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Reforms are a must for sustainable medium-term fiscal management

With preparations underway for the Union Budget 2008-09, it is an appropriate time to discuss sustainability of the overall fiscal targets set under the Fiscal Responsibility and Budget Management (FRBM) Act of 2003.

This Act set the medium-term target of elimination of revenue deficit (current receipts less current expenditure) to zero by 2008-09 and to generate surpluses thereafter. It also set the fiscal deficit (total expenditure less total receipts net of borrowing) target of no more than 3% of GDP by 2008-09. The Act also recognised the fiscal risk of liabilities arising from government guarantees and the like (called contingent liabilities), and set limits on them.

The officially projected revenue deficit of the Central government for 2007-08 is 1.5% of GDP (4.4% in 2002-03), while the gross fiscal deficit is projected at 3.3% (5.9% in 2002-03). Many states have also passed their own FRBM Acts.

Their passage suggests there is a consensus that sustainable medium-term framework is an essential element for sustaining high-growth, and for generating 140 million jobs needed between 2005 and 2020.

In spite of this consensus, it appears that the FRBM Act’s target of elimination of Revenue Deficit is unlikely to be met. The attainment of fiscal deficit target of 3% of GDP can only be met if the 2008-09 Budget exhibits an unlikely restraint on populist schemes in anticipation of the impending General Election.

Ongoing deliberations of the Sixth Pay Commission for civil servants add further uncertainty.

The quality of the fiscal consolidation achieved so far also requires improvement. Much of the progress has been due to robust nominal GDP growth of around 12%; and due to increases in effective tax rates, combined with limited efforts towards broadening of the tax base.

Progress in expenditure management and in obtaining better outcomes from the outlays has, however, been painfully slow. Without it, the FRBM targets are vulnerable to growth slowdown, a prospect that cannot be ruled out in the current uncertain external environment.

The FRBM Act, like the Stability and Growth Pact (SGP) set by the European Union (EU) for its members, relies heavily on quantitative limits to budgetary deficit as a share of GDP.

The EU deficit (it also has a 3% target) is, however, based on an accrual budgeting, which besides being complex can only be calculated ex-post. This prevents fiscal correction during the ongoing fiscal year.

India uses cash budget, which is simpler, and can be calculated monthly. For this reason, even as India widens the use of accrual and outcome budgeting, cash budget should continue to form the basis for quantitative fiscal targets.

Regardless of the budget used, formal and informal norms, and institutional checks and balances should severely limit any recourse to financial jugglery, such as one-off policy measures.

Reliance on quantitative targets, however, has a major limitation of de-emphasising the quality of public finance policies in general, and of the process of achieving the fiscal targets in particular.

Repeated concerns expressed by successive Indian prime ministers that outlays are not being effectively transformed into outcomes (while contradicting themselves by launching more and more expensive and complex schemes such as the National Rural Employment Guarantee Scheme strongly suggests that promotion of appropriate institutional and organisational changes (involving the whole gamut of laws, regulations, organisational and governance structures, budgeting structures, civil service retirement and promotions, etc) should receive high priority.

It is urged that the 2008-09 Budget incorporate specific steps towards modernisation of tax administration, making it consistent with India’s $1.1 trillion economy with external sector approaching 45% of GDP.

The Central Board of Direct Taxes (CBDT) should be given substantial autonomy to achieve the revenue and other goals, with insistence on a high degree of accountability and transparency. There is also a need for more sophisticated revenue forecasting based on prudent economic assumptions.

A framework should be laid to achieve greater coordination between CBDT and the customs and excise tax administration, which would be crucial in smoothly implementing the proposed goods and services tax (GST).

About half of the GST revenue is obtained at the importing stage.

The central issue of quality of public finance policies and management is also equally crucial at the state and local levels. They should not feel complacent as their fiscal positions are even more vulnerable to slower growth and other exogenous factors.

In particular, modern financial management practices, and focus on results need to be emphasised by them.

For the municipalities and other urban bodies, such reforms will be essential to access financial and capital markets (e.g. through securitisation of property tax revenues) to finance capital expenditure. By 2030, about 45% of India’s population, numbering about 625 million people will be living in urban areas and their periphery.

Given the general neglect of the urban bodies, institutional and organisational fiscal reform is considerably overdue and urgent.

To ensure a sustainable medium-term fiscal framework, the finance minister should explicitly recognise the need for better fiscal institutions and organisational arrangements, and propose specific measures in his February 2008 Budget speech.

This would help ease a major constraint in securing India’s economic future.