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Fiscal Responsibility Act:
Issues And Concerns

By Siba Sankar Mohanty

25 April, 2004

The Fiscal Responsibility and Budget Management Bill, 2000, has been enacted in Parliament. The Act is based on the presumption that the fiscal deficit is the key parameter adversely affecting all other macroeconomic variables. It is argued that lower fiscal deficits lead to higher as well as sustainable growth and higher fiscal deficits apparently lead to inflation. It is also argued that large fiscal deficits may lead to huge accumulation of public debt.

However, many development economists like C. P Chandrasekhar and Jayati Ghosh argue that if the fiscal deficit is dominantly in the form of capital expenditure, it contributes to future growth through demand and supply linkages, and in fact can create so much demand in the economy that private investment may crowd-in to supplement autonomous investment. As far as inflation is concerned, it results from an excess of aggregate demand over aggregate supply and there can be higher inflation with low, zero or even positive fiscal accounts. This may happen because of excessive spending by the private sector over and above its earnings, as was the case with many South Asian countries before the currency crisis.

There is nothing wrong in maintaining large fiscal deficits if resorting to public debt is made only to meet investment requirements as long as their social rate of return is higher than the rate of interest. Deficit per se is not bad as the Indian economy is a demand-constrained economy. Due to existence of underemployment of resources and production at much less than its optimal level, the economy can actually sustain a high level of fiscal deficit up to around 7-8 percent of GDP. Even in case of revenue deficit, if it is properly managed will help pumping in purchasing power to the economy and boost demand keeping in mind the persistently low level of inflation during recent years. In India, it is not the problem of growing deficits, which deserves concern but the composition for these deficits and the way these are being financed.

The Government aims to eliminate revenue deficit by 31st March 2008 - in turn leading to revenue account surplus, and possible progressive reduction of capital account liabilities. Elimination of revenue deficit requires a balance in revenue accounts, which can be done by reducing revenue expenditure drastically, or by enhancing receipts to fill the gap, or by trying both. The Government can substantially reduce revenue expenditure if a reduction is at all possible in those items, which constitute a major part of total revenue account. For example, interest payment alone takes away around 30 percent of the total expenditure. But unfortunately it is charged on the Consolidated Fund of India. The government, in no way, can actually reduce this expenditure till 2008 except deferring a part of it, which will further aggravate the fiscal situation. The government of the day will never compromise with defence expenditure particularly in a situation where the people in the government visualise threats to national security from all possible corners of the world. So if the government of the day tries to reduce expenditure it may do so in crucial sectors like social services and some of the economic services only. This will affect the all-round development of the country and further aggravate the fiscal situation.

In the receipts side, dividends and profits to the central government from its investments is less likely to grow in view of the disinvestment policies, the government is pursuing, for the PSUs. Unfortunately the skimpy amount the government could raise from disinvestment is also being spent for current expenditure. The trend of our government's commitment towards direct tax is clear from populist announcements of tax concessions in the budget speech. The government can go for more indirect taxes in order to mobilise more receipts. But it will actually reduce the overall demand further, through its impact on the purchasing power of the consumers. Even then, it is not a possible solution in case the government implements VAT in the country. VAT not only requires much higher tax rate on the value added in order to get the same revenue, but will also lead to revenue loss for the states and affect the distribution of revenue among the states.

The Act provides that the central government shall specify the annual targets of assuming contingent liabilities in the form of guarantees and the total liabilities as a percent of GDP. During last four years, the gross annual liabilities are growing at more that 14 per cent per year. In the 2003-04 budget, the government proposed an internal debt, which is around 12 per cent higher than the revised estimates for 2002-03. Has the government shown any respect to this law in its own activities?

As per Sec.4 (2) of FRBM Act, deviations from targets are allowed in case of exigencies like national calamity or national security. With situations like drought to a Kargil War every year, non-achievement of targets could be a normal feature.

As a self-imposed discipline the government will not borrow from RBI except to meet temporary excesses of expenditure. What if such excesses of temporary nature occur frequently?

Therefore, the optimism expressed in FRBM Act towards eliminating the revenue account deficits is only a misnomer. Will any government take steps to reduce unproductive expenditures? No doubt, India needs a policy for fiscal prudence -but FRBM in its present form is not the answer.

(The author is a Research Analyst at Centre for Budget Accountability. Email: )