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.
- A government that abides by the FRBM rules enjoys greater credibility among the rating agencies and market participants – both national and international.
- The FRBM is an act of the parliament that set targets for the Government of India to establish financial discipline, improve the management of public funds, strengthen fiscal prudence and reduce its fiscal deficits.
- It was first introduced in the parliament of India in the year 2000 by Vajpayee Government for providing legal backing to the fiscal discipline to be institutionalized in the country.
- Subsequently, the FRBM Act was passed in the year 2003.
Features of the FRBM Act
- It was mandated by the act that the following must be placed along with the Budget documents annually in the Parliament:
- Macroeconomic Framework Statement
- Medium Term Fiscal Policy Statement and
- Fiscal Policy Strategy Statement
It was proposed that the four fiscal indicators be projected in the medium-term fiscal policy statement viz.
- Revenue deficit as a percentage of GDP,
- Fiscal deficit as a percentage of GDP,
- Tax revenue as a percentage of GDP and
- Total outstanding liabilities as a percentage of GDP
Why FRBM is back in debate?
- 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 to reboot domestic 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.
Different types of deficits
- Fiscal 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 characterized 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.
What FRBM says on deficits?
- 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.
- But this impact (also called the “Multiplier” effect) is quite different for revenue expenditure and 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.
- 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.
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.
- 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.
What has been India’s record on adhering to FRBM Act?
- 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.
- There is a need to revert back to the original FRBM Act if 2003 by recognising and prioritizing the reduction in revenue deficit.
- Doing this will help the government boost the kind of expenditure that actually increases the GDP.