Fiscal consolidation

March 16, 2022
Posted by: OptimizeIAS Team
Category: DPN Topics

Fiscal consolidation

Subject :Economy

Section: Fiscal policy

Fiscal consolidation refers to the ways and means of narrowing the fiscal deficit.

The seeds for fiscal consolidation were sown in the Union Budget of 1994 which highlighted the need for fiscal discipline and pronounced a policy to end monetising the deficit.

Before 1994 deficit financed 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.

Later, in 2003 The Fiscal Responsibility and Budget Management (FRBM) Act gave the targets for fiscal consolidation in India.

The Fiscal Responsibility and Budget Management (FRBM) Act

The FRBM act also provided for certain documents to be tabled in the Parliament of India, along with Budget, annually with regards to the country’s fiscal policy. This included the

Medium-term Fiscal Policy Statement,
Fiscal Policy Strategy Statement,
Macro-economic Framework Statement, and
Medium-term Expenditure Framework Statement.

The FRBM rules mandate four fiscal indicators to be projected in the medium-term fiscal policy statement. These are:

revenue deficit as a percentage of GDP
fiscal deficit as a percentage of GDP.
tax revenue as a percentage of GDP.
total outstanding liabilities as a percentage of GDP.

Initial targets:

Revenue Deficit Target – revenue deficit should be completely eliminated by March 31, 2009. The minimum annual reduction target was 0.5% of GDP.
Fiscal Deficit Target – fiscal deficit should be reduced to 3% of GDP by March 31, 2009. The minimum annual reduction target was 0.3% of GDP.
Contingent Liabilities – The Central Government shall not give incremental guarantees aggregating an amount exceeding 0.5 per cent of GDP in any financial year beginning 2004-05.
Additional Liabilities – Additional liabilities (including external debt at current exchange rate) should be reduced to 9% of the GDP by 2004-05. The minimum annual reduction target in each subsequent year to be 1% of GDP.
RBI purchase of government bonds – to cease from 1 April 2006. This indicates the government not to borrow directly from the RBI.

Major amendments

FRBM Targets after Amendment to FRBM Act in 2012 (to be achieved by 2015)
- Revenue Deficit Target – revenue deficit should be completely eliminated by March 31, 2015. The minimum annual reduction target was 0.5% of GDP.
- Fiscal Deficit Target – fiscal deficit should be reduced to 3% of GDP by March 31, 2015. The minimum annual reduction target was 0.3% of GDP.
FRBM Targets after Amendment to FRBM Act in 2015 (to be achieved by 2018)
- Revenue Deficit Target – revenue deficit should be completely eliminated by March 31, 2018. The minimum annual reduction target was 0.5% of GDP.
- Fiscal Deficit Target – fiscal deficit should be reduced to 3% of GDP by March 31, 2018. The minimum annual reduction target was 0.3% of GDP.

In May 2016, the government set up a committee under NK Singh to review the FRBM Act.

Debt to GDP ratio: The review committee advocated for a Debt to GDP ratio of 60% to be targeted with a 40% limit for the centre and 20% limit for the states.
Revenue Deficit Target – revenue deficit should be reduced to 0.8% of GDP by March 31, 2023. The minimum annual reduction target was 0.5% of GDP.
Fiscal Deficit Target – fiscal deficit should be reduced to 2.5% of GDP by March 31, 2023. The minimum annual reduction target was 0.3% of GDP.

Escape clause refers to the situation under which the central government can flexibly follow fiscal deficit targets during special circumstances. This terminology was innovated by the NK Singh Committee on FRBM.

Setting up of an autonomous fiscal council that deals with the preparation of multi-year fiscal forecasts, improves fiscal data quality, could advise the government on fiscal matters.

In 2018, the FRBM Act was further amended. The clause allows the government to relax the fiscal deficit target for up to 50 basis points or 0.5 per cent, if the escape clause is triggered to allow for a breach of fiscal deficit target, the RBI is then allowed to participate directly in the primary auction of government bonds.

The original fiscal deficit target for 2020-21 was 3.5%. However, in reality, the deficit has shot up to a high of 9.5% of the GDP due to:

The impact of the COVID-19 pandemic.
Low revenue flows due to the lockdown.
Negative economic growth clubbed with high government spending to provide relief to vulnerable sections of society.

Thus, the targets revised- the fiscal deficit for 2021-22 at 6.8% of the GDP and aims to bring it back below the 4.5% mark by 2025-26.

Challenges in current fiscal consolidation:

Covid pandemic and need for social spending – health and education and related countercyclical fiscal policy measures.
Rising unemployment
Current Ukraine war and risk of supply chain shortages and rise in import bill due to higher crude oil prices.
Food security – food subsidies remain the major source of revenue expenditure.
Interest payments on debts -India’s debt to GDP ratio increased from 74 percent to 90 percent during the pandemic.
This fiscal consolidation in times of crisis delays the inclusive recovery process.

Way forward:

Increase capital expenditure– as it has a multiplier and crowd in effect- help increasing investment and country’s GDP.
Link fiscal cycle to credit cycle i.e linking of fiscal policy and monetary policy.
A committee for looking into the feasibility of subsuming all subsidies into a lump-sum direct benefit transfer.
Increase revenue of government- agri taxation, reducing discounts and remissions etc.
An autonomous fiscal council -Given the deteriorating state of fiscal health, the N.K. Singh committee in 2017, has suggested establishing an independent fiscal council.

Similar recommendations were mooted by the 13th and 14th finance commissions.

Multiplier is the ratio of change in national income arising from any autonomous change in spending (including private investment spending, consumer spending, government spending, or spending by foreigners on the country’s exports).The existence of a multiplier effect was initially proposed by Keynes student Richard Kahn in 1930 and published in 1931 and later it was elaborated by J M Keynes as the ‘Investment Multiplier’

In simple words, the multiplier measures the increase in national income due the increase in autonomous spending, depending on the propensity to consume. Suppose autonomous spending (spending that doesn’t depend on income – government spending, investment, consumption, net exports) rises, national income would rise to the multiple of autonomous expenditure. Thus,

Multiplier = 1/1-mpc

For example- the government would spend £3bn on multi-modal connectivity-roads, rails, bridges etc. This involves employing workers (previously unemployed) and paying suppliers for raw materials. Initially, GDP rises £3bn

-In the next period, workers spend part of this extra income – in shops and for transport. The suppliers also employ more workers – creating more employment. This creates an additional economic output of £1bn.

-Therefore the final increase in GDP is £4bn

In this case, the multiplier effect is 1.33

Crowding-in effect is a phenomenon that occurs when higher government spending leads to an increase in economic growth and therefore encourages firms to invest due to the presence of more profitable investment opportunities. The crowding-in effect is observed when there is an increase in private investment due to increased public investment, for example, through the construction or improvement of physical infrastructures such as roads, highways, water and sanitation, ports, airports, railways, etc.