Fiscal Consolidation | Economics Optional Notes for UPSC PDF Download

Introduction

Fiscal consolidation entails governmental measures, both at the national and subnational levels, with the objective of diminishing deficits and curbing the accumulation of debt. The outcome is an enhancement of the government's fiscal well-being, manifested by a reduced budget deficit. Vital components of fiscal consolidation encompass improving the collection of tax revenue and ensuring disciplined expenditure, leading to a more controllable budget imbalance. The guidelines for fiscal consolidation are delineated in financial criteria that must be satisfied in successive budgets, serving as the blueprint for the central government's fiscal strategy. In the context of India, the Fiscal Responsibility and Budget Management (FRBM) Act articulates the nation's goals for fiscal consolidation.

Strengthening India’s Budgetary Position

• The economic gains facilitated by India's early 1990s reforms were not sustainable over an extended period. By the year 2000, the combined budget deficit of the central and state governments had nearly surpassed the levels observed in 1991, coinciding with a severe financial crisis in India.
• The challenge of managing escalating debt was also becoming increasingly prominent. In December 2000, under the leadership of Atal Bihari Vajpayee, the Indian government introduced the Fiscal Responsibility and Budget Management (FRBM) Bill in Parliament. The aim was to establish institutional support through fiscal laws to delineate a future agenda for fiscal consolidation.

The government's initiatives, both in revenue generation and expenditure control, to achieve fiscal consolidation are outlined below:

• Precisely targeting government subsidies, with an expanded implementation of the Direct Benefit Transfer scheme to encompass additional subsidies.
• Enhancing tax administration efficiency by addressing issues such as reducing tax evasion, increasing tax compliance, and minimizing tax avoidance.
• Boosting tax revenues by broadening the tax base, eliminating tax concessions and exemptions, and improving the tax-to-GDP ratio.
• Fostering increased economic growth, which will contribute to the government's ability to collect more tax revenue.
• Given the limitations on reducing government spending in India, the imperative for accomplishing fiscal consolidation lies in augmenting tax revenue.

The Development of India’s Fiscal Consolidation Policy

• In the fiscal year 2000–01, the Ministry of Finance introduced the Medium-Term Fiscal Reform Programs (MTFRPs) with the aim of conserving resources and enhancing the management of tax administration.
• Although the MTFRPs were intended to achieve their objectives, they ended up exacerbating the fiscal position. In 2000, the Eleventh Finance Commission (EFC) established the Budgetary Reform Facility (BRF) as a means of fiscal adjustment. This initiative involved allocating a 15% grant to governments in exchange for improved fiscal performance.
• To enhance fiscal control, the Twelfth Finance Commission (TWFC) recommended a debt write-off mechanism for states and proposed the enactment of fiscal responsibility statutes in each state to reduce both revenue and budget deficits. The Thirteenth Finance Commission further suggested two consistent debt-relief measures for all states: a 9% interest rate on loans from the National Small Savings Fund (NSSF) and the write-off of debts owed by the federal government to states.
• In response to macroeconomic demands for immediate implementation of statutory limits on the central government's borrowings, debt, and deficits, the Indian government passed the Fiscal Responsibility and Budget Management (FRBM) Act in 2003.

What are the three instruments of Fiscal Policy?

The term 'fiscal,' an abbreviation for 'budget,' pertains to the government's financial plan. Consequently, fiscal policy involves utilizing government spending, taxes, and transfers to shape aggregate demand and, consequently, India's real Gross Domestic Product (GDP).

• Government Expenditure: Government spending holds the potential to impact economic production, encompassing the purchase of goods and services for the community's benefit. This expenditure is categorized as Government Final Consumption Expenditure. Additionally, Gross Capital Creation represents government investment in research and infrastructure for future benefits, while transfer payments include government disbursements to individuals through social welfare programs, student subsidies, and Social Security.
• Taxes: Alterations in taxation affect average consumer income, and shifts in consumption influence real GDP. Consequently, the government can steer economic output by modifying taxation, with various methods available for changing taxes.
• Fiscal Discipline: Fiscal discipline in an economy refers to maintaining an optimal balance between government revenues and expenditures. Failure to uphold fiscal discipline may lead to government spending surpassing earnings, prompting the government to borrow money from the central bank or finance the deficit. This scenario could result in currency depreciation and inflation in the economy.

About the Fiscal Responsibility and Budget Management (FRBM) Act

• The Fiscal Responsibility and Budget Management Act (FRBM) establishes a framework for fiscal accountability and management. It mandates lowering the fiscal deficit at the federal level to 3% of GDP at the end of each year, with a reduction of the revenue shortfall by 0.5 percent of GDP or more. State governments have committed to similar goals, aiming to reduce the budget deficit to 3% of GDP by 2013–14 and eliminate revenue deficits. 
• The FRBM Act compels the central government to disclose any changes in accounting standards, rules, or procedures to ensure transparency. Annually, the government must announce medium-term fiscal policy, the macroeconomic framework, and the fiscal policy plan, along with presenting Union Budget documents in Parliament. The act includes an exception provision allowing deviation from predetermined fiscal targets in the event of unforeseen occurrences like internal turmoil or natural disasters.

Recommendations from the 15th Finance Commission on Fiscal Consolidation

• The central government is advised to decrease its fiscal deficit to 4% of GDP by 2025-26, a reduction from the 6.8% recorded in FY22. State government fiscal deficits are suggested to be 4% of GDP in 2021-22, followed by 3.5% the subsequent year and maintained at 3% for the next three years.
• Borrowing limits for state governments should be set at 4% of GDP in 2021-22, 3.5% in 2022-23, and 3% from 2023-24 through 2025-26. If states meet the criteria for power sector reforms, they may be allowed additional borrowing of 0.5% of Gross State Domestic Product (GSDP). Additionally, all centrally sponsored initiatives must undergo third-party evaluations within a stipulated time frame.

Fiscal Consolidation and Growth

• As per the National Statistical Office's initial projections, real GDP is expected to reach INR 147.5 lakh crore by the end of 2021-22, a marginal increase from INR 145.7 lakh crore in 2019-20. India has witnessed two years of economic growth eroded by the impact of three COVID-19 waves. Preliminary estimates indicate that Gross Fixed Capital Formation (GFCF) as a percentage of GDP in 2021-22 will be 29.6%. 
• Capacity utilization in India remains low, and Private Final Consumption Expenditure (PFCE) is anticipated to grow modestly at 6.9% in 2021-22. Constraints on demand growth persist due to low-income growth in sectors with a high Marginal Propensity to spend (MPS), including trade and transportation, as well as the Micro, Small, and Medium Enterprise (MSME) sector. Therefore, a cautious estimate of real GDP growth in the range of 6% to 7% is deemed prudent. In 2022-23, growth may be impeded by supply-side bottlenecks and elevated global crude and primary product prices. The trajectory of growth will be influenced by fundamental drivers such as the economy's saving and investment rates in 2022-23.
• Extending the period for GST compensation is crucial to prevent a significant income shock in specific states, including Tamil Nadu, Kerala, and Andhra Pradesh, when the current provision expires in June 2022. The GST Council should carefully consider this scenario and, if necessary, modify and extend the compensation arrangement for an additional two years.
• In addition, there is a potential to increase non-tax revenue by expanding the National Monetization Pipeline (NMP) to include the monetization of government-owned land assets. There is a need to expedite disinvestment efforts. For the fiscal year 2022-23, the emphasis should be on restoring consumer and investment demand when determining spending priorities.
• Urban Employment Guarantee: Given the persistent weakness in consumer demand, there is a need for fiscal support in the form of an urban counterpart to the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA).
• The Fifteenth Finance Commission has recommended a fiscal consolidation path for 2022-23, proposing a budget deficit of 5.5 percent of Gross Domestic Product (GDP) for the Centre. The Union Government should aim to reduce the fiscal deficit, targeting a decrease from 6.8% in FY22 to 4% of GDP by 2025-26. State governments should collaborate in this effort, working towards reducing their fiscal deficits to 3.5% in the short term and eventually reaching 3% after FY22. Maintaining fiscal discipline, state credit limits should be set at 4% of GDP in 2021-22, reduced to 3.5% in 2022-23, and further decreased to 3% from 2023-24 to 2025-26. To incentivize energy sector reforms, an additional borrowing of 0.5% of the Gross State Domestic Product (GSDP) could be permitted. All centrally funded initiatives must undergo third-party verification within a specified timeframe, as mandated by law.

Importance of Fiscal Consolidation

The Indian government has implemented significant measures for fiscal consolidation, including:

• Enhancing Tax Administration Efficiency: The government aims to combat tax evasion, increase tax compliance, and reduce tax avoidance to enhance tax administration efficiency.
• Addressing Fiscal Deficit: Managing debt is essential to secure additional resources for capital and revenue expenditures. Uncontrolled budget deficits can negatively impact long-term economic growth.
• Increasing the Tax-to-GDP Ratio: To boost tax revenues, the government focuses on expanding the tax base, reducing tax breaks and exemptions, and increasing the tax-to-GDP ratio.