Fiscal consolidation

Fiscal consolidation

Sub: Eco

Sec: Fiscal Policy

Context: In a bid to provide maximum flexibility to growth, the government has tweaked its approach to fiscal consolidation. It no longer wants to fix a fiscal deficit target

New approach: Government wants to focus more on reducing debt and thereby the fiscal deceit

What is Fiscal consolidation?

It implies reduction in debt accumulation and fiscal deficit. Governments undertake different policies to achieve fiscal consolidation.

• Better targeting of government subsidies and extending Direct Benefit Transfer scheme for more subsidies.
• Improving efficiency of tax administration by eliminating evasion of tax, increasing tax compliance, reducing tax avoidance, etc.
• Enhancing tax GDP ratio by widening the tax base and minimizing tax concessions and exemptions also improves tax revenues.
• Higher economic growth rate will help the government to get higher tax revenues as well. Augmentation of tax revenue is necessary to bring fiscal consolidation as there are limitations for reducing government expenditure in India.

Why we need Fiscal consolidation?

Governments need to live within their means. But with the ability to print money and borrow at will, they often spend more than what they earn, causing fiscal deficit. So, that’s the difference between revenue and spending (shown as a percentage of gross domestic product). Having a high fiscal deficit is not good economics. It causes inflation to rise and hurts economic growth as it forces interest rates to remain high. Fiscal consolidation is the process of controlling the fiscal deficit by ensuring that expenditure does not significantly exceed revenue. Most governments do this by setting a legally mandated target

How did we get to the 3% target for India?

The Fiscal Responsibility and Budget Management Act, 2003, mandates the Union government to keep the fiscal deficit below 3% of its gross domestic product.

More than two decades after the law came into effect and for reasons both within and beyond its control, the Centre has not been able to meet this target even once. In FY19, the deficit came down to 3.4% but the pandemic that followed pushed it up to 9.2% in FY21. The Modi government has been aggressively reducing it ever since. In FY24 it managed to reduce it to 5.6%. The target for FY25 is set at 4.9% and in FY26 it is expected to be below 4.5%.

Fiscal Responsibility and Budget Management Act

• It was enacted in August 2003.
• It aims to make the Central government responsible for ensuring inter-generational equity in fiscal management and long-term macro-economic stability.
• The Act envisages the setting of limits on the Central government’s debt and deficits.
• It aims to limit the fiscal deficit to 3% of the GDP.
• To ensure that the States too are financially prudent, the 12th Finance Commission’s recommendations in 2004 linked debt relief to States with their enactment of similar laws.
• The States have since enacted their own respective Financial Responsibility Legislation, which sets the same 3% of Gross State Domestic Product (GSDP) cap on their annual budget deficits.
• It also mandates greater transparency in fiscal operations of the Central government and the conduct of fiscal policy in a medium-term framework.
• The Budget of the Union government includes a Medium Term Fiscal Policy Statement that specifies the annual revenue and fiscal deficit goals over a three-year horizon.
• The rules for implementing the Act were notified in July 2004. The rules were amended in 2018, and most recently to the setting of a target of 3.1% for March 2023.
• The NK Singh committee (set up in 2016) recommended that the government should target a fiscal deficit of 3% of the GDP in years up to March 31, 2020 cut it to 2.8% in 2020-21 and to 2.5% by 2023.

Escape Clause:

• Under Section 4(2) of the Act, the Centre can exceed the annual fiscal deficit target citing certain grounds. They are ,
• National security, war
• National calamity
• Collapse of agriculture
• Structural reforms
• Decline in real output growth of a quarter by at least three percentage points below the average of the previous four quarters.
• The lockdown could cause severe contraction in economic output and the COVID-19 pandemic could be considered as a national calamity.
• Also, the government has already made the use of escape clause this year.

Is there a change in approach?

Next cabinet secretary T.V. Somanathan has said the Centre is no longer committed to a 3% fiscal deficit target. He said that after FY26 (by when it would be below 4.5%) the target will be dynamic and set in a manner the government’s debt-to-GDP (an unsustainable 58.2% in FY24) is on a declining trend. This, the Centre feels, will provide more flexibility for growth by making enough resources available. A fast-growing economy like India, he argued, can afford a higher fiscal deficit and still reduce debt.

So is the 3% target sacrosanct?

The government says there is no scientific basis to the 3% target. A slightly higher deficit would actually help the economy grow faster. It will also provide the Centre with enough fire power when a crisis such as the pandemic strikes. Post-covid, it spent heavily on infrastructure to revive growth. But many economists say a deficit that is higher than 3% will increase India’s borrowings at a time when savings are declining. This will push up interest rates, hurt private investment and slow economic growth.