is received and expense is recognised when cash is paid. On the other hand, under accrual accounting revenue is shown in the balance sheet when it is earned and realised, regardless of when actual payment is received in cash. Accrual based accounting method will create a desirable measure of the complete financial health of the government. Development in the information technology and accounting profession will assist the government in moving towards the new system.

    Currently, the fiscal deficit does not take into account oil and other bond issues that do not involve any immediate cash outgo. But these are future liabilities that will need to be accounted for under the system. Some experts have argued that their inclusion can push up the fiscal deficit numbers to as high as 7% of GDP, far above the 2.5% mandated by the FRBM Act for this fiscal.1

    While all the second generation fiscal rules are crucial to put in place, the political compulsions may result in consensus building turning out to be time-consuming. Hence, we could follow the gradualist approach and prioritise the second generation rules – immediately enforce the rules which are relatively easier to push through politically. As a first step, we could introduce rules (d) and (e), i e, more stringent reporting requirements and budgetary accounting rules. These are administratively d emanding but politically easier to manage. In the second stage, rule (a) i e, pertaining to expenditure composition may be i ntroduced. This will put a check on revenue expenditures but given the existing requirement of zero revenue deficit, introducing this rule would be a natural extension of the existing scheme and no radical change. Finally, rules (b) and (c), viz, computing a consolidated budget deficit inclusive of contingent liabilities and that of including a penal clause could be incorporated in the final stage as these are likely to be met with maximum resistance.

    Further, we may point out that despite plugging the above listed inadequacies, we may still not succeed in achieving fiscal discipline if the fiscal rules are not backed by an enforcement mechanism. In the event of unforeseen circumstances the task has to be left to competent and dedicated policymakers and politicians who have good judgment and know when to exercise discretion and when to press for fiscal discipline. This, in turn, would require developing institutions which create incentives to act “responsibly”. Thus, initiating institutional reforms which provide incentives and strengthen the enforcement of the fiscal rules would make the package for instituting fiscal discipline complete.

    3 Institutional Reform

    Given the scope for institutional innovation, Independent Fiscal Agencies (IFA) could help inform, analyse, assess and implement fiscal policy (Debrun et al 2009). However, in one form or another, their operation would entail some delegation from elected representatives or their administration. They themselves point out that although there is a clear analytical case for IFA, none exist in practice primarily due to conflicts that are sure to arise with the government. An alternative that they strongly recommend is a Fiscal Council (FC) which could help reduce the deficit bias while leaving full discretion to the political representatives. A variety of FCs have been in operation in a number of countries. They range from organisations essentially mandated to provide independent projections of budgetary variables and general fiscal analysis, to bodies assessing the consistency of a government’s budgetary policies with its own long-term objectives, or proposing specific fiscal adjustment measures in the context of established fiscal rules.

    Several countries have Fiscal Councils, though their agendas may d iffer. For example, FCs issuing normative judgments include Belgium’s High Council of Finance, Denmark’s Economic Council and Sweden’s Fiscal Policy Council. Two countries where FCs prepare budget forecasts are Canada and Chile.

    In Canada, a panel of independent experts from academia and the private sector is polled for macroeconomic forecasts. In Chile, two independent expert panels help enforce a structural balance rule. FCs which provide impartial analysis include the US Congressional Budget Office (CBO), Japan’s fiscal system council and Germany’s Working Group on Tax Estimates. Other countries where FCs perform this function are Netherlands, Korea, Mexico and Sweden.

    In the Indian context, too, one could envision a Fiscal Council which would provide an impartial analysis. In a sense, we do have the Comptroller and Auditor General’s (CAG) Office which is entrusted with a similar task. However, the data and observations of mismanagement by governments made by the CAG do not receive the kind of attention that they should. Clearly, these observations are not favourable to the incumbent and hence are not publicised by them. The CAG reports merely show a broad balance sheet of the various government departments, and point out where the balance is not maintained. The CAG, however, cannot be faulted for this, for it has not been entrusted with the power to investigate what happened. It is merely there to raise the alarm for other institutions meant for the job to take the issues to their logical ends. It is unfortunate that no action is taken on the basis of these reports. If some action on these

    september 12, 2009 vol xliv no 37

    SPECIAL ARTICLE

    reports was mandatory, the corrupt and inefficient would fear these reports tremendously.2

    As a first step much greater publicity of the CAG reports and entrusting the CAG (rather than set up a separate Fiscal Council) with the power to track the progress of governments on the fiscal discipline front and meeting of the targets set out by the FRBM, could lend strength to the enforcement channel of fiscal rules.

    4 Concluding Remarks

    Three important issues on the way to fiscal responsibility pointed out by Rangarajan and Subbarao (2007) are: First, there needs to be fiscal correction not just at the centre but also in the states. Second, for sustaining and accelerating growth, achieving the FRBM targets is necessary, but not sufficient. It must, however, be borne in mind that sustained growth is an essential prerequisite for meeting the fiscal caps. Third, we need to pay attention not only to achieving the targets in quantitative terms but also with respect to the quality of adjustment. While the first two issues are now settled with almost all states having passed their FRLs, it is the third issue of “quality of adjustment” that we believe needs to be the focal point from here on.

    Having enacted the FRBM Act, the first step of curbing the gross fiscal deficit to GDP ratio and revenue deficit to GDP ratio has been taken. However, we find that in the process, the structure of fiscal adjustment seems to have suffered. Hence, one positive step f orward would be to plug the inadequacies that have become evident in the last four years since the FRBM Act was passed. The FRLs of some of the state governments are recent but we can learn our lessons from the central government experience. The second generation set of rules must ensure that:

  • (a) Expenditure composition is not distorted and essential expenditure categories like maintenance expenditure and social sector expenditure do not suffer.
  • (b) Contingent liabilities and power sector deficits need to be incorporated in the consolidated deficit to be targeted.
  • (c) Reporting requirements could be made more stringent as they impose a sense of discipline.
  • (d) Escape clauses should be tightened and some penalty must exist for not complying with targets.
  • (e) Institutional reform in the form of greater power to the CAG which could play the role of a Fiscal Council to tighten the enforcement channel.
  • We could follow a gradualist approach in implementing these second generation rules by prioritising them – immediately enforce the rules which are relatively easier to push through politically.

    The essence of the second generation rules must be to bear in mind that we need to go beyond the basics and make greater use of fiscal policy rules as a tool not only for institutionalising fiscal balance but for institutionalising better public expenditure management.

    NotesGrowth in India (New Delhi: Oxford University of Being Earnest about Fiscal Responsibility”, Press). Monograph 3/2007, Madras School of Economics.

    1 Financial Express, “Centre to Adopt Accrual-based Karnik, A (2002): “Fiscal Responsibility and Budget RBI (2005): “Report of the Group on Model Fiscal Accounting System”, 27 December 2007. http:// Management Bill Offering Credible Commit-Responsibility Legislation at State Level”, January.

    www.financialexpress.com/news/centre-to-adopt

    ments”, Economic & Political Weekly, 19 January. Roubini, N and J Sachs (1989), “Government Spendaccrualbased-accounting-system/331088/ viewed

    on 27 December 2008).

    McCarten (2000): “Multi-tiered Governments and ing and Budget Deficits in the Industrial Coun-Hart/Soft Budget Constraints: The Case of India”, tries”, Economic Policy, 8: 99-132.

    2 Imphal Free Press, CAG Reports Trivialised, 2006, http://www.worldbank.org/wbicp/decentralisa-Serven, L (2007): “Fiscal Rules, Public Investment, http://www.kanglaonline.com/index.php?templ

    tion/sasib/McCarten.pdf and Growth”, Policy Research Working Paper No ate=headline&newsid=1365&typeid=0 (viewed Rangarajan, C and D Subbarao (2007): “The Importance 4382, World Bank.

    on 13 April 2009).

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