Fiscal Responsibility and Budget Management (FRBM) Act

About:

The FRBM Act 2003 in its amended form was passed by the government to bring fiscal discipline and to implement a prudent fiscal policy. High fiscal deficit was the one major macroeconomic problem faced by Indian economy around 2000. It was argued that high deficits lead to inflation, reduces consumption, result in a crowding out of the private sector investment, rising unemployment and falling living standards of the people. Thus arose a need to institutionalize a new fiscal discipline framework.

Why was the FRBM Act enacted?

In India, the borrowing levels were very high in the 1990s and 2000s. Indian Economy was weak as it had high Fiscal Deficit, high Revenue Deficit, and high Debt-to-GDP ratio.

By 2003, the continuous government borrowing and the resultant debt had severely impacted the health of the Indian economy. Much of the borrowing was utilized for interest payments of previous borrowings, but not for productive-purposes. This resulted in interest payments becoming the largest expenditure item of the government.

Many economists then warned the government that this condition is not sustainable. They advised legal steps to prevent India to fall into a debt-trap.

Parliamentarians of India too felt that there should be control on the government of India not to resort to a high level of borrowing to fund its expenditure. Hence in 2000, they introduced a bill to bring responsibility and discipline in matters of expenditure and debt. This bill was passed by the Indian Parliament in 2003 and came to be known as the Fiscal Responsibility and Budget Management Act.

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.

Features of FRBM Act:

• The revenue deficit should be reduced to an amount equivalent by 0.5% or more of GDP every year, beginning with the financial year 2004-05 and eliminate revenue  deficit by March, 2009, 
• The fiscal deficit should be reduced by 0.3% or more of the GDP every year, beginning with the financial year 2004-05and bringing it down to 3% of GDP by March 2009.
• The Central Government should not provide guarantees in excess of 0.5% of GDP in any financial year, beginning with 2004-05
• The Central Government should not assume additional liabilities in excess of 9% of GDP for financial year 2004-05 and progressive reduction of this limit by at least 1 % point of GDP in each subsequent year
• The RBI should not subscribe to primary issues of Central Government securities from the year 2006-07.
• The Finance Minister to make a quarterly review of trends in receipts and expenditure in relation to budget and place the outcome of such reviews before both the Houses of Parliament.
• The Central Government should specify four fiscal indicators- Fiscal deficit as a percentage of GDP; Revenue deficit as a percentage of GDP; Tax revenue as a percentage of GDP; Total outstanding liabilities as percentage of GDP.
• The Central Government should place in each financial year before houses of Parliament three statements-Medium Term Fiscal Policy Statement; Fiscal policy strategy statement; Macro-economic Framework statement along with Annual Financial Statement and Demands for grants.
• The FRBM Act States that the Central Government shall not borrow from RBI except by way of means and advances to meet temporary excess of cash disbursements over cash receipts.
• The revenue and fiscal deficit may exceed the targets specified in Rules only on grounds of national security or national calamity or such other exceptional grounds as the Central Government may specify

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.

FRBM- The Impact and Limitations

       A.  Impact on deficits

FRBM act has been violated more than adhered to since its enactment.

•  Since its enactment, the act has been paused for four times including a reset of the fiscal deficit target in 2008-09 following the global financial crisis.

•  In 2010-11, Government replaced revenue deficit with the concept of Effective Revenue Deficit in the budget documents. 

•   In Budget 2012-13, the finance act changed the FRBM act and it brought in a new commitment of eliminating the effective revenue deficit. The amended rules extended the time for elimination of Effective revenue deficit by March 2015 and bringing down fiscal deficit to 3% by March 2017.

•   The Act has helped on the issues relating to fiscal consolidation due to the mandatory medium-term and strategy statements which are required to be presented annually before Parliament. 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.

       B. Impact on development

Has the law been successful to ensure that the growth momentum is maintained, without either significantly fueling inflation or curtailing socio-economic welfare expenditure?

•  While we notice a drastic fall in deficits, it has largely been on account of reductions in critical sectors of the economy.The Union Government’s development expenditure as proportion of GDP declined in the post FRBM era from 7.49% in 2002-03 to 6.42 % in 2005-06.

•  An analysis of revenue account of the development expenditure by states shows that in almost all sectors there has been a decline in the post FRBM era. In case of education, it declined from around 2.5 % of GDP in 2002-03 to less than 2.2 % of GDP in 2005-06. In Health sector, the decline has been from 0.6% to 0.49 % and in agriculture, from 0.67 % to 0.58 %. In overall Social sectors, it declined from 4.5 %of GDP to 4.16 % of GDP during the period.

Thus the act and its rules are adverse to social sector expenditure necessary to create productive assets and general upliftment of rural poor of India.

       C. Impact on credit growth

Further the FRBM Act ignores the possible inverse link between fiscal deficit (fiscal expansion) and bank credit (monetary expansion). That is, if credit growth falls, fiscal deficit may need to rise and if credit rises, fiscal deficit ought to fall — to ensure adequate money supply to the economy. 

•  Data on money supply growth, bank credit and GDP establishes that, in the last six years, both money supply growth and credit expansion have halved absolutely and in relation to GDP growth. Even the combined fiscal deficit (fiscal expansion) and credit growth (monetary expansion) as a percentage of GDP has halved from 17.4 per cent in 2009-10 to 8.8 per cent, which is less than nominal GDP growth. Thus the FRBM Act has not only reduced fiscal deficit but also starved the growing economy from much needed investment.

       D. FRBM Act as a borrowed concept

The 3 per cent fiscal deficit limit which emerged from the famous Maastricht Treaty to form the European Union (EU) in 1992 was applied to Indian context without any modifications.

•  Fiscal deficit is the quantum amount a nation borrows to meet expenditure. As long as we restrict borrowing to investment needs it does not seem logical to say why a nation should borrow only 3 per cent of its GDP to make investments. The investment needs are independently determined by the structural developments in the economy, its stock of capital and its planned growth profile.

Thus the FRBM Act has faced numerous hurdles in its implementation and has become a subject of animated debate. It is in this context the Finance Minister’s Budget proposal to have a committee to review the implementation of the FRBM Act is right step to ask the question whether the law has served the purposes for which it was envisaged.

Different types of deficits

• Fiscal is the excess of what the amount the government plans to spend over what the government expects to receive.
• Obviously, to make up this gap, the government has to borrow money from the market.But all government expenditure is not of the same kind.
• For instance, if the expenditure is for paying salaries then it is counted as “revenue” expenditure but if it goes into building a road or a factory – that is, something that in turn increases the economy’s capacity to produce more – then it is characterized as “capital” expenditure.
• The fiscal deficit is another key marker and it maps the excess of revenue expenditure over revenue receipts.
• The difference between fiscal deficit and revenue deficit is the government’s capital expenditure.

What FRBM says on deficits?

• As a broad rule, it is considered fiscally imprudent for a government to borrow money for “revenue” purposes.
• As a result, the FRBM Act of 2003 had mandated that, apart from limiting the fiscal deficit to 3% of the nominal GDP, the revenue deficit should be brought down to 0%.
• This would have meant that all the government borrowing (or fiscal deficit) for the year would have funded only capital expenditure by the government.

Why prefer capital expenditure over revenue expenditure?

• In any economy, when the government spends money or cuts taxes it has an impact on the economic activity of the country.
• But this impact (also called the “Multiplier” effect) is quite different for revenue expenditure and capital expenditure.
• In other words, when the government spends Rs 100 on increasing salaries in India, the economy grows by a little less than Rs 100.
• But, when the government uses that money to make a road or a bridge, the economy’s GDP grows by Rs 250.
• The question then is: How to get governments to switch from revenue expenditure to capital expenditure? That’s where the FRBM Act comes in handy.

What is the significance of an FRBM Act?

• The popular understanding of the FRBM Act is that it is meant to “compress” or restrict government expenditure. But that is a flawed understanding.
• The truth is that FRBM Act is not an expenditure compressing mechanism, rather an expenditure switching one.
• In other words, the FRBM Act – by limiting the total fiscal deficit (to 3% of nominal GDP) and asking for revenue deficit to be eliminated altogether – is helping the governments to switch their expenditure from revenue to capital.
• This also means that – again, contrary to popular understanding – adhering to the FRBM Act should not reduce India’s GDP, rather increase it.

Here’s how: When you cut on revenue deficit – that is, reduce your borrowings for funding revenue expenditure – and instead borrow to only spend on building capital, you increase the overall GDP by 2.5 times the amount of money borrowed. So adhering to FRBM Act is a win-win.

What has been India’s record on adhering to FRBM Act?

• Between 2004 and 2008, the Indian government had made giant strides on reducing both revenue deficit and fiscal deficit.
• But this process was reversed thereafter thanks largely to the Global Financial Crisis and a domestic slowdown.
• Since then, there have been several amendments to the Act essentially postponing the targets.
• But the worst development happened in 2018 when the Union government stopped targeting revenue deficit and instead focussed only on fiscal deficit.

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.

Way Forward

The politics of sound finance in a globalized financial environment is well understood. The FRBM Act has the potential of ensuring macro-economic stability provided it is revised to needs of Indian economy. Further, there are some other approaches which can help:

• The possibility of adopting a target range rather than a specific number which would give the necessary policy space to deal with dynamic and volatile situations such as the one India currently faces
• Aligning the monetary and fiscal economies so that if bank credit growth falls, fiscal deficit may need to go up.
• An autonomous Fiscal Management Review Committee (FMRC) which would conduct an annual independent and public review of FRBM compliance.
• Move the annual numerical targets from FRBM rules (which are framed and amended by central Government at whim by gazette notification) to the FRBM act itself 
• Do away with the ambiguous concept of the Effective Revenue Deficit which is nothing but a jugglery to rewrite revenue expenditure as capital expenditure.

Besides, it must also be ensured that resources gained from this fiscal reset are utilized imaginatively for creation of long-term public assets and putting the country back on her growth tracks.