Fiscal Consolidation: Strengthening Government Finances

Definition:

• Fiscal consolidation entails strengthening government finances, aiming to reduce annual borrowings and historical cumulative public debt.

Importance of Fiscal Consolidation:

1. Macroeconomic Stability:
• Provides macroeconomic stability to the economy.
2. Cutting Wasteful Expenditure:
• Involves cutting wasteful expenditure, optimizing resource utilization.
3. Increased Spending on Infrastructure and Social Sectors:
• Enables the government to allocate more funds to infrastructure and social sectors.

Strategies for Fiscal Consolidation:

1. Tax Reforms:
• Implementation of tax reforms, including:
• GST implementation.
• Corporate tax reform.
• Abolition of wealth tax.
• Reforms in capital gains tax.
• Rationalization of tax exemptions.
• Improving the efficiency of tax collection.
2. Capital Receipts Enhancement:
• Boosting capital side receipts through disinvestment and privatization.
3. Expenditure Side Reforms:
• Rationalizing subsidies through digital technologies and Aadhaar.
• Cutting non-essential and unproductive activities, schemes, and projects.
• Allocating resources to priority areas.
• Reducing the cost of services.
• Rationalizing subsidies.
• Reducing time and cost overruns on projects.
• Ensuring proper outcomes from outputs.

Guiding Principles for Fiscal Consolidation:

• Emphasizes that reducing fiscal deficit should not lead to a reduction in capital expenditure.
• Advocates achieving fiscal consolidation through higher revenue realization and rationalizing revenue expenditure.
• Recommends applying austerity measures to cut down on administrative waste.

Recent Reforms in India:

• India's recent fiscal consolidation efforts include:
• Implementation of GST.
• Corporate tax reforms.
• Disinvestment and privatization initiatives.
• Subsidy rationalization through digital technologies and Aadhaar.
• Efficient allocation of resources to priority areas.

Role of FRBM Act:

• The enactment of the FRBM Act provides an institutional framework, binding the government to adopt prudent fiscal policies.

Balancing Budgets:

• Fiscal consolidation necessitates both the central and state governments to work towards balancing their budgets.

Overall Goals of Fiscal Consolidation:

• Macro stability, reduced wasteful spending, and increased allocation to crucial sectors define the overarching goals of fiscal consolidation.

N.K. Singh Review Committee on FRBM: Recommendations

In 2016, a five-member FRBM Review Committee, led by Shri N.K. Singh, was established with the following Terms of Reference (ToR):

• Conduct a comprehensive review of the existing FRBM Act.
• Consider contemporary changes, past outcomes, global economic developments, and best international practices.
• Recommend a future fiscal framework and roadmap for the country.

Key Recommendations of the Committee:

1. Creation of a Fiscal Council:
• Proposed the establishment of a new Fiscal Council responsible for preparing multi-year fiscal forecasts for the central and state governments (referred to as the general government).
• The Fiscal Council would provide an independent assessment of the central government's fiscal performance and compliance with targets set under the new law.
2. Debt to GDP Ratio:
• Advocated a gradual reduction of the debt-to-GDP ratio from the existing level of 68% to 60%, comprising 40% for the Centre and 20% for the States.
3. Fiscal Deficit as the Key Operational Target:
• Recommended adopting fiscal deficit as the key operational target, setting it at 3% of GDP for three years (2017-18 to 2019-20).
• Prescribed a glide path for steady progress towards these targets.
• Suggested flexibility in deficit targets, allowing adjustments downward during periods of strong economic growth and upward during economic downturns.
4. Deviation in Fiscal Deficit Target:
• Specified permissible deviations in the fiscal deficit target in the event of unforeseen events, such as war, calamities, collapse of agricultural activity, structural reforms, and a sharp decline in real output growth.
• Allowed a deviation of not more than 0.5 percentage points.
5. Formal Consultations for Deviations:
• Mandated that in case of any deviations, the Centre should engage in formal consultations with the three members of the Fiscal Council.

These recommendations aimed to provide a robust fiscal framework, balancing the need for fiscal discipline with the flexibility to address unforeseen economic challenges. The proposed Fiscal Council would play a crucial role in ensuring transparency and accountability in fiscal management.

Crowding Out:

Definition: Crowding out refers to a phenomenon in economics where increased government spending and borrowing lead to reduced private sector investment, primarily due to higher interest rates and reduced liquidity in the financial markets.

Key Points:

1. Mechanism:
• When the government increases its borrowing to fund expenditures, it competes with the private sector for available funds in the financial markets.
• This increased demand for funds tends to raise interest rates as lenders seek higher returns for the increased perceived risk.
2. Effect on Private Investment:
• Higher interest rates make borrowing more expensive for businesses and individuals.
• As a result, private investment may decline because businesses are discouraged from taking loans or investing in new projects.
3. Impact on Economic Growth:
• Crowding out can lead to a slowdown in economic growth because reduced private investment affects productivity, job creation, and overall economic activity.
4. Resource Allocation Concerns:
• Critics argue that excessive government borrowing may not always be utilized efficiently, with funds being allocated to less productive or even populist projects.
5. Counterpoint: Crowding In:
• In some cases, if government spending is directed towards productive investments such as infrastructure projects, it can have a "crowding-in" effect.
• Productive government spending may stimulate private sector investment, job creation, and economic growth.

Example:

• If the government embarks on a large infrastructure project, like building highways under a program such as Bharatmala, it can potentially boost economic activity. The increased demand for labor, raw materials, and services can positively impact various sectors of the economy.

Conclusion: Crowding out is a complex economic phenomenon with both potential drawbacks and benefits. While it can hinder private sector investment, the impact depends on how efficiently the government utilizes borrowed funds and whether the spending contributes to long-term economic growth.