## Sunday, September 10, 2006

### Fiscal consolidation now?

As the academic literature has long pointed out, India has a serious problem with a growing debt/GDP ratio. The decline in interest rates in the last six years has masked the problem, but the situation remains difficult.

For a while, it looked like India was winning on a dramatic fiscal turnaround. The Fiscal Responsibility and Budgetary Management (FRBM) FRBM Act was a nice piece of work and some of the numbers have improved well.

### Are the FRBM targets adequate for solving India's fiscal problem?

The rough targets appear to be shaping up as a 3% deficit for the centre and a 3% deficit for the states (link). One problem is that these numbers are not enshrined in the law itself and can easily be changed by a future government. In addition, the Act has defined no penalties which come into play when the targets are breached.

And, from an international perspective, a 6% deficit would still be one of the biggest in the world! A few comparisons from the IMF World Economic Outlook (WEO):

 Advanced economies Other emerging markets and developing countries India Central government fiscal balance -2.4 -0.9 -4.2 General government fiscal balance -3.1

This suggests that our central government fiscal deficit, of -4.2%, is big when compared with advanced countries (who are at -2.4%) and even bigger when compared with our peer group (who are at -0.9%). The WEO does not have comparable data for all three cases, but for industrial countries, they show that the general government balance, at -3.1%, is only slightly worse than the central government balance. We in India seem to think that it's okay to do much worse.

So I think of hitting the FRBM targets as a bare minimum modicum of fiscal responsibility. It is possible to paint plausible scenarios under which the Debt/GDP ratio is not stabilised even if the FRBM targets are adhered to: it is not a sufficient condition.

### The importance of tax buoyancy

The FRBM Act was followed up by a careful game plan called the "FRBM Task Force report" for achieving the targets. The politically easiest strategy for achieving FRBM targets is based on high tax buoyancy. When nominal GDP grows by 10%, tax revenues should grow by 15% to 20% -- i.e. tax buoyancies of 1.5 to 2. In this case, the sheer growth of India leads to a closing of the gap. Roughly speaking, this was the game plan of the Kelkar FRBM Task Force report:

1. Tax reforms which change buoyancy but don't immediately pinch the pocket of the tax payer are most politically feasible;
2. So reform tax policy and tax administration so as to get up to high buoyancy;
3. Don't do new damage in terms of spending money;
4. and let GDP growth take care of the rest.

At first, things seemed to be working. Tax administration (particularly income tax) has been pumping out high growth rates of tax revenues. From 2001-02 to 2004-05, the investment rate went up from 23% to 30% - a huge gain of seven percent! Of this seven percentage point swing, 4 percentage points occured because of an improvement in the fiscal situation (link).

Now the situation is looking more difficult. Tax revenues might not do as well as hoped owing to the Special Economic Zones (SEZs). Expenditures might be higher than expected owing to welfare programs like the National Rural Employment Guarantee (NREG) program, and the 6th pay commission. The most remarkable recent development on India's journey to the FRBM targets is that Montek Ahluwalia thinks the targets should be breached.

### The SEZ problem

The rationale for SEZs is supposed to be that there are huge infrastructure and institutional problems with India, so in order to win on exports growth, the way out is to create enclaves with good infrastructure (particularly urban infrastructure) and generous tax treatment. The government seems to be ready with generous tax concessions, but no relaxations to labour law are proposed.

Does it make sense to undertake distortionary policies which artificially prop up exports, e.g. by tools such as export subsidies, tax breaks, or manipulation of exchange rates? Economic growth is accentuated by openness, not by faking exports. (See two articles by Ila Patnaik [link, link], and this recent piece by Adam S. Posen). So I am not enthusiastic about doing SEZs "in order to boost exports". We need a sound, well-run country, which will (by the way) import a lot and export a lot.

What about the fiscal implications? The generous tax treatment of SEZs constitutes a threat to the high tax buoyancies that we have been seeing. If a lot of SEZs come up, and if they succeed, we could see two possibilities. On one hand, existing output could relocate from the taxed zone to the untaxed zone. This would be very bad news. Or, a more mild scenario, a lot of incremental output could take place in SEZs. This sounds nicer from a fiscal perspective, but it isn't. In this case, we will see a decline in the tax buoyancy. I have crunched the data, and it is not clear to me how FRBM targets will be met if tax buoyancies drop below 1.25. Or if I may say this differently, if tax buoyancies drop below 1.25, then a new level of political pain will be required, in cutting discretionary expenditures, in order to get back to FRBM targets.

A short while ago, Ila Patnaik had an article worrying about the tax exemptions for SEZs and other fiscal largesse.

### Welfare programs

A daunting feature of a program like the NREG -- which guarantees some mandays of employment for every household at the choice of the household -- is that it is hard to budget for how big the outlays will be. Some preliminary budget numbers look weak, and I don't know whether the NREG is yet playing a role there. Business Standard had a good editorial on the unfolding difficulties showing up in fiscal data, despite remarkable tax buoyancy. The NREG is not alone; the UPA has had a penchant for big expenditure programs. And, there remains the risk that the UPA will implement the Arjun Sengupta proposals for a giant welfare program for employees of the unorganised sector (link).

### The 6th Pay Commission, and the New Pension Scheme (NPS)

Then there is the 6th Pay Commission. The HR framework for the civil service is awful, and there is a crying need for change. It is not, as yet, clear that the 6th Pay Commission will be constituted in a way that will make progress on these problems. If one extrapolates from the experience of the 5th Pay Commission, the 6th Pay Commission could induce acute fiscal stress from 2009 onwards. Subir Gokarn has a good article on this issue.

A short while ago, Ila Patnaik pointed out in an article titled First payoff to structural pension reform that with the 6th Pay Commission, we are seeing the first payoff to the long-term structural reform that the New Pension Scheme (NPS) represents. The `grandfathering' approach to phasing in the NPS means that for one generation, the government is paying contributions to recent recruits while paying pensions to old ones. But from 2004 onwards, new recruits who are in the NPS have a pension which is decoupled from pay commissions. That changes the way we think about pay commissions. In an NPS world, the employer-employee relationship reduces to a decision about the contribution rate into the NPS.

### Planning Commission vs. FRBM Act

I have previously written about the approach paper for the 11th plan, emphasising the good things that it says about reforming the mechanisms for production of public goods. In my earlier scanning of this document, I did not pay enough attention to the fiscal aspects.

Financial Express recently reproduced extracts of a letter from P. Chidambaram to Montek Ahluwalia on fiscal issues. (See story). For what it's worth, Arjun Singh agrees with Montek, which suggests that old Congress may be pushing for violating the FRBM. A piece with a response from Montek Ahluwalia underlines the gap between what is sought and the FRBM.

Just in case we lost sight of the Things That Matter, Dr. S. Narayan reminds us that what we really need to be doing is closing down the Planning Commission. There ought to be no contest between an Act of Parliament and a non-constitutional body like the Planning Commission. Nirvikar Singh has an article in Financial Express on a related theme.

Montek Ahluwalia carries a lot of credibility, and his willingness to take the FRBM Act lightly opens the floodgates for a lot of people who have always wanted less fiscal discipline. Ila Patnaik wrote two pieces on the importance of fiscal discipline (link, link). I recently wrote in a debate in Business Standard on it. The Martin Feldstein lecture that I refer to is here.

### Putting the pieces together

How do we put these pieces together? Ila Patnaik evaluates the pros and cons of violating the FRBM (also see this review of two years of the UPA). Paromita Shastri has an article in Outlook on the "hole in the bucket" perspective. In the Business Standard of 22 July, T. Ninan has an excellent article worrying about the fiscal outlook.

I feel we should be cognisant of the 2009 dimension. A host of difficulties will come together by 2009: the next elections, the FRBM targets, the fiscal impact of the 6th pay commission, UPA welfare programs at full steam, and a possible global downturn. Fiscal stress could spill over into bad economics and bad politics in unpleasant ways.

Given India's unique demographic situation, the most wonderful thing would have been if the revenue deficit vanished by 2008-09, and stayed that way, and the fiscal deficit was capped at 3%. This is not the best fiscal rule - as I argue above, this is probably not a deficit level which will stabilise debt/GDP - but it's a minimum first step. This would free up savings for investment at the perfect time for India to be able to generate astonishing growth (see article by Ronald Lee and Andrew Mason on the demographic dividend). If the FRBM Act is violated by the UPA, it will be do long-term damage to India's development project, by contaminating growth in what could be the most important 10-15 years of India's history.

#### 1 comment:

1. Ajay, i am looking for RBIs technical note on observations of planning commissions approach paper on FRBM Act. I would appreciate if you send me the same.

Please note: Comments are moderated. Only civilised conversation is permitted on this blog. Criticising me is perfectly okay; uncivilised language is not. I delete any comment which is spam, has personal attacks against anyone, or uses foul language. I delete any comment which does not contribute to the intellectual discussion about the blog article in question.

Please note: LaTeX mathematics works. This means that if you want to say $10 you have to say \$10.