This post seeks to initiate a discussion for the formulation of a fiscal framework that could govern fiscal management by state governments in India. This would consist of a set of rules on fiscal rectitude and also outline a mechanism for its enforcement.
The constitution of India defines India as a federal system. It has defined certain domains where the state and central governments respectively exercise sovereignty and certain others which are concurrently administered. The state governments are responsible for managing their respective finances.
The issue of fiscal prudence among governments has been a recurrent concern in public finance debates. There have been several efforts over the years to institutionalize the addressing of fiscal imbalances. The most important of which has been the Fiscal Responsibility and Budget Management (FRBM) Act 2003 which enshrined a fiscal deficit limit of 3% of economic output for both central and state governments. However, its performance has been mixed.
The Covid 19 pandemic has had the effect of upending the fiscal balances of state and central governments. The fiscal consolidation requirement from the devastation caused by the once-in-a-century event presents an opportunity to examine the fiscal framework afresh and develop a compact that not only addresses fiscal stability but also the quality of expenditures.
The compact should consist of budget balance rules, debt rules, expenditure rules, and revenue rules. The enforcement mechanism could range from softer approaches like moral suasion and market restraints to hard approaches like legislative constraints. But it's important that the hard approaches emerge through a consultative process and consensus, on the lines that marked the landmark Goods and Services Tax.
What has been the global experience with fiscal rules? What parameters should be included in the fiscal compact? How might this compact be operationalized?
There are several examples of fiscal rules that are followed by national economies. The focus here is on fiscal rules that govern sub-national governments. In this context, in terms of the nature of their operationalisation, there are two broad types of fiscal rules – top-down and bottom-up approaches. These fiscal rules have generally focused on the flow and stock of debts, as captured by the budget deficit and the public debt.
A good example of a top-down fiscal compact is that enshrined in the European Union’s Stability and Growth Pact 1997 and Treaty on Stability, Coordination and Governance 2012. Broadly, this fiscal compact has the following Rules:
a. The fiscal deficit is to not exceed 3% of GDP.
b. The government debt to GDP ratio is benchmarked to be less than 60%.
c. A pathway for rapid convergence to a balanced budget with a structural deficit of 0.5-1% of GSP, an automatic correction mechanism, and a mechanism for enforcement
In fact, the EU Fiscal Compact has been encoded into the respective national laws, including provision for fines in case of deviations from its Rules. And adherence to the fiscal rules is a condition for accessing any assistance under the European Stability Mechanism (ESM).
The Switzerland cantons and US states are other commonly cited examples of federal and sub-federal fiscal rules, which however follow the bottom-up approach. In the US, the federal government exercises limited control over the fiscal policies of state governments. Most states have budgetary constraints, or ‘golden rules’ written into their constitutions prohibiting the government from running their budget at a deficit. Interestingly, in the US, the constraints in the state constitutions were not necessitated by any federal law but emerged from their independent realisation of having to ensure access to the financial markets.
This also has a historical basis. Since the mid-nineteenth century, the federal governments in the US have refused to bail out states facing financial collapse and have laid the responsibility of debt service fully on the defaulting states. This has “set an enduring precedent and created a strong incentive for each state to ensure sustainable budgetary policies”.
In other words, the fiscal compact in the US federal system emerged bottom-up. Currently, 35 US states have constitutional balanced budget requirements, and fourteen have statutory or de facto obligations to ensure a balanced budget.
The contrasting approaches towards a fiscal compact adopted by the EU and US are instructive. A monetary and political union (the US) has preferred the bottom-up approach, whereas the nascent monetary union adopted the top-down approach.
So what are the contours of a fiscal compact proposal for India?
As mentioned earlier, a good fiscal compact should seek to target both fiscal stability and the quality of expenditures. Given this, a possible set of parameters could be as follows:
Fiscal stability parameters
Structural deficit (or average fiscal deficit over 5 years) or fiscal deficit
Primary balance (or revenue balance)
Public debt to GSDP ratio (including all off-balance sheet liabilities)
Quality of expenditure parameters
Revenue expenditure as a share of the state's own revenues
Salaries and pension expenses as a share of revenue expenditure
Pensions as a share of total HR expenditure
Capital expenditure as a share of total expenditure
These are purely illustrative and aimed at starting a debate. A guidance value in the form of a threshold or a band for each parameter could be defined that provides the benchmark for state governments to target.
We can choose other parameters too. The individual parameters should be supplemented with an index (even if imperfect) that allows for comparison across governments.
How to operationalise this fiscal compact?
Given its sensitive nature, especially considering the current circumstances, state governments would be wary of any efforts by the centre to constrain their fiscal freedom. Any efforts would be seen as attempts to squeeze the state government finances and thereby constrain their fiscal autonomy.
It’s therefore essential that any attempt in this direction be done with the greatest sensitivity, without giving the impression that it’s being enforced top-down. Instead, it should emerge through a process of opinion consolidation from public debates and extensive consultations and consensus building by the central government with the state governments.
The Indian fiscal compact should combine features of the bottom-up US system and the top-down EU Stability and Growth Pact. Besides, it should combine both the soft and hard approaches, with the latter being gradually phased in. The process is important.
Accordingly, instead of directly hard coding the parameters of the fiscal compact into legislation, we could start with something which serves as a guidance framework. The Economic Survey, for example, could surface this issue for debate (not in terms of naming and shaming states, but pointing to possible benchmarks for important relevant parameters). The Ministry of Finance and the RBI could publish working papers on a fiscal framework for the state and center. The NITI Aayog could bring together officials concerned from all states to prepare a fiscal compact through a consultative process. In fact, these are not mutually exclusive and could all be done simultaneously.
This should be complemented with a simple data reporting and disclosure system aimed at ushering in greater transparency about the state government’s finances. The RBI, as G-Sec market regulator, could mandate both state and central governments to disclose certain information with defined periodicity. We could start with the CAG audited accounts that come with a two-year lag.
While these parameters are already in the public domain in some form or other, there are at least three problems. One, they should be standardised. So for example, pensions and salaries reported by many states do not include the wages of contract and outsourcing employees. Or public debt excludes the off-balance sheet figures and guarantees are not captured. Two, the information is not consolidated in one place and presented in a manner that allows for easy comparison across states. Say, a Fiscal Monitor of public finance. While there are various reports that occasionally compile them, they are both one-off and suffer from the first problem. Three, and most importantly, there is no guidance standard to evaluate the performance on each of these parameters. What's a desirable benchmark for capital expenditures as a share of total expenditure?
If we are able to address these three problems and make this information available, it would expose state government’s finances to greater public and market scrutiny. There would be some form of pressure on lagging state governments to reform. Over time the bond markets would start to price state government bonds more accurately based on their risk profiles. It would help differentiate among state government bonds and reflect in their G-Sec spreads. These parameters should also reflect in the lending decisions of development finance institutions like PFC, REC, and HUDCO.
The disclosure should also include the actual outcomes against the commitments made in the three-year Medium-Term Fiscal Policy Frameworks (MTF) presented in state and central government budgets. The MTF covers a set of fiscal parameters and informs the stakeholders about the balance between revenue receipts and expenditures and how capital receipts are being deployed. The track record of adherence to its MTF commitments is a good indicator of the commitment to fiscal stability and the general credibility of a government.
Once stakeholder consultations have been initiated and some information disclosures started, the fiscal compact could be discussed in a forum like the Inter-State Council. The central government could consider convening a Council meeting exclusively to discuss this issue. A sub-committee of the ISC could be entrusted with the responsibility of examining the outputs from various consultations, discussing with experts, and coming up with a set of recommendations. A mutually accepted fiscal compact could be formulated based on these recommendations.
All the while, the central government should strive to build confidence about its intentions and foster consensus among states about the compact. This process could borrow from the consensus-building approach followed by the remarkably successful GST Act.
In due course, the GoI could gently introduce these parameters as entry-level conditions to access assistance like the 50-year loan or additional borrowings (some of it is already being done). There are precedents in so far as the central government has for long mandated sector-specific reform conditionalities to access assistance under CSS programs in the urban, power, etc sectors. Besides the Finance Commission transfers too include such conditionalities. However, there are very few examples of overall macroeconomic management conditionalities being part of any central government support.
Formulating and institutionalising a fiscal compact is a very important long-term requirement. No government, anywhere in the world, likes to place fetters on itself, especially on its expenditures. Accordingly, fiscal rules have generally targeted one or two headline fiscal parameters and have had mixed success in realisation of their desired objectives.
In the aftermath of the pandemic, we have an opportunity to formulate a fiscal compact for India that targets both the sustainability and the quality of fiscal spending by the state and central governments. However, given the federal nature of the Indian polity, it's important that this process involve consultations with the state governments and the compact should be seen as emerging directly from this process. The process is critical, and the central government should go the extra length to build consensus, even if some states don't reciprocate.
It may also be useful to adopt a multi-track and phased approach that starts with extensive stakeholder consultations, information disclosures, and surveillance systems. Moral suasion and market dynamics should become the primary means to enforce accountability among states on the fiscal compact. It may be prudent to introduce mandatory requirements and legislative constraints only after consensus starts to emerge.
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