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Following is the Summary of ECONOMIC SURVEY 2016-17 – Chapter – 6 Fiscal Rules: Lessons from the States:
Introduction
Fiscal Responsibility and Budget Management (FRBM) Act was adopted by the centre in 2003. This Act was mirrored by Fiscal Responsibility Legislation (FRL) adopted in the states since states account for roughly half the general government deficit.
At first blush, the FRL seem enormously successful. The financial position of the states improved considerably after 2005, based on any measure.
The average revenue deficit was entirely eliminated, while the average fiscal deficit was curbed to less than 3 percent of GSDP, just as the FRL had mandated. The average debt to GSDP ratio accordingly fell by 10 percentage points to a mere 22 percent of GSDP in 2013.
But the deficit reduction was not only because of FRL but owes much tofavorable exogenous factors:
- An acceleration of nominal GDP growth helped boost states’ revenues by about 1 percent of GSDP.
- Increased transfers from the centre of about 1 percent of GSDP both because of the 13th Finance Commission recommendations and the surge in central government revenues.
- Reduced interest payments of about 0.9 percent of GSDP on account of the debt restructuring package offered by the centre; and
- Reduced need for spending by the states as the centre took on a number of major social sector expenditures under the Centrally Sponsored Schemed (CSS).
Summary of the Fiscal Responsibility Legislation
The FRL aimed to impose fiscal discipline through a number of mechanisms:
- Fiscal targets were established, which were the same for all states: the overall deficit was not allowed to exceed 3 percent of GSDP at any point, while the revenue deficit was to be eliminated by 2008/9 (later extended to 2009/10).
- The 12th Finance Commission allowed states to borrow directly from the market, in the hope that investors would also exercise some discipline, by pushing up interest rates on states whose fiscal position had not improved.
- Finally, broad public discipline was enhanced by introducing new reporting requirements. States were required to publish annual Medium-Term Fiscal Policy reports.
The fiscal deficit target was relaxed temporarily because of Global Financial crisis but by FY 2010, the targets were set to the original FRL level of 3 percent.
Subsequently, the 14th Finance Commission (FFC) recommended that fiscal deficit limits were to be relaxed by 0.5 percentage points for states which meet three conditions:
- Zero revenue deficit in the previous year;
- Debt to GSDP ratio lower than 25 percent; and
- Interest payments to GSDP ratio less than 10 percent of GSDP.
Assessment Methodology
One reason why figures on fiscal progress since 2005 give a misleading impression of the impact of the FRL is that not all states adopted FRL in that year.
Some states enacted their legislation even before the central government did so in 2003. Many others adopted FRLs in 2005/6, while in a few states legislation did not fall into place until 2010.
During this period, many other developments occurred that had a profound impact on fiscal positions viz. value added taxes (VAT), 6th Pay Commission, 12th and 13th Finance Commissions and also this was a period of high nominal GDP growth.
So a second challenge is to distinguish the impact of the FRL in imposing fiscal discipline from the impact of these concurrent policy changes and macro-economic trends.
Impact on Deficits
- The first thing to note is that states essentially achieved the fiscal targets right away, years in advance of the target year of FY 2008 (extended to 2009/10 due to the financial crisis).
- These reductions in deficits mask considerable variation across states.
- The largest reductions in fiscal deficits came from states like Orissa, Punjab, Madhya Pradesh and Maharastra which lowered their deficit by more than 3 percentage points. These states also showed some of the largest reductions in revenue deficit.
- Another indication that the FRL had a significant impact is that states kept a tight rein on wage and salary expenditure. Instead, they expanded more discretionary spending, which would be easier to scale back if needed to achieve the deficit targets.
- At the same time, the path of primary deficits hints at an underlying problem.
- A decade into the FRL, the average primary deficit was just as large as it was before the law – and the only reason this slippage hadn’t shown up in the other deficit figures was that interest payments had fallen sharply, in large part due to the centre’s debt relief.
Implications of fiscal rules
A crucial concern with any fiscal rule is that it would encourage governments to shift spending off budget.
By their very nature, these off-budget items are difficult to measure since the instruments may vary by state, are difficult to quantify and are not centrally compiled and accounted. These expenditure channels undermine the power of fiscal rules.
Following 2 data provide the clarity about situation:
- Prior to the FRL states added guarantees worth on average 0.9 percent of GSDP each year. But in the first three years after FRL adoption the flow of explicit guarantees actually turned negative.
- Borrowing by state utilities also fell after the FRL from 4.3 percent of GSDP to 3.4 percent of GSDP
The caveat remains that these measures do not provide a complete picture as spending may have shifted to other unobserved channels Budget Process.
Budget process
Another area of positive impact was on the states’ budgeting process.
After the FRL, there is sharp drop in the magnitude of the revenue forecast errors in the budgeting process.
Assessment
- FRLs clearly made an important difference, both in terms of outcomes and behaviour.
- States kept their average fiscal deficit at 2.4 percent of GSDP in the 10 years after the FRL, well below the prescribed ceiling of 3 percent of GSDP.
- And there was also a striking change in behaviour: budget forecasting procedures improved, and there was a more cautious approach to guarantees, a build-up of cash balances, and a reduction in debt.
- But another reality is that rather than encouraging states to tighten their belts, the role of the FRL may really have been to prevent them from spending all of their windfall.
- A few years after the FRL, all indicators of fiscal performance—deficits, expenditures, and especially off-budget activities—started deteriorating.
- It is possible that the Centre has also prevented this deterioration by exercising Article 293 (3) of the Constitution. Under this clause, States must take consent of the Centre for additional borrowing since they all had borrowing outstanding throughout the post-FRL period
Lessons for Future Fiscal Rules
- As the fiscal challenges mount for the states going forward because of the Pay Commission recommendations, slowing growth, and mounting payments from the UDAY bonds, there is need to review how fiscal performance can be kept on track.
- The Fourteenth Finance Commission (FFC) attempted to shift toward incentives by relaxing some of the FRL limits for better-performing states. But there was an element of tension in its recommendations.
- On the one hand, the relaxation itself was an incentivizing mechanism;
- On the other, the Commission abolished entirely the other more broad-based incentive mechanism deployed by the Thirteenth Finance Commission (TFC) of allocating resources across states (the so-called “horizontal” criteria) based on states’ own fiscal performance.
- There may be considerable merit in going back to such an important incentive mechanism.
- In addition, greater market-based discipline on state government finances is imperative.
- Highly indebted states would have to offer a higher yield to make their bonds attractive. Instead, there is a flat relationship between the spread and the indebtedness of states – states are neither rewarded nor penalized for their debt performance.
- Similarly, there is no relationship between the coupon rate and the fiscal deficit of states.
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