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Monday, August 10, 2020

Explained: The ugly truth about India’s adherence to the FRBM Act

By completely ignoring Revenue Deficit, and only focusing on containing Fiscal Deficit, the government has ensured that the FRBM Act now hurts growth – which is exactly opposite of what fiscal consolidation was supposed to do.

Written by Udit Misra | Updated: January 31, 2020 3:55:09 pm
Fiscal Responsibility and Budget Management Act, frbma, union budget 2020, budget expectations, budget explained, what is fiscal deficit A government that abides by the FRBM rules enjoys greater credibility among the rating agencies and market participants – both national and international.

As the years have rolled by, fiscal deficit has become a key factor to watch out for in every Budget presentation. It is considered the most important marker of a government’s financial health.

The Fiscal Responsibility and Budget Management Act, which was initiated in 2003 but has been tweaked several times since then, lays down the red lines for all types of government deficits including fiscal deficit. A government that abides by the FRBM rules enjoys greater credibility among the rating agencies and market participants – both national and international.

Not letting the fiscal deficit go completely out of control has been one of the standout achievements of the incumbent NDA government. However, as India’s economic growth has decelerated, there have been growing pressures on the government to breach the FRBM orthodoxy and spend in excess of fiscal deficit targets in a bid to reboot domestic economic growth.

Others, however, continue to caution that the “real” fiscal deficit is already far more than the official number, and as such, there is no room for further increasing the expenditure by the government.

Which of these narratives is true?

Actually, neither. But to understand that one has to first understand what are the different types of deficits and why does it matter to limit them.

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What are the different types of deficits?

As mentioned above, fiscal deficit is the excess of what the amount the government plans to spend over what the government expects to receive. Obviously, to make up this gap, the government has to borrow money from the market.

But all government expenditure is not of the same kind. For instance, if the expenditure is for paying salaries then it is counted as “revenue” expenditure but if it goes into building a road or a factory – that is, something that in turn increases the economy’s capacity to produce more – then it is characterised as “capital” expenditure.

The fiscal deficit is another key marker and it maps the excess of revenue expenditure over revenue receipts. The difference between fiscal deficit and revenue deficit is the government’s capital expenditure.

As a broad rule, it is considered fiscally imprudent for a government to borrow money for “revenue” purposes. As a result, the FRBM Act of 2003 had mandated that, apart from limiting the fiscal deficit to 3% of the nominal GDP, the revenue deficit should be brought down to 0%. This would have meant that all the government borrowing (or fiscal deficit) for the year would have funded only capital expenditure by the government.

Why prefer capital expenditure over revenue expenditure?

In any economy, when the government spends money or cuts taxes it has an impact on the economic activity of the country (measured in terms of a change in the nominal GDP or total incomes). But this impact (also called the “Multiplier” effect) is quite different for revenue expenditure and capital expenditure.

To be exact, as a paper, titled “Fiscal Multipliers for India” by Sukanya Bose and N R Bhanumurthy shows, the multiplier is less than 1 for revenue expenditure and over 2.5 for capital expenditure. In other words, when the government spends Rs 100 on increasing salaries in India, the economy grows by a little less than Rs 100. But, when the government uses that money to make a road or a bridge, the economy’s GDP grows by Rs 250.

If governments spend on capital building instead of frittering the money they have on populist schemes like higher salaries or sops, the economy would benefit by two-and-a half-times more.

The question then is: How to get governments to switch from revenue expenditure to capital expenditure? That’s where the FRBM Act comes in handy.

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What is the significance of an FRBM Act?

The popular understanding of the FRBM Act is that it is meant to “compress” or restrict government expenditure. But that is a flawed understanding. “The truth is that FRBM Act is not an expenditure compressing mechanism, rather an expenditure switching one,” says Bhanumurthy, professor at National Institute of Public Finance and Policy (NIPFP).

In other words, the FRBM Act – by limiting the total fiscal deficit (to 3% of nominal GDP) and asking for revenue deficit to be eliminated altogether – is helping the governments to switch their expenditure from revenue to capital.

This also means that – again, contrary to popular understanding – adhering to the FRBM Act should not reduce India’s GDP, rather increase it.

Here’s how: When you cut on revenue deficit – that is, reduce your borrowings for funding revenue expenditure – and instead borrow to only spend on building capital, you increase the overall GDP by 2.5 times the amount of money borrowed. So adhering to FRBM Act is a win-win. “Why would any country adopt FRBM rules if they were not going to help in faster growth?” asks Bhanumurthy.

What has been India’s record on adhering to FRBM Act?

In a recent working paper, titled “Fiscal Policy, Devolution and Indian Economy” by Bhanumurthy, Bose and Sakshi Satija, the authors trace the history.

Between 2004 and 2008, the Indian government had made giant strides on reducing both revenue deficit and fiscal deficit. But this process was reversed thereafter thanks largely to the Global Financial Crisis and a domestic slowdown. Since then, there have been several amendments to the Act essentially postponing the targets.

But the worst development happened in 2018 when the Union government stopped targeting revenue deficit and instead focussed only on fiscal deficit.

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What is the significance of not targeting revenue deficit?

Bhanumurthy recounts a story he often teaches in class: ‘A father gave his son a chicken and a duck and asked him to take them home. But the father cautioned: “Make sure you carry the duck by its neck and the chicken by its legs. A duck’s neck is strong and its legs are weak; the reverse is true for the chicken”. The son started his journey home but somewhere along the way took and break, and when he resumed, he held the chicken by the neck and the duck by its legs. By the time the son reached home, both the birds were of no use.’

This is exactly what has happened when the government stopped targeting revenue deficit while focusing only on containing the fiscal deficit. “It has turned the FRBM Act’s functioning upside down,” says Bhanumurthy.

Why?

Because with no compulsion to reduce revenue deficit, the government has, over the past couple of years, been containing the fiscal deficit by reducing its capital expenditure. “As a result, we have now reached a point where adhering to the FRBM Act is actually sending a contractionary pulse. In other words, adherence to FRBM Act is achieving the exact opposite of what it was supposed to do,” says Bhanumurthy. “ I have been arguing that this is one factor that contributes to the “structural” slowdown in the Indian economy.

So, what is the way forward for the government at a time when it is struggling to boost the economy and adhere to the FRBM Act?

Bhanumurthy says there is a need to revert back to the original FRBM Act if 2003 by recognising and prioritising the reduction in revenue deficit. Doing this will help the government boost the kind of expenditure that actually increases the GDP.

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