Importance of fiscal consolidation

Subject – Economy

Concept –

What is fiscal deficit?

Fiscal deficit is the excess of total disbursements from the consolidated fund of India, excluding repayment of debt, over total receipts into the fund (excluding debt receipts) during a financial year.
Simply put, it is the amount the government spent beyond its income and is measured as a percentage of the GDP.

Why is fiscal consolidation important for an emerging economy?

Fiscal consolidation refers to the ways and means of narrowing the fiscal deficit. A government typically borrows to bridge the deficit. It will then have to allocate a part of its earnings to service the debt. The interest burden will increase as the debt increases.
In the Budget for FY22, of the total government expenditure of over ₹34.83 lakh crore, more than 8.09 lakh crore (around 20 per cent) went towards interest payment.
Debt is one liability that is difficult to defer and, at the end of day, the government struggles to find more resources not just for capital expenditure but also revenue expenditure. In the long run, uncontrolled fiscal deficit will hurt economic growth.

Is fiscal consolidation legally mandated in India?

The seeds for fiscal consolidation were sown in 1994 by the then Finance Minister Manmohan Singh.
- In his Budget speech for FY95, he highlighted the need for fiscal discipline and pronounced a policy to end monetising the deficit.
- Till then the government was financing its deficit by creating money, through unlimited recourse to the Reserve Bank, by issuing ad hoc treasury bills. This weakened the Reserve Bank’s ability to direct effective monetary policy. Singh announced phasing out ad hoc treasury bills, after which the government would fund its deficit through market borrowings.
- As open market borrowings piled up to fund the deficit, Yashwant Sinha, in his Budget speech for FY01, called for a strong institutional framework to ensure fiscal responsibility.
- This resulted in the enactment of the ‘Fiscal Responsibility and Budget Management (FRBM) Act, 2003’, which mandated limiting the fiscal deficit to 3 per cent of GDP.

How has India performed on this front?

When FRBM was enacted, the idea was to limit the fiscal deficit under 3 per cent of GDP by the end of FY08. But that never happened.
The fiscal deficit declined from 5.9 per cent in FY12 to 3.4 per cent in FY19. In FY20, it went up to 3.8 per cent. The following year, it was proposed at 3.5 per cent, but the pandemic struck and it surged to 9.5 per cent. Now, for the current year, it is estimated at 6.8 per cent and the government will seemingly work towards 4.5 per cent by FY26.
A fiscal deficit of 3 per cent now appears to be a distant possibility. To ensure it was within the law, the government periodically amended the FRBM Act to reset the fiscal deficit target.

Is there a trade-off between fiscal consolidation and growth?

It is debatable.
Many economists have said that speedier economic growth depends on limiting the fiscal deficit. Their reasoning is that high fiscal deficit will increase borrowings and the interest burden would curtail the government’s ability to spend productively. Also, increased government borrowing will crowd out the private sector in the debt market, leading to higher interest rates, which will hurt growth.
Other economists have argued that fiscal consolidation is not a fiscal compression mechanism, rather it is an expenditure switching mechanism. The original FRBM Act of 2003, they say, pushed for shifting the expenditure from revenue to capital, which will lay the foundation for higher growth. They argue that the FRBM Amendment Act of 2018 completely dilutes the original Act to become contractionary.