Re-thinking the FRBM PDF Print E-mail
Friday, 20 May 2016 03:48
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Address counter-cyclicality & ‘crowding out’ of private investment


Given how many times the fiscal deficit target has been ‘paused’ or breached in the last decade, the 5-member team deliberating on the FRBM Act needs to do some innovative thinking on how to both construct the target as well as implement it—given the Budget is a money Bill, the government can breach the FRBM target whenever it wishes to. Also, while the idea was to allow for counter-cyclical spending—more in a year when the economy is weak and less in a year when it is strong—so far, the target has been a fixed one, regardless of how the economy is faring.

Former deputy chairman of the Planning Commission Montek Singh Ahluwalia has some very good suggestions that must be kept in mind in addition to the issue of counter-cyclicality and sustainability of government debt. Given the high growth in FY08, that was clearly a year in which the deficit needed to be reined in, to create a buffer for a poor year. But, as Ahluwalia says, it is also important to focus on the ‘crowing out’ effect, the original reason why the deficit was sought to be controlled. In FY08, with net financial savings of the household sector at 11.6% of GDP, the combined central and state fiscal deficit of 4.1% left enough for the private corporate sector to tap into. So a higher fiscal deficit could have been tolerated. However, having two to three parameters to define the deficit is important, as the current situation demonstrates. Given the slowing private investment in the economy right now, there appears a natural case for higher public investment. But with net financial savings down to around 7.5% of GDP, a combined state plus central deficit of around 6% is a recipe for disaster as there will be no money left for the private sector. It is also important to keep in mind the economy’s potential output—if the potential output is pretty near the actual output, as appears the case right now, even though GDP growth looks low, there may not be a case for higher public spending.

Which is why, Ahluwalia comes up with the concept of a ‘structurally adjusted’ deficit target—much like the concept of structurally adjusted growth—that needs to be calculated from time to time and then monitored. A US-style Congressional Budget Office (CBO) that monitors such a structurally adjusted deficit—and reports directly to Parliament – is a good idea, even though it will have no binding power on the government of the day. Indeed, the proposed CBO-like body should be projecting the impact of various taxes or expenditure, including the cost of providing pensions and universal health/life cover.


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