Introduction
Considering the extraordinary fiscal situation and extreme difficulties being faced in overcoming them, the Sixteenth Finance Commission should be advised to take a broader view of the issues and explore/recommend radical and practical solutions for fiscal prudence and debt sustainability. What are these solutions? We must confess that many of them we don’t know. However, to get a perspective, a comprehensive long-run view is necessary and this note is an attempt in that direction.
Let us take an intertemporal view of the fiscal deterioration in India. Since borrowing for capital spending is expected to be growth and revenue enhancing, borrowing for revenue expenditure to finance current consumption could become non-affordable borrowing. There is no denying the fact that there is some degree of complementarity between revenue and capital expenditure, and the fiscal space for social sector spending in revenue account needs to be protected. However, long run fiscal unsustainability of a borrowing programme driven by revenue deficits cannot be ignored. As per the 2023-24 Union Budget, the share of the revenue deficit is expected to be around 53% of the gross fiscal deficit of the Government of India. For 18 major states, the same ratio for the year 2023-24 is estimated to be 28%.
In normal circumstances, a revenue deficit should be avoided. The spirit of the Constituent Assembly debates was that every borrowing by the Government of India should be justified for getting the approval for borrowing. However, this was not incorporated in the Constitution. It was expected that Parliament would be prudent and in fact pass a law fixing a ceiling on the debt that the Government of India can incur in a year.
As regards the state governments, the Constitution expected that any borrowing by a state government would have to be approved by the Government of India. It is apparent that the Constituent Assembly was hoping that the Union government would be the custodian of national interest and hence will ensure fiscal prudence of the states. How much has Parliament respected the need for prudence in approving borrowings (be it on budget or off budget)?
When did the fiscal deterioration start?
The Union government started having a deficit in revenue account from 1979-80. The combined all-state fiscal balance started experiencing revenue deficit from 1987-88. The Union government was the earliest to incur revenue deficits and this continues r today, sometimes by diluting the concept of fiscal prudence itself (See Box-1). However, the state governments followed with revenue deficits about 10 years thereafter.
In fact, the First Finance Commission proceeded on the assumption that there will be no revenue deficit of the Union or state governments financed by borrowings. And certainly not from a revenue account. This has not been followed. The fiscal prudence legislation, the Fiscal Responsibility and Budget management (FRRBM) Act has been passed, but invariably breached in spirit and has avoided legal problems only by redefining the concepts. The series of changes in the FRBM Act of the Union government are presented in Box 1:
Box 1: Changes in the FRBM Act of the Union Government
| Following Changes were made in 2012: It introduced the concept of effective revenue deficit(ERD)1, setting a target for elimination of ERD by 31st March 2015 (this date was pushed further to 31st March, 2018 through another amendment). Reducing Revenue deficit (RD) to 2 per cent by 31st March, 2015 (the date was pushed further to 31st March, 2018). On the recommendation of the 13th Finance Commission, the Act was amended by an insertion of Section 7A, which allowed the Centre to entrust the CAG with the authority to review compliance with the Act2. This is meant to improve compliance as CAG audit reports are placed before both Houses of Parliament. Following Changes were made in 2018: Removed the target of ERD and RD from the FRBM Act (The NK Singh Committee recommended discontinuation of ERD, but continued targeting of RD, to bring it down to 0.8 per cent by FY23). Specified the limits on fiscal deficit in the Act itself, requiring the government to reduce it to 3 per cent of GDP by 31st March, 2021. It made debt, both the Union and General government debt, a target. The government was required to reduce Union debt to 40 per cent and general government to 60 per cent of GDP by 31st March, 2025. Specified more grounds for the escape clause, removing the earlier provision which allowed the Centre to specify exceptional grounds. Reduced the possible deviation under the escape clause, to 0.5 per cent of GDP. |
Also, any fiscal prudence exercise needs to factor in the asymmetry in the accumulated fiscal imprudence. While the share of the expenditure of all the states put together is about 60%, the accumulated public debt of the states stands at only 30% of the country’s GDP. Conversely, though the expenditure responsibilities as per the Constitution, under the Union is only 40%, their accumulated debt is around 58% imposing a burden on the Indian citizens double that of those imposed by all the state governments put together.
Is High Revenue Deficit of the Union a Problem of Excess Fiscal Space?
The more important question to ask here is whether the problem of the revenue deficit is due to scarcity of finances for discharging the functions of the union or is it that the union government was borrowing from the people of India, paying for the spending on subjects which are not solely in the Union list?
Successive Finance Commissions have noted that the share of Union government spending on state list and concurrent list subjects have reduced the fiscal space for spending on Union list subjects.
Financing of large revenue deficits through financial repression, where household savings put in the financial sector institutions such as banks and insurance are repressed forcibly and transferred to the Government, has made the issue more complex by increasing inefficiency in allocation and distribution of financial savings.
Hence deficits at the Union level cannot be viewed in isolation but in a consolidated manner of the public sector, including banks and other financial institutions. The Union government benefits more from financial repression compared to the states because of its unrestricted access to such resources. The hidden fiscal cost of such practices is large and has significantly weakened the fisc by encouraging fiscal profligacy.
Approach of the Finance Commissions
Successive Finance Commissions have also contributed to the accumulation of fiscal imprudence by restructuring and writing off the state debt, to make them appear less insolvent. Usually, it is done through automatic provisions for interest expenditure by states. This is another reason for making the fiscal imbalance enormous. The changing approach of successive Finance Commissions in reducing the revenue deficit added to the challenges in dealing with fiscal imprudence.
A Framework for Incentive Compatible Fiscal Prudence
Almost two decades of rule- based fiscal control clearly shows that a forward looking incentive compatible framework is necessary. Going forward, the Finance Commission should devise a forward looking incentive compatible framework for reduction of the revenue deficit and accumulated debt. There are three approaches in this regard: the approaches adopted by (a) the Twelfth Finance Commission, (b) the Thirteenth Finance Commission and (c) the Fourteenth Finance Commission.
The Twelfth Finance Commission recommended an incentive framework to introduce rule-based fiscal control at the state level by providing debt relief and allowing restructuring of the State debt to the Union government. The rule based fiscal framework recommend by the Twelfth Finance Commission also required elimination of revenue deficit of States by the end of the fiscal year 2008-09.
The Thirteenth Finance Commission provided a performance incentive grant for elimination of revenue deficit of States. The Thirteenth Finance Commission framework required adherence to a time bound and quantified (state specific) path of fiscal prudence targeting the revenue deficit, fiscal deficit and debt to GSDP ratio.
The Fourteenth Finance Commission considered fiscal prudence as the basis to provide additional borrowing power to the States, and to operationalize the said approach it provided an indicator framework based on four indicators of fiscal prudence, namely, interest payment to revenue receipts ratio, debt to GSDP ratio, zero revenue deficit and fiscal deficit at 3% of GSDP.
The Fifteenth Finance Commission faced an unprecedented macroeconomic and fiscal uncertainty and provided necessary fiscal flexibility to deal with the Covid-induced fiscal shocks. The flexible fiscal framework of the Fifteenth Finance Commission emphasized the need to return to fiscal prudence at the earliest and quantified the necessary path of fiscal adjustments.
A detailed review of the effectiveness of these approaches to arrive at an incentive compatible framework of revenue deficit reduction and a rule-based, credible, and transparent fiscal regime is necessary to reduce the level of debt and deficit at the State level.
The path proposed should aim to reduce the structural part of the revenue deficit. In other words, there is a need to reduce in a timebound manner the deficit arising due to structural imbalances. The structural component should be operationally simple and should consists of interest payments, pensions, wages and salaries and other inflexible components of state expenditure. A revenue expenditure re-prioritization is also necessary to create fiscal space for operation and maintenance, and necessary development spending in social and economic sectors.
However, the recommended approaches of successive Finance Commissions have not worked for the Union government as there was no binding constraint for the Union to follow the recommended path. When macroeconomic stability is a central function, fiscal imprudence at the Union level only indicates that the issue is beyond fiscal balance and is related to the political economy of the fiscal stance of the Union government. This also requires a relook at the effectiveness and financing options of centrally sponsored schemes.
Conclusions
To conclude, since accumulated public debt represents the accumulated fiscal imprudence, the 16th Finance Commission will be specifically required under the Constitution to recognize the chronic nature of fiscal indiscipline. When the Finance Commission gives its recommendation, it should be openly effective and should be symmetrical for states and the Union government. The objective of achieving a strong fiscal balance for macroeconomic stability is the long run goal. The most appropriate path for such improvements needs to be carefully defined to make it operationally feasible, with built-in incentive compatibility for both the Union and States.
[1] Effective Revenue Deficit (ERD) = Revenue deficit- Grants in aid for creation of capital assets. The Union gives grants-in-aid to states and other agencies to create capital assets, but as the ownership of these assets don’t lie with the Union, they form a part of revenue expenditure, and hence revenue deficit. ERD is, hence, meant to depict that part of RD which is spent only on consumptive items.
[2] The CAG had the discretionary authority to review implementation of any Act dealing with financial matters. But the amendment allowed it to be made a mandatory review.