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Budgeting and Fiscal Policy
Budgeting and Fiscal Policy
A parallel economy may also be termed as ‘informal economy’, ‘black money economy’,
‘unaccounted economy’, ‘illegal economy’, ‘subterranean economy’, or ‘unsanctioned
economy’.
The World Bank research group’s work done in 2010 — Shadow Economies All Over the World: New
Estimates for 162 Countries from 1999 to 2007, by Friedrich Schneider, Andreas Buehn and Claudio
E Montenegro — is regarded to be one of the most reliable report on the illegal economy through the
globe. It estimated India’s shadow economy in 2006 to be 25.1 per cent of GDP, against 22.9 per cent
in 1999. This is estimated at around 30% currently
It is not impossible to curb, control, and finally prevent the generation of black money in future as
well as repatriation of black money, if a comprehensive mix of clear-cut strategies is followed
with patience & perseverance by the central & state governments & placed into practice by all
their agencies in a coordinated manner.
The Fiscal Responsibility and Budget Management (FRBM) Act, 2003
The Fiscal Responsibility and Budget Management Bill (FRBM Bill) was introduced in India by the
then Finance Minister of India, Mr.Yashwant Sinha in December 2000. The provisions provided in the
initial versions of the bill were too drastic. After much discussions, a watered-down version of the bill
was passed in 2003 to become the FRBM Act. The FRBM Rules came into force from July 5, 2004.
What is the FRBM Act all about?
FRBM Act is all about maintaining a balance between Government revenue and government
expenditure.
The intention of the Fiscal Responsibility and Budget Management Act was to bring –
fiscal discipline.
efficient management of expenditure, revenue and debt.
macroeconomic stability.
better coordination between fiscal and monetary policy.
transparency in the fiscal operation of the Government.
achieving a balanced budget.
Objectives of the FRBM Act
The main objectives of the act were:
1. to introduce transparent fiscal management systems in the country.
2. to introduce a more equitable and manageable distribution of the country’s debts over the
years.
3. to aim for fiscal stability for India in the long run
Additionally, the act was expected to give the necessary flexibility to Reserve Bank of India (RBI) for
managing inflation in India.
Provisions of the Fiscal Responsibility and Budget Management Act
The FRBM rules mandate four fiscal indicators to be projected in the medium-term fiscal policy
statement. These are:
1. revenue deficit as a percentage of GDP
2. fiscal deficit as a percentage of GDP.
3. tax revenue as a percentage of GDP.
4. total outstanding liabilities as a percentage of GDP.
The FRBM Act set targets for fiscal deficit and revenue deficit.
The FRBM act also provided for certain documents to be tabled in the Parliament of India, along with
Budget, annually with regards to the country’s fiscal policy. This included the Medium-term Fiscal
Policy Statement, Fiscal Policy Strategy Statement, Macro-economic Framework Statement, and
Medium-term Expenditure Framework Statement. For details check the details of the budget
documents.
Initial FRBM Targets (to be met by 2008-09)
1. Revenue Deficit Target – revenue deficit should be completely eliminated by March 31,
2009. The minimum annual reduction target was 0.5% of GDP.
2. Fiscal Deficit Target – fiscal deficit should be reduced to 3% of GDP by March 31, 2009. The
minimum annual reduction target was 0.3% of GDP.
3. Contingent Liabilities – The Central Government shall not give incremental guarantees
aggregating an amount exceeding 0.5 per cent of GDP in any financial year beginning 2004-
05.
4. Additional Liabilities – Additional liabilities (including external debt at current exchange
rate) should be reduced to 9% of the GDP by 2004-05. The minimum annual reduction target in
each subsequent year to be 1% of GDP.
5. RBI purchase of government bonds – to cease from 1 April 2006. This indicates the
government not to borrow directly from the RBI.
Did the government meet the FRBM targets by March 2009?
No. Implementing the act, the government had managed to cut the fiscal deficit to 2.7% of GDP and
revenue deficit to 1.1% of GDP in 2007–08. However, the targets were not met.
The global financial crisis (2007-08) led the government to infuse resources in the economy as the
fiscal stimulus in 2008. Therefore, fiscal targets had to be postponed temporarily in view of the global
crisis.
Amendments in the FRBM Act
In 2012 and 2015, notable amendments were made, resulting in relaxation of target realisation year.
A new concept called Effective Revenue Deficit (E.R.D) was also introduced.
The requirement of ‘Medium Term Expenditure Framework Statement’ was also added via
amendment in FRBMA.
FRBM Targets after Amendment to FRBM Act in 2012 (to be achieved by 2015)
1. Revenue Deficit Target – revenue deficit should be completely eliminated by March 31, 2015.
The minimum annual reduction target was 0.5% of GDP.
2. Fiscal Deficit Target – fiscal deficit should be reduced to 3% of GDP by March 31, 2015. The
minimum annual reduction target was 0.3% of GDP.
FRBM Targets after Amendment to FRBM Act in 2015 (to be achieved by 2018)
1. Revenue Deficit Target – revenue deficit should be completely eliminated by March 31, 2018.
The minimum annual reduction target was 0.5% of GDP.
2. Fiscal Deficit Target – fiscal deficit should be reduced to 3% of GDP by March 31, 2018. The
minimum annual reduction target was 0.3% of GDP.
FRBM Review Committee headed by NK Singh: Recommendations
The government believed the targets were too rigid.
In May 2016, the government set up a committee under NK Singh to review the FRBM Act. The
committee recommended that the government should target a fiscal deficit of 3 per cent of the GDP
in years up to March 31, 2020, cut it to 2.8 per cent in 2020-21 and to 2.5 per cent by 2023.
The Committee suggested using debt as the primary target for fiscal policy. This ratio was 70% in
2017.
These are the targets set by NK Singh:
1. Debt to GDP ratio: The review committee advocated for a Debt to GDP ratio of 60% to be
targeted with a 40% limit for the centre and 20% limit for the states.
2. Revenue Deficit Target – revenue deficit should be reduced to 0.8% of GDP by March 31,
2023. The minimum annual reduction target was 0.5% of GDP.
3. Fiscal Deficit Target – fiscal deficit should be reduced to 2.5% of GDP by March 31,
2023. The minimum annual reduction target was 0.3% of GDP.
Latest FRBM Targets
The latest provisions of the FRBM act requires the government to limit the fiscal deficit to 3% of the
GDP by March 31, 2021, and the debt of the central government to 40% of the GDP by 2024-25,
among others.
The Act provides room for deviation from the annual fiscal deficit target under certain conditions.
Escape Clause in the FRBM Act
Escape clause refers to the situation under which the central government can flexibly follow fiscal
deficit target during special circumstances. This terminology was innovated by the NK Singh
Committee on FRBM.
In Budget 2017, Finance Minister Arun Jaitley deferred the fiscal deficit target of 3% of the GDP and
chose a target of 3.2%, citing the NK Singh committee report.
However, the Comptroller and Auditor General of India (CAG) pulled up the government for deferring
the targets which it said should have been done through amending the Act.
In 2018, the FRBM Act was further amended. Specific details were updated in sub-section (2) of
Section 4. The clause allows the govt to relax the fiscal deficit target for up to 50 basis points
or 0.5 per cent. Under FRBM, if the escape clause is triggered to allow for a breach of fiscal deficit
target, the RBI is then allowed to participate directly in the primary auction of government bonds, thus
formalising deficit financing.
The Escape Clauses can be invoked:
by the Government after formal consultations and advice of the Fiscal Council.
with a clear commitment to return to the original fiscal target in the coming fiscal year.
In 2020, Finance Minister, Nirmala Sitharaman used the escape clause provided under the FRBM Act
to allow the relaxation of the target. Finance Minister revised the fiscal deficit for FY20 to 3.8 per cent
and pegged the target for FY21 to 3.5 per cent.
Note: The Act exempts the government from following the FRBM guidelines in case of war or
calamity.
What is the current status of Fiscal Deficit and Revenue Deficit?
Fiscal Deficit (FD)- The Fiscal deficit as per the Indian Budget 2020-21 was estimated 3.5
% of GDP.
Revenue Deficit (RD)- The Revenue Deficit as per the Indian Budget 2020-21 was
estimated 2.7 % of GDP.
Effective Revenue Deficit (ERD)- The effective revenue deficit as per the Indian Budget 2020-
21 was estimated 1.8 % of GDP.
Tax to GDP ratio: 10.8
Debt to GDP ratio (Central Government): 50.1
What if there is no Fiscal Discipline?
If there is no fiscal discipline, the government (executive) may spend as it wishes.
A country is just like a house; if the expenditure is too much and if there is no revenue to balance the
high expenditure, the country will eventually fall into a debt trap, which may finally result in its
collapse.
Conclusion
The FRBM Act seeks to achieve long-term macroeconomic stability, while generating budget
surpluses, prudential debt management, limiting borrowings to cut down deficits and debt, greater
transparency, removal of fiscal impediments and providing a medium-term framework for budgetary
implementation.
As seen in the above analysis, different governments have failed to achieve the FRBM targets set to
be achieved in 2008 even by 2020.
Though the Act aims to achieve deficit reductions prima facie, an important objective is to achieve
inter-generational equity in fiscal management. This is because when there are high borrowings
today, it should be repaid by the future generation. But the benefit from high expenditure and debt
today goes to the present generation.
Achieving FRBM targets thus ensures inter-generation equity by reducing the debt burden of the
future generation.
PUBLIC EXPENDITURE
· Spending incurred by public authorities to fulfill the collective social wants of the people
is termed as public expenditure.
· As economies experience tremendous growth in public expenditure, it is essential to formulate
judicious public expenditure policies so as to attain the objectives of income generation and its
equitable distribution, employment, and sustainable growth.
It is very important for government to spend on social & economic for accomplishing the basic
needs of people in developing countries. However the proportion of the centre’s expenditures on
social services is low. On an average about 85% of the spending in social services in India is
undertaken by the state governments given the division of duties between the centre and the states
in India. It is the responsibility of the states, rather than the centre, to provide social services that
matter more for human development. Further, states are responsible for most of the infrastructure
facilities (except telecommunications, civil aviation, railways and major ports) and law and order.
Such an increase has mainly been accredited to a rise in revenue expenditures at the cost of
capital expenditures. Post reforms the government had to resort to suppressing capital
expenditures to bring down the deficits, as it was unable to reduce its revenue expenditures. This
has raised concerns about the future growth prospects of the Indian economy.
The first major trend in public expenditures which we observe in India is the growing revenue
expenditures of the government from Rs.14,410 crores in 1980-81 to Rs. 10,40,723 crores in
2010-11 which is an 80 fold increase.
Capital expenditures during the same period increased about 20 times, from Rs. 8,358 crores
in 1980-81 to Rs. 1,56,605 crores in 2010-11
The composition of total expenditures was skewed in favour of revenue expenditures and the
ratio of revenue expenditures in total expenditures increased from 63 percent in 1980-81 to about
70 percent in 1990-91 and further to 85 percent in 2000-01 and then to about 87 percent in 2010-
11. Capital expenditures as a percentage of total expenditures reduced accordingly from 36.7
percent to 30 percent to 14.6 percent to 13 percent.
Revenue expenditures as a percentage of GDP, increased from 9.6 percent in 1980-81 to 12.5
percent in 1990-91. With the increasing public debt, the interest payments grew from 1.7 percent
of the GDP in 1980-81 to 3.6 percent in 1990-91. Defence expenditures during this period stayed
above 2 percent of GDP throughout. Subsidies increased from 1.3 percent in 1980-81 to about 2
percent in 1990-91. Out of the capital expenditures, loans and advances and capital outlay
declined, resulting in a fall in capital expenditures to GDP ratio from 5.5 to 5.4 percent during
this period.
In the nineties, as a percentage of GDP, capital expenditures fell from 5.4 percent in 1990-91
to 2.2 percent in 2000-01. Revenue expenditures, on the other hand showed an increase from 12.5
percent in 1990-91 to 12.8 percent in 2000-01, mainly because of the increase in interest
expenditures. Defence expenditures and subsidies both showed a decline during this decade. The
fall in capital expenditures could be attributed to fall in loans and advances from 3.3 percent in
1990-91 to about 1 percent in 2000-01 and fall in capital outlays from 2 percent to 1.1 percent
during the same period.
Revenue expenditures increased to 13.5 percent in 2010-11 from 12.8 percent in 2000-01 and
capital expenditures, on the other hand, declined from 2.2 percent in 2000-01 to 2 percent in
2010-11. Out of the revenue expenditures, defence expenditures and interest payments as a
percentage of GDP, have shown a
decline, whereas, subsidies have increased from 1.2 percent in 2000-01 to 2.2 percent in 2010-11.
Out of the capital expenditures, loans and advances have shown a decline whereas; capital outlays
have shown an increase from 1.1 percent in 2000-01 to 1.7 percent in 2010-11.
PUBLIC DEBT
It is a significant source of revenue for government. If revenue collected from taxes & other
sources is not sufficient to cover government expenditure govt may depend on borrowing. Local,
state and central governments borrow money to compensate for big projects, like new buildings,
schools or for financing public expenditure etc. Such borrowings turn out to be essential in times
of financial crises & tragedies like war, droughts, etc. Public debt can be upraised internally or
externally. Internal debt denotes to public debt floated within the country, while external debt
denotes to loans floated outside the country. Public debt may be categorized as:
In 2013, govt debt to GDP was 67.72% of the India's GDP. It was around 73.97% from 1991 till 2013,
attaining an all-time high of 84.30% in 2003 & as low as 66.60% in 2012. Government debt to GDP
in India is reported by Ministry of Finance, GOI.
In 2011, India had 44th position in the world, having 55.9% of GDP as public debt. Japan had the
maximum public debt at 225.8% of GDP.
The chief reason for rise in internal public debt in India has been increasing necessity of funds for
financing various developmental programmes as both tax & non-tax revenues have been
insufficient to finance government expenditure.
The external public debt in India has increased significantly as it is instrumental in providing
funds to make import payments and solve balance of payment problems.
There is also a problem of Debt Trap as certain countries borrow heavily from external sources.
Quite often, these funds are utilised for non-development and unproductive purposes. Every so
often, countries which are highly indebted borrow funds to repay its earlier debts. These heavy
borrowings to repay earlier debts put already highly indebted countries in an external debt trap.
Counties affected by 2010 crisis are European nations such as Portugal, Italy, Spain and Ireland.
Also, Dubai debt crisis did have an effect on International community.
The paying off the external debt puts a liability on foreign exchange reserves of a nation.
International crisis, often lead to a contagion (spreading) effect. This means, if one country is
affected, the other countries are also affected. Internal debt is considered less burdensome as
compared to external debt.
FISCAL REFORMS
One of the primary objectives of fiscal policy in the post-independence years was stimulating and
accelerating growth. In a newly emerging economy due to low income levels and financial
savings, the fiscal policy was given the responsibility of creating the capital base for
infrastructure building and stimulating growth. As India embarked on a planning process since
1950 which assigned a large role to the public sector, taxation was the main instrument used to
raise funds for planned development.
In 1970s the taxation and expenditure polices aimed at achieving the twin objectives of equity
and social justice. However a regime of high marginal tax rates did not yield the necessary
revenue to support the required public expenditure. The government action of administered
pricing also did not yield desired results.
So, by 1980s public finance was in a state of disarray. It seemed that the fiscal pattern was
destabilizing the relationship between the economy and budget, thereby resulting in persistently
increasing huge deficits. The decade of 1980s was considered as a decade of fiscal deterioration,
also raising the pertinent question of sustainability of fiscal stance of the Government.
The fiscal issues of 1980s also had an impact on the external sector resulting in the
macroeconomic crisis of 1991. The economy was facing a large size monetized deficit which was
exerting immense inflationary pressures. Also a persistent and burgeoning revenue deficit
increased debt burden and reduced the availability of resources for capital investment.
The structural adjustment programme and the consequent economic reforms gave a fresh
dimension to fiscal policy which focused not only on the various instruments and issues of debt,
but also on the overall fiscal sustainability in the long run. Although the first half of the 1990s
witnessed some fiscal correction, its retraction during the second half of the decade underlined
the need for a consistent and sustainable fiscal consolidation process
Phase I: 1947 to 1968
The fiscal policy in the post-independence era focused on the taxation policy to achieve various
economic objectives. To promote employment, tax incentives and tax holidays were granted to
new investment ventures; inequality was aimed to be reduced through progressive taxes on
income and wealth; emphasis was given to increasing import duties to reduce pressure on balance
of payments; and tax rebate in excise duties on consumption goods were introduced to stabilize
prices. As initially there was a narrow tax base, the tax policy had to rely mainly on indirect
taxes.
Phase II: 1969 to 1980
In the IInd phase, fiscal policy was used as a means to reduce income inequality, along with
promoting economic growth. The main instrument to achieve this objective was taxation. So the
Government raised the income tax rates by substantially high levels during the 1970s. Marginal
rate of taxation was moved up to 97 per cent and, together with the incidence of wealth tax,
crossed 100 per cent. Wealth tax, estate duty and gift tax were also imposed. Indirect taxes were
increased on goods considered luxuries or inessential. These initiatives were taken to meet the
government objective of alleviating poverty and bring about social justice.
Phase III: 1981 to 1990
At the beginning of the IIIrd phase the economic situation was characterized by low economic
growth, high inflation and deteriorating balance of payments as a result of a sharp increase in
price of crude oil imports. The Government sought to reduce its deficit through tax increases.
New tax savings instruments were introduced to enable financing of the large plan expenditure.
Tax concessions were also given to non-residents to encourage flow of foreign exchange
remittances to address the balance of payments problem. Customs duties were hiked to contain
growth in imports, augment revenue and protect the domestic industry. A modified system of
Value Added Tax (MODVAT) was introduced in 1986 in a phased manner to reduce the
distortionary effect of tax on production, and minimize tax cascading. Reforms in customs duty
focused on increased reliance on tariff system rather than on quantitative restrictions to regulate
imports in order to yield more revenue. This phase marked the first real effort towards a long-
term perspective for tax reform.
Phase IV: 1991 onwards
The focus of tax reforms before 1991 was on enhancing revenue productivity to finance large
developmental plans and promoting equity. The reforms since 1991were aimed ataugmenting
revenues. Efforts were made to resolve issues in the tax structure through restructuring,
simplification and rationalization of both direct and indirect taxes. These were based on Chelliah
Committee report recommendations. The key tax reforms included:
lowering the maximum marginal rate on personal income tax
widening of the tax base by way of a series of steps including introduction of presumptive
taxes
adoption of a set of six economic criteria for identification of potential tax payers in urban
areas and taxation of services
reducing the corporate tax rate on both domestic and foreign companies
unification of tax rates on closely held as well as widely held domestic companies
rationalization of capital gains tax and dividend tax
progressive reduction in the peak rate of customs duty on nonagricultural products and
rationalization of excise duties
Various steps that were initiated by policy makers to achieve the objectives of LTFP included:
Simplification of income tax and brining stability in tax regulations
Identifying new areas of taxation to expand the tax base
Bringing transparency in budget framing
Introduction of MODVAT
Merging several excise duties into a single basic duty for ease in functioning
Reducing tariff in order to promote international competitiveness
Abolition of surcharge on profits
Improvement in tax administration and effective implementation
Debt Reforms
Governments obtain money by incurring public debt when they raise public loans. Such
loans can be raised internally as domestic debt or externally as foreign debt.
Internal borrowings of Government are mainly required to meet budgetary deficit.
External borrowings assist in meeting deficit in balance of payments.
Public loans may be raised for short, medium or long terms to meet an economy’s
requirements of development. Long-term borrowing by a government are justified when
gains of a capital project undertaken by it are likely to be reaped in the long run i.e. by
more than one generation of taxpayers. The financing of such projects should place the
repayment burden on present as also the future generations. If long-term capital projects
are financed from current revenues or short-term borrowings, future generations would
enjoy free riding. Thus, it is fair and efficient, that projects with long-term benefits are
financed through long-term borrowings.
The mounting debt and debt-servicing liabilities of States have garnered considerable
attention in recent years. The non-Plan revenue gap of States is looked after by Finance
Commission while Planning Commission takes care of the Plan gap, both on revenue and
capital accounts. Some disturbing features of debt profile of States and its management
are:
diverting borrowed funds to meet revenue expenditure
using loans in unproductive enterprises, or enterprises while being productive
show signs of poor performance, and currently yield low or negative returns
lack of provisions for depreciation or amortization funds Debt-related relief to the States
may be provided in various forms, such as writeoffs, rescheduling of the loans to shift the
timing of repayments, consolidation of past loans on common terms, and reduction of interest
rate.