Tuesday, October 24, 2006

An alternative fiscal rule?

As is well known, a debate has been developing in India on the issue of the FRBM targets. On one hand, fiscal purists argue that it is terribly important for India to achieve these meagre targets - which will probably deliver a consolidated deficit of centre and states of around 6% of GDP, the highest in the world. On the other hand, there is a legitimate criticism of the FRBM fiscal rule as not directly representing a stability condition for debt/GDP.

In a recent EPW article [pdf], Percy Mistry offers a fascinating way out of the conflict. He proposes a fiscal rule that directly fits economic logic: a 60% target for the debt/GDP ratio. Along with this, he proposes a rules-based trigger for ensuring this limit is met. Everytime the limit is breached, the government would sell assets (land or shares in PSUs) so as to get back to the 60% limit.

A fiscal stability condition phrased in terms of debt/GDP is clearly technically sound. It gives space for a bigger/lower fiscal deficit based on interest rates and GDP growth rates, thus permitting greater flexibility when compared with a rule phrased in terms of the fiscal deficit. Most importantly, a fiscal stability condition like this can be backed by a clear action which ensures that the limit on the debt/GDP will not be breached. This is unlike the existing situation, where it's possible to get FRBM rules being met but the debt/GDP can continue to rise.

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