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The responsibility test

Pressures for increasing government expenditure are on the rise. Without going into the compulsions which have led to such pressures, I want...

Written by C. Rangarajan |
September 16, 2005

Pressures for increasing government expenditure are on the rise. Without going into the compulsions which have led to such pressures, I want to focus on two issues that arise as a consequence of increasing expenditures. One relates to efficiency in expenditure and the other, and more importantly, to the impact on the fisc.

By presenting the Outcome Budget to Parliament last month, the government responded to a growing concern about the effectiveness in the utilisation of public resources. Making a distinction between outputs and outcomes, the Twelfth Finance Commission (TFC) addressed this issue earlier by saying in its report: “The conventional budget exercises have focused on allocation of resources to different heads, without taking into account how these government expenditures get translated into outputs and outcomes. Outputs are the direct result of government expenditure and outcomes are the final results. Thus, in the context of education, opening a new school or appointing a new teacher is an output and reduction in the rate of illiteracy is an outcome.”

The TFC added: “A critical part of budgetary reforms must include information on the relationship between expenditures and the corresponding performance in producing real results. Although in the past there have been attempts at introducing performance budgeting, such endeavours have receded in importance. There is need to bring back performance budgeting as an integral part of the preparation and evaluation of budgets, both for the centre and the states. Thus, the management of public expenditures should be guided by economy, efficiency, and effectiveness.”

Emphasis on outputs and outcomes demands a commitment to zero-based budgeting requiring that all continuing expenditure commitments are questioned de novo as to their relevance during budget formulation. Although conceptually neat, relating outlays to output and outcome is complex as it is difficult to establish a one-to-one correspondence between outlays on the one hand and outputs and outcomes on the other. For example, upgrading educational standards depends not only on expenditures on education but also on a variety of other variables such as quality of teaching and attitudinal factors. Also the relationship between outlays and outcomes is not always linear. Spending twice the amount of money may, in some cases, yield more than twice the benefits. Even as the government’s recent initiative on output budgeting is to be commended, the real test of success will depend on how the actuals compare with targeted outputs at year-end and the action taken thereon.

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The other important public finance issue is the impact of increased government expenditures on the fisc. Tautologically, if increased expenditures are not matched by a corresponding increase in revenues, the fiscal deficit will widen. The issue is not whether or not there should be a deficit, but its appropriate level. After much debate, the Fiscal Responsibility and Budget Management (FRBM) Act was passed by Parliament in 2003. The new government accepted the FRBM discipline but pushed back the target for eliminating the revenue deficit by one year to 2008-09. The TFC recommendation of taking loans to states off the central budget also provides additional fiscal space to the Centre. Revenue deficits mean government dissavings, and unless these dissavings are compensated by an increase in private savings, the overall savings go down thereby negatively impacting on investment and growth. Higher deficits mean higher debt and higher interest payments which preempt an increasingly larger share of available resources. The consequent burden of adjustment inevitably falls on capital expenditure with a negative impact on growth. That this is already happening is evident from the fact that in the 2005/06 budget, interest payments of the Centre constitute as much as 42 per cent of its revenues.

Fiscal sustainability requires that a rise in fiscal deficit is matched by a rise in the capacity to service the increased debt. It has been argued that, from this angle, borrowing for creating assets is justified. Woefully, the return on our debt financed capital assets has been far short of the amount required to service the debt mainly because of low user charges and low expenditure efficiency. Furthermore, nearly 70 per cent of the borrowing goes to cover revenue deficit and not to create capital assets, at least of the physical kind which can generate financial returns. Admittedly, the currently available analytical models do not provide unique answers as to the appropriate level of fiscal deficit. Much depends on the state of the economy, the level of public and private savings and the prevailing level of outstanding debt. It should also be quite evident that a level of deficit that is acceptable when the debt to GDP ratio is lower may not be so when the ratio increases.

The fiscal deficit target is best determined by reference to the financial savings of the household sector and the relative investment demand of the government, the public and private corporate sectors. On the basis of historical trends, the TFC determined that a combined deficit of 6 per cent for the general government sector will be consistent with the available supply of funds in the form of financial savings of the household sector of the order of 10-11 per cent of GDP and an acceptable level of current account deficit of the order of 1.5-2 per cent of GDP. This will eventually stabilise the debt-GDP ratio at 56 per cent.

Fiscal consolidation is critical to achieving sustained growth. Increased government expenditures should not be at the cost of raising the deficit. The only sustainable way of raising expenditures is by raising the tax-GDP ratio. The central budget for 2005-06 projects an ambitious target for tax-GDP ratio of 10.6 per cent, which will mean an increase of 0.8 percentage points in one year. Indeed, we need to move faster in this direction, if larger expenditures are to be supported within a sustainable fiscal framework. There is no elbow room to give up revenue on any ground. To date, eleven state governments have also passed fiscal responsibility legislations. More will inevitably follow since the benefits arising from the TFC recommendations relating to debt restructuring and relief are contingent upon states passing such legislations. It is important that they too stay committed to the fiscal deficit targets, notwithstanding pressures for additional expenditures.

The FRBM rules already impose a target of 3 per cent of GDP for the fiscal deficit of the Centre to be achieved by 2008-09. It is important that we do not tamper with this target. The finance minister hit the “pause” button on FRBM commitments this year. Hopefully, he will press the “fast forward” button next year.

The writer is a former governor of the Reserve Bank of India and chairman, Twelfth Finance Commission

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