Wednesday, August 26, 2009

Check to deficit!!?

WHETHER the fiscal deficit is too high or not is a matter on which economists in India may isagree, but supporters as well as opponents of fiscal conservatism tend to view the Fiscal Responsibility and Budget Management (FRBM) Act 2003 as a curb on large deficits. The Act came into effect on July 5, following the issue by the Finance Ministry of the notification and the FRBM Rules 2004 made under the Act. This article looks at the likely impact of the new law.

What the Act requires

The FRBM Act has four main requirements. First, it requires the Government to place before Parliament three statements each year along with the Budget, covering Medium Term Fiscal Policy, Fiscal Policy Strategy and Macroeconomic Framework. The content is prescribed in the Act and the format in the Rules.

Second, the Act lays down fiscal management principles, making it incumbent on the Centre to "reduce the fiscal deficit" (no target is mentioned in the Act, but the Rules prescribe 3 per cent of GDP) and, more categorically, to "eliminate revenue deficit" by March 31, 2008.

It requires the Government to set a ceiling on guarantees (the Rules prescribe 0.5 per cent of GDP). The Act provides that the ceilings may be exceeded on grounds of "national security or national calamity or such other exceptional grounds as the Central Government may specify".
Third, in its most stringent provision, the Act prohibits the Centre from borrowing from the Reserve Bank of India — that is, it bans `deficit financing' through Money creation.

The RBI is also barred from subscribing to primary issues of Central Government securities. Temporary Ways and Means advances to tide over cash flow problems are permitted. This provision will not apply till April 2006. Exceptions are also allowed whenever the Government declares an exceptional situation, as mentioned earlier.

Fourth, the Finance Minister is required to keep Parliament informed through quarterly reviews on the implementation, and to take corrective measures if the reviews show deviations. The Act provides that no deviation shall be permissible "without the approval of Parliament".

An Act and Rules to bind the Centre

The FRBM Act is unusual. Acts of Parliament are usually directed at prescribing the law to be followed by the public or a class of persons or by the government in its dealings with others — either the public at large or a section of it.

This Act, on the other hand, is aimed solely at fettering the Centre itself from doing things that Parliament does not want it to do. No party other than the government itself is legally bound by the Act. The Rules are even more unusual; the Centre is to issue them in order to constrain itself.
How effective is such a legislative curb? Insofar as the Rules are concerned, their legal effect is largely cosmetic. The Government can itself amend them. If the 3 per cent fiscal deficit target is found unrealistic, a notification from the Finance Ministry can change it to 4 per cent or indeed any other figure.

The only legal restriction may be that as the Act uses the word `reduce', a target which is higher than the level of deficit in the year the Act was passed may be ultra vires. If more guarantees are to be issued, the target can be raised to any desired level. The portion of the Act dealing with placing of statements before Parliament is hardly something that will cause any difficulties. Portions of the Economic Survey and the Budget Speech will suffice to prepare all three of the new statements. The one firm target in the Act is the (welcome and uncontroversial) aim of eliminating the revenue deficit by 2008.

This target can however be relaxed, by none other than the Centre: A bad monsoon or an international recession or an oil crisis may well qualify as a "national calamity" or at least as an "other exceptional circumstance". In such a situation, the other hard provision — prohibition on deficit financing is also lifted.

This much can be done without amending the Act. In the Indian Parliamentary system, the government of the day can, except when it lacks a majority, pass Money bills without difficulty. Indeed the legislature cannot reject a money bill without toppling the government. (Even Article 292, which has not been invoked and provides that Parliament may legislate debt ceilings, does not prescribe a special majority.)
As such the FRBM Act can be amended routinely by simply adding a clause to the annual Finance Act, the way the Income Tax Act or Sales Tax Act is amended.
Confronted with a choice between saying "aye'' to a routine clause in the Finance Bill, on the one hand, and unseating the government, on the other, how many ruling party or coalition members of Parliament would vote against an amendment?

If this sounds theoretical, it is not — the first amendment has already been introduced by the Finance Minister within three days of the Act coming into force, to postpone the date for elimination of revenue deficit from March 2008 to March 2009.

Cynics would argue that the overall effect is like a pact between a heavy smoker and his wife, in which the wife (concerned for his health) prescribes the maximum number of cigarettes per day with a gradual reduction to nil; after giving him the agreed number, she would lock away the cigarette box — but leave the key with him in case of `emergency' smoking needs, the only condition being that he should tell her after each emergency. Also, if he really felt bad, she would even amend the ceiling for a while, till he felt better.

International experience

Fiscal responsibility legislation was touted as a solution to fiscal profligacy by experts, based largely on three international examples of apparent success.

The first exemplar was New Zealand, which introduced a Fiscal Responsibility Act with that very title in 1994. This Act has been hailed by many experts as a model, and from an economist's point of view, it is conceptually and theoretically elegant.

However, it is noteworthy that this enactment was passed by a government that gave up control over its central bank, and was already strongly committed to a tight fiscal policy and indeed to all the elements of conservative economic orthodoxy.

Second, the New Zealand Act provides a very large degree of flexibility (more than the Indian FRBM Act). It is a moot point whether it was the Act that induced the government to be fiscally responsible or whether the government, already politically committed to fiscal conservatism, simply used the Act to declare and achieve its aims.

Arguably it led to greater fiscal transparency, but whether fiscal transparency leads to fiscal prudence is extremely doubtful especially in the context of a country like India.
Indeed, the reverse may be true — transparent but high deficits may be politically popular!
The second exemplar is the US. The first and very radical legislative attempt to put a ceiling on the deficit and then force the US Government to reduce it (the so-called Gramm-Rudman-Hollings Act of the Reagan era) was an abject failure. This was largely because the cuts required to enforce the Act became impractical in the face of unavoidable increases in expenditure on mandatory items like social security.

The Act was simply violated and the deficit continued to rise. This gave rise to the Budget Enforcement Act 1990, which does not impose any mandatory deficit target and distinguishes between mandatory expenditure (not subject to ceilings) and discretionary expenditure (subject to detailed and tight ceilings). This law also allows for the effect of the business cycle as there is no ceiling on the deficit itself.

In a time of boom, tax revenues increase and the deficit shrinks; in times of recession tax revenues decline; since there is no change in expenditure ceilings, the deficit will rise. A study of the literature shows that the Act has been a qualified success and has helped in restraining discretionary government expenditure.

But this was primarily because of its rigidity: in the American constitutional system; the Executive cannot pass fiscal legislation as it pleases. Defeat of a Money bill does not unseat the President. A mere Act of Congress can effectively restrain the government because the Executive cannot easily amend a law once passed — quite different from our Parliamentary system.

The third exemplar is the European Union and the Growth and Stability Pact of 1997, which bound members to bring down and then keep their deficits below 3 per cent of GDP. Strictly, this is a `fiscal responsibility treaty' rather than an Act, but nevertheless legally binding. In the years before the introduction of the euro, the Treaty appeared to have succeeded in achieving deficit reductions. Since then, however, its record has been awful. The last 12 months have seen the Treaty almost totally unravel, with the two biggest Euro countries — France and Germany — being in breach of the ceiling.

The Treaty even had provisions for a penalty in the form of a non-interest bearing deposit of 0.2 per cent of GDP to be paid by defaulting countries, to be later treated as a fine if the problem was not remedied in two years.

However, the European Council of Ministers chose not to enforce the provisions, by disagreeing with the recommendation of the European Commission (the executive wing)!
This decision was taken with full transparency (as required by the Pact) and detailed written reasons, even disclosing who voted for and against — indicating that transparency is an over-rated virtue.

On July 12, 2004 the European Court of Justice held that countries could not simply waive the provisions, but the Council nevertheless does have the right to desist from collecting the penalty. All in all, for practical purposes the Treaty is becoming more of a statement of good intentions than a binding legal obligation.

The question that arises is whether a government not politically committed to a particular level of fiscal prudence can be restrained by the passing of fiscal responsibility legislation. The answer is clearly `no'. Does the Act serve any purpose at all? Perhaps it does.
First, it has the barking dog effect on outsiders — as house owners know, barking dogs do have value even if they do not bite. Part of the value of the Act lies in its apparent strictness. The barking dog (the elegantly drafted prose of the Act and Rules) could impress Moody's and Standard & Poor's and international onlookers as a credible commitment to fiscal responsibility, with consequent benefits for borrowing costs.

Second, as the mothers of Tamil Nadu might put it, it may have a poochandi (scare) effect on insiders. It could help civil servants and the Finance Ministry restrain the more spendthrift among the Ministers, by pointing to the FRBM ogre.

Third, like the directive principles of state Policy or, more aptly, the Dowry Prohibition Act, the Age of Consent Act, etc., it may have some value in the long run in influencing behaviour. These are real, not imaginary, benefits.

What remains to be seen is whether these benefits are worth the elaborate legal framework and administrative burden that go with it. But if the fiscal or revenue deficit is to be substantially reduced, there is no substitute for political will; if the government of the day wants a high deficit, the Act will not stop it.

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