Prof. Errol D'souza

 

India requires strong institutions for macroeconomic govenance to manage the vagaries of business cycles and contain high inflation. In the monetary policy sphere, this was addressed by the Agreement on Monetary Policy Framework that was signed by the ministry of finance and the Reserve Bank of India (RBI) a few days before the Union budget. The agreement stated the objective of monetary policy as price stability, while keeping in mind the objectives of growth and strengthening the institutional architecture of monetary policy. 

A focus on a similar agreement for fiscal policy is required. We have made some important strides towards increasing transparency in fiscal policy with a plethora of budget documents stating the fiscal policy strategy and the statement of revenue forgone. It is time now to reduce the cyclicality of fiscal policy and to rein in unsustainable fiscal policy. From a macroeconomic perspective, fiscal policy in the short run contributes to output stabilization. However, it is not very effective as a stabilization tool because it is subject to what the profession calls as inside lags—a change in fiscal policy requires parliamentary approval for changes in govenment spending and tax programmes. This usually occurs during the budget session of Parliament and, outside this calendar, it could take a lot of time to put fiscal policy changes into effect. By contrast, monetary policy has a shorter decision lag as central bankers meet on a daily basis and, in this window, can decide on how to steer the economy. Thus, it is the long-run macroeconomic objective of fiscal discipline that is central to fiscal policy.

The emphasis on making govenment budgets sustainable is because it promotes equity across generations. Targets for debt and deficits were defined with reference to the Fiscal Responsibility and Budget Management (FRBM) Act, which came into effect in 2003. These rules, however, were modified thrice over the years and were not complied with in practice. This year too, citing drastically reduced fiscal space and to account for the need to increase public investment, the finance minister decided to push the deadline for achieving the 3% deficit target to three years from two years. 

It is the case that investment projects producing deferred benefits should have their costs spread over all the generations of taxpayers who benefit from it. This implies debt financing of investment expenditure, which ensures future generations pay for the benefits received when the investment fructifies. The burden of current generations then gets restricted to the repayment of debt that financed past investment projects that produce a current flow of services. That is an ideal theory. In practice, it is usually the pile-up of past domestic debt that severely restricts the ability to finance new investment. Such a phenomenon is not restricted to just emerging markets—it occurred in the OECD (Organisation for Economic Cooperation and Development) countries where a fast growing mountain of public debt between the 1970s and the 1990s resulted in a squeeze on fiscal space that was resolved through a decline in public investment in the ’90s. Second, such a rule (indeed, economists call it a golden rule) that is sound, in principle, to finance public investment through govenment borrowing can result in a preference for expenditures on physical assets rather than on spending for intangibles such as health or education.

There is a wider spectrum of current expenditures, such as those that increase human capital or skills that contribute to economic growth just as much as public expenditures in the capital budget. If we begin to include such expenditures as qualifying for financing through debt, then we exacerbate the problem of opportunistic behaviour by politicians resulting in unsustainable public debt.

Finally, even though public investment can be very productive when it is directed at putting an end to bottlenecks that stymie growth, there is no guarantee that such expenditure will eventually do so. If public investment is inefficient (time and cost overruns) or accompanied by corruption, then the dividend that is anticipated will not materialize, while the pile of debt will continue to grow. Public investment results in capital accumulation and growth if there are no govenance issues (weak contractual arrangements typified by the ease of doing business) associated with the complementary private investment that it crowds in. 

Govenments can always find good excuses, such as citing the crying need for investment, in order to postpone the rendering of sustainable public finances. It is thus important to institutionalize an independent fiscal council (IFC). The 14th Finance Commission has pointed out that Article 292 of the Constitution envisages fiscal responsibility in the form of legislation that obliges the govenment to have a ceiling on debt. Much like central banks foresee inflation at a policy relevant horizon, the IFC should commit to stabilizing debt at a feasible horizon that should extend beyond the business cycle, since sustainability is a long-run phenomenon. Of course, debt targets may vary with time and demographic considerations as well as major upheavals like natural disasters or wars may warrant some rebasing of the target. Yet, it is important to set a quantitative target as it anchors expectations and provides an understandable policy goal.

The IFC will have the job of deciding on the deficit in the budget on the basis of an explicit GDP growth forecast. The govenment’s budget must match the IFC’s budget balance decision for the most likely growth forecast. Thus, all fiscal authority regarding spending and revenue decisions stay with the finance ministry. The level of debt and deficits that is permissible has to be delegated to the IFC, which is to be a body of independent experts. Such experts ought to be appointed for a long duration so as to make them fully independent. In this way, fiscal policy that has the tendency to be over-expansive and have detrimental long-run impacts will be made sustainable through ex ante control by the IFC.

 

Prior to joining IIM-A, Professor Errol D’Souza was the IFCI chair professor at the department of economics, University of Mumbai, and was also a visiting scholar at Columbia University, New York, and a visiting senior fellow at the Institute of South Asian Studies, National University of Singapore. At present, his academic interests include tax reforms and fiscal/monetary policy, the structure of corporate finance, social security and livelihood issues in the informal sector, personnel economics, and govenance issues.

This article presents the author’s personal views and should not be construed to represent the institute’s position on the subject.

 

First published in 'View from IIMA' column in Mint.