India needs a new fiscal policy framework: Here’s why

Life is normal again. Economic activity in most countries is humming, much as before. 

However, the costs of the global economic disruption are still evident in government finances. The massive intervention to support households, firms and national economies was inevitably costly. 

Global public debt is now more than $100 trillion—and still rising.

This is the backdrop against which India’s finance minister Nirmala Sitharaman will present the new budget of the Narendra Modi government on 1 February. 

The pandemic shock derailed Indian public finances. 

The fiscal deficit of the Union government shot up to 9.5% of gross domestic product (GDP), while public debt soared to 88% of GDP. 

Compare this with the aspirational goals of keeping the fiscal deficit of the Union government at 3% of GDP and the consolidated public debt of all levels of government at 60% of GDP.

The focus since then was obviously to get Indian public finances back on track. 

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In the budget speech she delivered in 2021, the finance minister announced her intention to gradually bring down the fiscal deficit to 4.5% of GDP over five years, or by fiscal year 2025-26. 

She did not provide any estimate of public debt for the same time frame.

The government has since then done well to keep to this glide path for the fiscal deficit, and it is very likely that Sitharaman will next month announce a fiscal deficit target of 4.5% of GDP for the next fiscal year—and thus meet the promise she made in 2021. 

Also, such a gradual withdrawal of fiscal stimulus to the economy has not damaged economic growth till very recently because households stepped in to spend down the excess savings they had accumulated during covid lockdowns.

The fiscal path announced in 2021 has been credibly maintained. 

What now? 

Sitharaman said in the course of her budget speech last year that the goal after fiscal year 2025-26 would be “to keep the fiscal deficit each year such that the central government debt would be on a declining path as a percentage of GDP."

There were two key points embedded in this statement. 

First, the nominal anchor of Indian fiscal policy would be the level of public debt, while the fiscal deficit would be an annual operating target. 

Second, what would matter for now was not any specific level of public debt, but its general direction over the medium term.

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The logic of making public debt the nominal anchor of Indian fiscal policy is not without merit, since what really matters in terms of public finance is the eventual stock of debt that a government will accumulate over the medium term rather than the annual additions to it, aka the fiscal deficit. The latter may fluctuate in sync with the vagaries of the underlying economy.

However, the intent to make the trajectory of public debt the cornerstone of fiscal policy comes with a problem. 

The fiscal deficit is an annual accounting number that is easy for the government to communicate—and easy for the financial markets to track. 

The trajectory of public debt is a more complex affair, as it depends on a host of factors such as the growth in nominal GDP, the nominal interest rate on government borrowing and the primary deficit of the government. 

Of these three driving forces, the government has direct control over only the primary deficit.

For example, it is possible that either a drop in nominal GDP growth or a spike in financing costs can result in the ratio of public debt to GDP inching up despite the government reducing its deficit. 

Such unexpected outcomes mean that a government targeting public debt as the nominal anchor of its fiscal policy over the medium term needs both a record of budgetary credibility as well as an independent institution to estimate how public debt will move in the years ahead.

That in turn would require a new fiscal policy framework. 

India is one among around 100 countries that have a formal fiscal rule to guide government budgets, the Fiscal Responsibility and Budget Management (FRBM) Act of 2003 in our case.

Fiscal rules should have three core features. 

First, they should be simple to understand. 

Second, they should be flexible, so that governments have the ability to respond to sudden shocks to the economy. 

And, third, there should be some enforcement mechanism so that these fiscal rules do not just remain in the legal books as a showpiece.

A fiscal framework centred around public debt rather than the fiscal deficit will be more flexible than the current system. 

It would also better deal with the problem of perverse incentives, which means that the pursuit of a nominal fiscal deficit target will often mean that the government sacrifices capital spending or public-goods provisions rather than touch politically sensitive subsidies. 

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However, a fiscal policy driven by public debt targets over the medium term will struggle on the simplicity and enforceability parameters.

One final point. 

The system of flexible inflation targeting that India has accepted for its monetary policy system is based on the assumption that the fiscal deficit of the government stays within the limits imposed by the FRBM Act. 

So a question worth asking is what the transition in India’s fiscal policy framework would mean for the efficacy of the monetary policy framework.

The author is executive director at Artha India Research Advisors.