A New Fiscal Policy Framework For The Post-Pandemic Economy

Context: The economic situation after the COVID has prompted calls for the complete reformation of the Fiscal Responsibility and Budget Management Act (FRBM).

Calculating warranted nominal GDP growth rate:

• Assuming a high debt-to-GDP ratio of 85% in 2021-22 and allowing for annual reduction of the FD by 0.5% of GDP, as per the 15th Finance Commission recommendation accepted by the government, a study shows that with nominal growth of less than 9%, the debt-to-GDP ratio will rise, while at growth over 9%, that ratio would gradually decline. So 9% is the warranted nominal GDP growth rate.

Issues with the FRBM: The arbitrary setting of targets unrelated to the actual requirements of debt sustainability and ignoring the prevailing state of the economy makes fiscal policy pro-cyclical and inherently destabilizing.

• While the FRBM Act set a target for the Centre and the state annual fiscal deficit ratio (FD) at 3% of their gross domestic product (GDP), this translated to a combined FD target of 5.8%.
• When GDP growth and revenue growth are high, a fixed FD target translates to high expenditure growth, pump-priming, and even higher growth.
• Conversely, when GDP and revenue growth are low, the fixed FD translates to slow expenditure growth, which further reduces growth.

Suggestions for Post-Covid fiscal framework for India:

• Derived from debt-sustainability conditions: Debt will be sustainable if the primary balance (PB)—fiscal balance net of interest cost—is greater than the interest rate-growth rate differential (r-g).
  • This condition was violated in India in 2020-21 because the PB remained negative while r-g turned positive, consequent to the steep decline in growth.
  • Therefore, PB should be increased. But instead of setting yearly PB targets, it should be raised gradually, by 0.5% of GDP per year on average.
• Identify the warranted level of fiscal deficit (WD) (absolute level) every year: for five years
  • The WD can be derived from the warranted nominal growth rate, which is calculated as the required growth rate for debt sustainability.
  • This framework can also be extended to derive the warranted primary balance (WPB) path, i.e. FD net of the interest cost of past debt.
  • Such a rule builds in automatic stabilization since the fixed WD in a given year will automatically raise the FD (or PB) when actual growth is lower than warranted growth, and lower the FD (or PB) when growth is higher than warranted growth, thereby tending to drive actual growth back towards the warranted growth path.

Way forward:  The above 5-year series of WD, consistent with a gradually declining debt-to-GDP, is a simple, non-discretionary deficit rule that is also automatically stabilizing.

• FRBM Acts should provide escape clauses to deal with extreme shocks like the present Covid pandemic.