review the Fiscal Responsibility and Budget Management (FRBM) Act?

What could be the options before the five-member committee that has been set up to review the Fiscal Responsibility and Budget Management (FRBM) Act?

The committee, headed by former revenue secretary N K Singh, held its first meeting last Saturday and is expected to propose an alternative fiscal framework as suggested by Finance Minister Arun Jaitley in his last Budget.

Why a review?

From the fiscal perspective, the arguments in favour of transitioning to a new, rule-based, fiscal framework can be made at many levels.

First, the governments of all hues would prefer to pivot away from the fiscal conservatism towards profligacy as it pays rich dividends politically. But, such policy leads to wasteful expenditure at both at the central as well as state level.

Second, higher fiscal deficits tend to crowd out the private sector. For instance, in the current macroeconomic situation, the combined fiscal deficit of the Centre and states is pegged at six per cent of gross domestic product or GDP (for Centre, fiscal deficit is budgeted at 3.5 per cent of GDP while for a state it is projected at around three per cent). Add to this, borrowing of the public sector enterprises and bodies like the National Highways Authority of India (NHAI) and with the household sector's financial savings dipping down to around 7.5 per cent of GDP, the space for private sector borrowing is severely constrained.

Third, higher fiscal deficits also tend to be inflationary.

Alternative frameworks

It was in the backdrop of this context the finance minister took the decision to review the FRBM Act. And though the committee has just begun to deliberate, it has time till the end of October to put forth a road map. Analysts have proposed various alternative frameworks.

One such proposal is to transition to a cyclically adjusted fiscal deficit framework. Under this arrangement, government spending would increase during economic downturns to shore up aggregate demand, only to recede when private spending strengths. The policy stance would thus be counter cyclical- increase government spending during times of distress as opposed to a pro-cyclical policy and increase government spending when the going is good.

There is some merit in this argument. While theoretically moving to such a framework makes sense, in practice it's difficult to implement. Part of the problem is that of measurement. This framework relies on measuring the economy's potential GDP and also requires clarity about the nature of business cycles. But, here lies the problem. There does not exist any reliable estimate of India's potential GDP.

The most recent study that estimates potential GDP was carried out by Barendra Kumar Bhoi and Harendra Kumar Behera, who work at the Monetary Policy Department of RBI. They have estimated India's potential GDP to be close to seven per cent (6.8 per cent to be precise) during 2009-15.

But the problem with this estimate, as the authors themselves acknowledge, is that "considerable uncertainty attached to these estimates, mainly related to the methodology, underlying data and judgments about different parameters." Thus the authors provide an indicative range of 6.3- 7.3 per cent. Such a big range is unlikely to inspire confidence, especially when doubts over the new GDP series continue to linger.

Echoing these concerns, Rathin Roy, director, the National Institute of Public Finance and Policy (NIPFP), says, "We simply do not have robust modelling of either the Indian business cycle or the output gap on which any credible policy analytics can be based." Roy is a member of the committee which has been tasked with the review of the FRBM act.

Some have also floated the idea that rather than a fixed fiscal deficit target, a range or a band is more preferable. The governments are likely to prefer a higher fiscal deficit.

Simply ascribing a range may not work as the government of the day may choose the higher end of the range. This would undercut the governments efforts to rein in wasteful expenditure.

Economists like Pinaki Chakraborty, Professor at NIPFP, therefore, propose to "link the range for fiscal deficit to a number of indicators such as the governments debt level, its interest service obligations and its revenue deficit which gauge the fiscal health of the government."

"If the governments are able to reduce or eliminate their revenue deficit then they should get the flexibility for a higher fiscal deficit," he says.

One possible alternative is to link government spending to bank credit, data on which is both reliable and available timely. The logic for choosing this indicator is pretty straightforward. Sluggish bank credit signals low private sector demand and could be construed as a sign that greater government spending is needed to boost aggregate demand.

But the problem with this framework is "it ignores supply side issues" says M Govinda Rao, member of the 14th Finance Commission and former director of NIPFP. Bank credit could be sluggish due to a variety of reasons. "It depends on many other factors too like global economic environment, the governments borrowings, among others" says Chakraborty.

Another indicator that could be used is electricity consumption by the manufacturing sector. But in the absence of reliable data, this option is also off the table.

While the committee will grapple with these issues in the coming months, what indicators are finally used is a matter of inclination. "At the end of the day it's a question of judgment. A thumb rule have to be applied," says Rao.

---

THE PANEL

• Panel to review the fiscal framework is headed by former secretary N K Singh
   
• Its members are former finance secretary Sumit Bose, Chief Economic Advisor Arvind Subramanian, RBI Deputy Governor Urjit Patel and NIPFP Director Rathin Roy
   
• The existing FRBM Act prescribes a target fiscal deficit of 3% of GDP
   
• The Fourteenth Finance Commission (chaired by Y V Reddy) recommended a 3% fiscal deficit for the centre and another 3% for the states