Not too strict, not too loose – keeping fiscal rules on target

Published on Monday, 08 January 2018

Published by Bruno Carrasco and Çiğdem Akın on Monday, 08 January 2018

India adopted the Fiscal Responsibility and Budget Management Act in 2003.
India adopted the Fiscal Responsibility and Budget Management Act in 2003.

One of the most important pieces of any country’s macroeconomic policy framework is the law governing fiscal rules and budget management. This law is typically presented as a numerical ceiling on a budget aggregate, often as a limit on fiscal deficit, public debt, or expenditure.

Last year, ADB was invited by a task force from the Government of India to make recommendations to improve the effectiveness of the country’s Fiscal Responsibility and Budget Management (FRBM) Act, adopted in 2003.

Over 80 countries have adopted FRBM legislation since the 1980s. Originally concentrated in advanced economies, there has been a rapid adoption of fiscal rules legislation across emerging markets, and throughout Asia and the Pacific.

There are many advantages to adopting fiscal rules. By anchoring them in legislation, they remove the temptation of governments to ride the political cycle and spend (or cut taxes) in the run-up to elections.

  Fiscal rules can be ineffective if they are not well designed

In addition, by setting targets that are transparent and easy to understand, fiscal rules help anchor fiscal policy, support macroeconomic stabilization over the short term, and debt sustainability over the medium term. They also provide greater predictability on interest rate and its movements, an important contributing factor to investment.

However, fiscal rules can be ineffective if they are not well designed. For instance, when governments undertake fiscal consolidation to meet a fiscal deficit target, it is often done at the expense of reducing less politically sensitive capital spending rather than current spending – even if this undermines capital asset formation and GDP growth over the long term.

A clear shortcoming in fiscal rules, including India’s FRBM legislation, is that fiscal deficit targets tend to result in pro-cyclical fiscal outcomes. Economic downturns are then amplified by contractionary fiscal measures—typically associated with weaker expenditures traced to lower revenue collection and cutting spending—to meet the deficit targets instead of expansionary spending and/or lower taxes to stimulate the economy. This is common in emerging countries, where tax collection is relatively low (less than 15% of GDP).

Making fiscal policy more effective

ADB’s research to strengthen India’s fiscal rules under the FRBM Act came up with several recommendations based on international best practices.

To address the procyclicality challenge, countries can adopt multiple fiscal rules, particularly counter-cyclical expenditure policies consistent with stable debt targets, rather than relying on a single fixed fiscal deficit target. This gives the flexibility to accommodate economic shocks through expansionary spending during downturns.

Reorienting the government budget to capital spending—as ADB has supported in various Indian states—helps attain fiscal sustainability. As a golden rule, borrowing should be limited to growth-enhancing capital spending, and current expenditures should be streamlined to maintain a current account balance.

The recommendations based on economic simulations suggest that if India were to increase its capital spending from 4% of GDP to 5% by rationalizing and reorienting current expenditures, among them subsidies, within a prudent fiscal position, these budget savings could spur faster economic growth that would in turn reduce the country’s fiscal deficit and its debt-to-GDP ratio. India’s capital spending is below that of similar Asian economies, so there is significant potential in this area.

  Fiscal councils help make fiscal rules credible

To make fiscal policy more effective, countries should also closely link their fiscal policy targets (top-down approach) and budget operations (bottom-up approach), with a clear articulation of fiscal responsibilities across tiers of government. For example, in our ongoing ADB programs in states of Punjab and West Bengal in India, besides supporting measures to reorient budget to capital spending, we map the various components of the budgeting cycle and propose measures to better align fiscal policy with budget management and implementation.

Proper alignment reduces the risk of misallocation of public resources, deviations between planned and actual budget spending, and missing public sector targets. In this regard, reliable reporting of expenditures, revenues, and quasi-fiscal activities such as contingent liabilities is also crucial to provide an objective picture of fiscal risks when monitoring stability. These systems should be strengthened for effective implementation of fiscal policy.

Finally, creating autonomous institutions like fiscal councils, which effectively monitor and enforce compliance with fiscal rules and are accountable to parliament, can help make the rules credible in the eyes of the public.

The prevalence of fiscal councils has been on the rise globally, and ADB recommends establishing one in India under the FRBM Act. Besides, introducing credit ratings at the sub-national or state level in India would also foster fiscal discipline.