A study on the design of fiscal responsibility and budget management act

Abstract

The design of the Fiscal Responsibility and Budget Management (FRBM) Act particularly its emphasis on elimination of revenue deficit has evoked sharp debate among scholars and policymakers. On one side of the debate, Neoclassicals say that revenue deficit reduces the overall savings rate, induces high interest rate which in turn reduces the investment rate and thus is growth constraining. Accordingly, they favour strict enforcement of FRBM stipulations on revenue deficit. On the other side of the debate, the second school of thought say that FRBM stipulations on revenue deficit would undermine the ability of the State to undertake the social and infrastructural investment and thus constrain our inclusive growth strategy. Further, given the pan-generational effect of investment of human capital, insisting on elimination of revenue deficit also makes fiscal policy to deviate from the path of inter-generational equity and tax smoothing. Accordingly, they oppose the focus of FRBM Act on elimination of revenue deficit. The present paper examined these two divergent perspectives over the design of FRBM Act by probing into the question as to what has been the historic role of deficits in India i.e. whether deficits have added more to our debt obligations than to the our income or they have caused our income to grow faster than the debt obligations. We examined the debt sustainability of the government using Bohn s framework Model Based Sustainability and found that Government has historically responded to increases in the debt GDP ratio by raising the primary surplus or equivalently, by reducing the primary deficit. It provides strong evidence that the debt GDP ratio of the government is sustainable in the sense that fiscal policy is complying with the inter-temporal budget constraint, notwithstanding the frequent deficits. In essence, we could not find any evidence that revenue deficit, in the long term, has led us to the path of unsustainable debt dynamics. This calls for amending the FRBM Act to remove its focus from revenue deficit and for adjusting fiscal deficit targets cyclically thereby enabling government to undertake the countercyclical measures, when required.