Focus on fiscal stability 

RBI Governor Dr Raghuram Rajan recently argued against a loose fiscal policy to spur growth. Government’s policy think-tank NITI Aayog Vice-Chairman Dr Arvind Panagariya also cautioned the government against relaxing the deficit target, saying it could impact the government’s credibility as it had already deferred the deficit reduction plan once. The debate was sparked by Chief Economic Advisor Dr Arvind Subramaniam who in the mid-year review suggested that the government could relax fiscal consolidation to boost public investment at a time when the private sector was shy of pumping in funds

The current fiscal situation in India is precarious and is a cause for concern. Growing interest in fiscal adjustment in India is attributable in part to the deterioration in its fiscal performance. India witnessed tremendous economic growth in the past two decades. Its GDP growth rate was 8%, but its sustainability has been in question, first with the 1991 fiscal Balance of Payments (BoP) crisis and then again after 1997–98 when fiscal deficits returned to the 10% GDP range and the government debt grew.

Now, fiscal sustainability is in question again after the global economic crisis. To make economic growth sustainable with macroeconomic stability, fiscal policy is a critical factor. Fiscal adjustment is moderated by some attempts to reverse this trend. High deficits, unproductive expenditure, and tax distortions have constrained the economy from realising its full growth potential. The fiscal position of both Central and State governments worsened significantly since the fiscal consolidation achieved after the 1991 BoP crisis.

There is a remarkable downward inflexibility demonstrated by the fiscal deficit and stubborn upward movement exhibited by revenue and primary deficits. The combined fiscal deficit of the Centre and the States, which was 9.3% of GDP in the crisis year of 1990–91, dropped to 6.3% in 1996–97 before creeping back up to 9% in 1998–99. Due to the global economic crisis, the fiscal deficit increased in 2009–10 to 9.3%. Similarly, the combined revenue deficit of the Centre and the states, which was 4.2 % in the crisis year of 1990–91 and declined to 3.2% by 1992–93, grew to the alarming level of 6.9% by 2001–02.

Policy alternatives

The broad goal of macroeconomic policy is to find the most effective trajectory through which the FRBM (Fiscal Responsibility and Budget Management) goals can be achieved. There are two main questions about the implementation of the fiscal correction which is required by the FRBM: (a) The question of an early or a late adjustment; and (b) The question of how adjustment should be shared between taxation and expenditure. Economic principles to bear on these two key choices are: 1. Early versus delayed adjustment; and 2. Cutting expenditure versus raising tax revenues.

One thing is clear, that the revenue deficit has to go to zero. There is room for flexibility when it comes to the intermediate years. However, there are alternative trajectories which can achieve this. It is possible to have a ‘front-loaded adjustment,’ which emphasises finishing the bulk of the required fiscal correction in the early one or two years. Alternatively, there can be a ‘back-loaded adjustment,’ which emphasises achieving the bulk of the required fiscal correction in the late years.

In addition, there is an important distinction between front-loaded policy reforms and front-loaded fiscal adjustment. It is possible to conceive of policy decisions taken early in the adjustment period, which generate a sustained impact over the following years. The second key question about the fiscal correction concerns the relative role of revenue expenditure and revenue receipts.

Current scenario

Union Finance Minister Arun Jaitley recently ruled out a populist budget for the fiscal year 2016-17 but remained non-committal on reworking the fiscal consolidation plan to boost public spending amid suggestions that the Union government should scrap the FRBM Act that mandates fiscal deficit be cut to 3% of the GDP. The FM is consulting all shades of opinion and for first time grappled with divide over the fiscal deficit where each one has a strong argument in his/her favour.

RBI Governor Dr Raghuram Rajan recently argued against a loose fiscal policy to spur growth. Government’s policy think-tank NITI Aayog Vice-Chairman Dr Arvind Panagariya also recently cautioned the government against relaxing the deficit target, saying it could impact the government’s credibility as it had already deferred the deficit reduction plan once. The debate was sparked by Chief Economic Advisor Dr Arvind Subramaniam who in the mid-year review suggested that the government could relax fiscal consolidation to boost public investment at a time when the private sector was shy of pumping in funds.

While as usual the corporate sector is also pushing for relaxation of the deficit target, several economists are against the proposal and even the government is divided. The government’s fiscal deficit target is 3.9% for the current fiscal 2015-16. It further plans to reduce it to 3.5% during 2016-17 and to 3% in 2017-18. Now, all eyes are on the Union Budget 2016-17 which will state the government plan. It is for the government to think and decide whether to target or forget fiscal consolidation. (The author is an economist at Ernst & Young, New Delhi)