Indian Fiscal Rules: Framework and Critical Review of Outcomes and Design

Urjit R. Patel
Urjit R. Patel Former Brookings Expert, Governor - Reserve Bank of India

July 26, 2010

The challenge of reining in large fiscal deficits has re-emerged in India and elsewhere. Since the mid-2000s, India’s federal and state governments have conducted their budgetary affairs against the background of fiscal responsibility legislations (FRLs).  The fiscal rule for India’s central government was enshrined in the Fiscal Responsibility and Budget Management Act (FRBMA), which was legislated in 2003 (and amended in 2004) and whose targets were effective from fiscal year 2004/05 up to 2008/09. A recent National Bureau of Economic Research working paper, “Fiscal Rules in India: Are They Effective?” by Willem H. Buiter and Urjit R. Patel, critically explores the outcomes of the FRBMA over the period of its operation using an eclectic but comprehensive metric comprising of quantitative targets, qualitative strictures, transparency, integrity, and overall financial performance over the business cycle. The paper deploys a formal solvency arithmetic framework to guide, direct and discipline the discussion.

The paper also reviews FRLs and concomitant outcomes at the state government level. Furthermore, the recommendations of the 13th Finance Commission (FC) regarding a prospective roadmap for fiscal consolidation are examined against the background of both the Indian experience and outcomes of similar fiscal rules in the European Union (Stability and Growth Pact) and in the U.S. (Gramm-Rudman-Hollings Act).

India has a long-standing “preference” for running large fiscal deficits compared to not only its peer group of emerging economies, but also globally.  Over the last three decades, India has found it impossible to sustain, for an appreciable time, an overall public sector financial deficit of less than 8 percent of GDP. It has also been extremely rare for the general government fiscal deficit to be lower than 6 percent of GDP.

There were two key “hard” features of the FRBMA: (1) a restriction that by 2008/09 the overall central government financial deficit be not more than 3 percent of GDP; (2) the “golden rule” restraint that the revenue or current budget should be in balance or surplus by 2008/09. 

The “outcomes” section of the paper clearly shows that the central government has missed both the fiscal and revenue deficit targets by some margin. Its fiscal deficit for the terminal year, 2008/09, was 6 percent of GDP, excluding estimated off-budget expenditure (settled by IOUs or simply ignored) of about 2 percent of GDP. After 2004/05, not only has there been no fiscal correction once off-budget items are included, but indicators mostly deteriorated. Taking into account off-budget expenditure, it is amply clear that the FRBMA “transition” annual targets towards a 3 percent of GDP fiscal deficit and balance on the revenue account by 2008/09 were exceeded before the onset of the 2008 Great Recession. Moreover, the FRBMA’s clauses were insufficient to prevent the finance minister from excluding (unpaid) dues on account of subsidies in calculating the fiscal and revenue deficits; the provision for off-budget bonds was inadequate to cover the expenditure overrun (or deliberately shown to be low); for example, estimates by market analysts suggest that excess expenditure was about 1.9 percent of GDP in 2007/08.

 The adverse evolution in the center’s fiscal balances was not on account of the operation of automatic stabilizers during a cyclical slowdown; on the contrary, the Indian government’s revenues have been buoyant. The gross tax-GDP ratio increased from 9.7 percent in 2004/05 to 12.6 percent in 2007/08 on the back of an almost 9 percent average annual real growth rate. The recent profligacy of the central government has its primary driver in populist spending policies by the ruling coalition leading up to national elections in May 2009. Three stimulus packages, including a reduction in indirect taxes, starting in late 2008 to counter global recessionary headwinds only helped matters along in the same direction. Much of the slippage on the expenditure side can be attributed to large and increasing energy, food and fertilizer subsidies; funding loss-making public sector units; expanding a rural income support scheme (started in 2005); increasing salaries and pensions of civil servants (implemented in 2008), and a huge agricultural loan waiver scheme announced in early 2008 but not budgeted for!

It is instructive that central government liabilities have declined even with an annual average central government fiscal deficit over the five years at 4.8 percent of GDP (including off budget bonds). The driver for this happy state of affairs is India’s unprecedented growth performance in recent years – annual average nominal GDP growth of 15 percent during the 5 years of the FRBMA’s operation – in comparison to the government’s cost of borrowing. This is also the case from a wider perspective: between 2002/03 and 2007/08, overall public sector debt ratios in India declined substantially. The net public debt level is relatively low at about 56 percent of GDP and is largely domestically held, primarily in the banking system, much of which is state controlled.

Fiscal consolidation by state governments (in aggregate) in recent years has been commendable. Between 2003/04 and 2007/08, their fiscal deficit declined markedly from 4.4 percent to 1.5 percent of GDP. The main explanation being that enhanced budget revenues were not offset by discretionary action on the expenditure side. During 2008/09, the fiscal performance deteriorated somewhat with the deficit at 2.6 percent of GDP, but still below the mandated 3 percent ceiling. This was due to the economic slowdown and the accompanying moderation in the pace of revenue growth. However, the revenue deficit in most states was within the target of zero balance in 2008/09. The management of states of their fiscal affairs over both a period of high growth and the subsequent slowdown exhibits successful conduct of “discretionary countercyclical” policy within the rules. Therefore, the recent deterioration in India’s national fiscal situation cannot be blamed on state governments. The evidence suggests that in recent years the fiscal space “vacated” by the states has been usurped by the central government.  Nevertheless, caution is warranted:  recent fiscal restraint by state governments does not necessarily imply continuation of rectitude in the future.

Political opportunism (rational at the individual, partisan level) in India as elsewhere calls for the postponement of expenditure cuts or tax increases and the prompt spending of revenue windfalls. There is always the chance that the political cost of painful fiscal retrenchment will be borne by the opposition, when its turn in office comes around. The main difficulty thrown up by our analysis of outcomes under the FRBMA and other FRLs remains the design of a fiscal rule to incentivize the government not to give in to a procyclical bias, which behaviourally and in practice is especially pertinent for policy during upswings.

It is not surprising that given the fiscal situation in India, there has been a flurry of activity. Both the 13th Finance Commission’s report and the central government’s 2010/11 budget have laid out a road map to cut the fiscal deficit and public debt over the next five years. Drawing lessons from the central government’s conduct in recent years, the FC’s report has, to its credit, made constructive suggestions for changes in the areas of transparency, limited in-built flexibility, and enhancing the integrity of fiscal policy in the design of future legally-binding rules. Although the “golden rule”, a balanced revenue budget, has been maintained as an objective in the latest proposals, the important change in emphasis is the dominance of gross public debt-GDP ceilings over the next five years. It is noteworthy that the FC spurned the opportunity to demonstrate innovation in the urgent and difficult task of designing and implementing a time consistent fiscal rule for the sovereign (in a democracy which shows a sustained proclivity for running high fiscal deficits without public opprobrium). In this context, we draw the paper to a close by outlining a basic incentive compatible framework for state and central governments to hold each other accountable over agreed pre-determined targets.

See related National Bureau of Economic Research working paper, “Fiscal Rules in India: Are They Effective?” by Willem H. Buiter and Urjit R. Patel.