Montek Ahluwalia has some good suggestions
Though most agree the Fiscal Responsibility and Budget Management (FRBM) Act needs reviewing—which is why, finance minister Arun Jaitley has said that a committee would suggest modifications for the future—in order to allow contra-cyclical expenditure by the government, former Planning Commission deputy chairman Montek Singh Ahluwalia has made some important suggestions in an article in Mint, apart from pointing out that there is little point in having an FRBM Act that has been breached so often if Parliament doesn’t get seriously exercised about it. While discussing whether a 6% of GDP fiscal deficit number makes sense—3% for the Centre and 3% for all the states taken together—Ahluwalia says it is important to focus on whether the deficit is ‘crowding out’ private investment, the original reason for why deficit control was considered necessary. In FY08, when net financial savings of the household sector added up to 11.6% of GDP, the combined central and state fiscal deficit of 4.1% left enough money for the private corporate sector to tap into—not surprisingly, this was a year in which private investment boomed. But with net financial savings down to around 7.3% of GDP now, a combined fiscal deficit of 6% is a recipe for trouble. Which is why, Ahluwalia argues that the new FRBM should not specify a number, but give simulations on what the funds-flow for the private corporate sector will be.
Debt sustainability is the other reason why FRBM limits are sought. According to Ahluwalia’s simulation, if an economy grows at 7.5% per year in real terms for a decade and you have an inflation level of 4%, a 6% combined fiscal deficit would reduce government debt-to-GDP from 65% to 59.5% which is desirable. In other words, the fiscal deficit target should be set—based on likely GDP growth and inflation—in such a manner that debt is sustainable. In the case of state governments, instead of a standard 3% number for all, states with higher debt levels must have tighter constraints on their budgets, and those with lower growth potential should also be allowed to borrow less.
Even if this definition of how to set a sustainable fiscal deficit which allows contra-cyclical expenditure is to be agreed to, the question is how this is to be enforced. Since the budget is a money Bill, this effectively ensures the government is always free to set the deficit at any level it likes, with only the wrath of the bond markets acting as a possible check. Ahluwalia goes along with what the 13th and 14th Finance Commissions recommended—an autonomous body monitoring it, possibly reporting directly to Parliament would certainly allow Parliament to have a greater influence on the Budget. Indeed, since the permissible deficit will keep changing depending upon economic circumstances—Ahluwalia brings up the concept of a ‘structurally adjusted’ deficit which needs to be monitored, in the same way ‘core’ inflation does—much like the US Congressional Budget Office, this autonomous body can regularly provide forecasts of the impact of the likely deficits on both the investible surplus of savings and sustainable debt. Were such information to be made available regularly, hopefully the finance ministry wouldn’t be the only body within the government—and Parliament—battling for fiscal discipline.