How to bring fiscal discipline

Legislation on fiscal discipline will not help unless government is ready to bite the bullet, says M Govinda Rao.

Given that the council will be appointed by the Finance Ministry and will report to it, how independent will the review be and how effective the monitoring process? Without the government's willingness, institutions cannot ensure fiscal discipline.

With renewed emphasis on fiscal consolidation, it is necessary to internalise the lessons from the first phase of the implementation of the fiscal responsibility legislation. It is clear from experience that the mere passing of the legislation will not bring about fiscal discipline.

First of all, it is necessary for the government, not just the Ministry of Finance, to take responsibility for fiscal discipline for stable macroeconomic management and political motivation; no legislation can ensure this. This is not to mean that legislation does not have any role.

This can work when the executive realises the urgency of the issue and is willing to make the required sacrifices. Secondly, it is necessary to evolve an institutional mechanism not only to monitor but also to ensure the participation of all spending departments in implementation.

The experience with the implementation of the Fiscal Responsibility and Budget Management Act (FRBMA) has raised some important questions on its efficacy.

First, there were attempts at creative accounting to show compliance, the most obvious being the subsidies on fertilizer, food and oil which were taken out of the budget to show lower fiscal and revenue deficits.

Second, although the fiscal deficit estimates broadly followed the targets set by the task force for the first three years, the targets were missed in the last two years by a wide margin.

This was mainly due to burgeoning subsidies, the loan waiver and revision of pay scales. The attempt to attribute this to the global financial crisis and characterise the rise in expenditure as "stimulus" only raises questions about the credibility and commitment of the government.

Third, even in the first three years, there were pauses and the actual adjustment did not follow the path set out by the FRBMA task force.  Contrary to the stipulated reduction of revenue expenditure by two percentage points from 13.1 per cent in 2003-04 to 11 per cent in 2008-09, the revenue expenditure actually increased to 14.5 per cent.

Similarly, FRBMA adjustment path required an increase in the percentage of capital expenditure to GDP ratio from 2.3 in 2003-04 to 3.4 in 2008-09. Instead, it declined to 1.6 percent. Thus, whatever adjustment was made was on account of the increase in tax revenues, lower interest payments due to debt swap and compression of capital expenditures.

The 13th Finance Commission in its revised roadmap for fiscal consolidation has recommended that the Central government's debt-GDP ratio should be reduced from 54.2 percent in 2009-10 to 44.8 per cent in 2014-15.

In their scheme, this translates into compression of the fiscal deficit from 6.8 per cent to 3 percent and phasing out of the revenue deficit from 4.8 percent. It has also recommended increase in disinvestment proceeds from 0.1 percent to one percent and increase in capital expenditure from 2.1 percent to 4.5 percent; outstanding guarantees are to be capped at 5 percent of GDP instead of an annual 0.5 percent of GDP

The commission has also recommended a number of reforms in the FRBM legislation to make the adjustment process more transparent, responsive to exogenous shocks and to ensure better monitoring and compliance.

It has recommended the preparation of a more detailed medium-term fiscal plan (MTFP) to put forward detailed forward estimates of revenues and expenditures to make it a statement of "commitment" rather than merely one of "intent".

It has recommended a number of micro measures such as putting forward the economic and functional classification of expenditures as a part of MTFP, preparing the detailed statement on Central transfers to states, reporting compliance costs on the major tax proposals, presenting the revenue consequences of capital expenditures, fiscal fallout of PPPs, preparation of an inventory of vacant land and buildings valued at market prices by all departments and enterprises.

The commission has recommended that the values of parameters underlying the projection of revenues and expenditures in the MTFP should be made explicit and the band within which the parameters can vary when there are exogenous shocks while remaining within the FRBM targets.

It has also recommended that the nature of shocks warranting the relaxation of FRBM targets should be specified. The stimulus to the states should be in terms of larger devolution rather than increased borrowing limits and the Centre should meet this additional cost.

Most importantly, the commission has recommended the setting up of a committee which will eventually transform into a fiscal council to conduct an annual independent public review and monitoring of the FRBM process.

The council should be an autonomous body reporting to the Ministry of Finance, which in turn should report to the Parliament on matters dealt with by the council.  

Although many of the recommendations are important, the question is whether the commission has gone beyond its mandate to micro manage the process.  In fact, some of the recommendations are not necessary for the implementation of FRBM per se, whether it is providing a detailed statement on Central transfers to states or a statement on the inventory of land and buildings.

Indeed, requirements such as presenting compliance costs of various tax proposals have formidable data problems with the taxpayers unwilling to disclose the cost such as the amount of bribe paid to tax officials. The NIPFP study in 2002 by Arindam Das-Gupta had to rely on a small sample to make the estimates.

Mere passing of the FRBMA and presenting the detailed MTFP with all the details recommended does not translate the intent into commitment. Has the government not been presenting the documents on outcome budgeting and revenue foregone from various tax exemptions and concessions without much effect?

Furthermore, without the involvement of the various spending departments in the preparation of MTFP, it will be impossible to ensure discipline from them.

How much faith can we repose in the capacity of the committee which will evolve into a Fiscal Council to undertake independent review and monitoring of the process?

The author is director, National Institute of Public Finance and Policy, Delhi. Views are personal.