Debt, not deficit: Aim for more clarity in next-generation of fiscal rules

India currently has a fiscal law that expects the Union government to keep its annual fiscal deficit below 3% of gross domestic product (GDP). So, government borrowing in any given year cannot exceed that limit, to rein in profligate budgeting. 

However, a rigid limit on government borrowing can be counterproductive in some situations. For example, during a pandemic, when the treasury must step in to support a shrinking economy. 

The fiscal law thus has an escape clause that provides the government with some welcome flexibility in the way it conducts fiscal policy, rather than being tied to mindless austerity when it is least needed.

Also read: Budget 2024: The math of how the Centre will cut its fiscal deficit, explained

The design of our Fiscal Responsibility and Budget Management (FRBM) law, which got a stamp of approval from Parliament in 2003, is modelled on similar legislation in many other countries. 

Its passage was a remarkable moment in India’s political economy, when the political system decided to subject itself to legal boundaries for the conduct of fiscal policy, while also helping participants in the economy make better decisions because of more predictable government budgets.

There has since been a global shift to what is often called a second generation of fiscal rules. These have been based on the principle that what actually matters for a country is sustainable public finances over the medium term, rather than the bottomline of every annual budget—a focus on the stock of public debt rather than the flow of government borrowing. 

It is not yet clear whether the government will seek to introduce a new fiscal law, amend the existing one, or change its strategy within the existing legal framework.

An FRBM review committee headed by N.K. Singh had said in its 2017 report that India needs a new fiscal paradigm for the 21st century. Central to this new paradigm should be the ratio of public debt to GDP as the new anchor of fiscal policy. 

The annual fiscal deficit would still matter, since public debt is the accumulation of what a government borrows every year to cover its financial gap. 

In technical language, annual government borrowing would be the operating target, while the public debt ratio would be the intermediate target of Indian fiscal policy. The statement by the finance minister in her budget speech is a reflection of such thinking.

What will that mean in practice? There are two issues to consider here for everyone ranging from consumers to companies and investors. First, will a shift from the annual fiscal deficit to the public debt ratio change how the government manages its finances? 

Also read: Lower debt-to-GDP ratio could boost India’s chances of a credit rating upgrade: Fitch

This question matters because the finance minister has indicated that the Union government wants its public debt to be on a declining path. It is currently around 58% of GDP, or 18 percentage points higher than what the original FRBM law identified as the ideal level.

The mathematics of public debt tells us that there are two ways in which the public debt ratio of any country can come down. First, when nominal GDP growth is higher than the cost of government borrowing. Second, through an explicit policy that cuts the primary deficit of the government. 

Much depends on how these two factors combine. A country with a large growth-interest rate differential has to do less work in its annual budget. And a country with a small growth-interest rate differential has to focus more on fiscal austerity.

India has historically allowed high growth to take care of its public debt challenges. However, the N.K. Singh committee warned that this should not lead to the breezy conclusion that our public debt problems will be solved automatically through high nominal GDP growth. Fiscal policy will have to do some heavy lifting.

“In the Indian case, rather than fiscal prudence, it is in fact a favourable interest rate growth differential arising from high growth rates and relatively low interest rates that has facilitated the consolidation of debt. A negative interest growth differential, however, cannot be a long-run equilibrium, and may not persist over time. 

The trend has already begun to slope upwards, which may make it difficult to sustain India’s debt in the long run," the committee said in its report. What was said in 2017 is true even today.

The second issue is communication. It is easy to convey fiscal policy intentions to the private sector through an annual deficit target. Getting across the message on a sustainable public debt ratio will be more difficult, especially in a credible manner. 

Also read: Spare the fisc: Don’t run rings around the budget deficit

It entails a shift from fiscal accounting to fiscal projections, and the latter will necessarily be an estimate based on opaque assumptions about the future.

The accepted solution is a fiscal council akin to the bipartisan Congressional Budget Office (CBO) in the US. Such an institution will not decide fiscal policy, or how much to tax and spend, which is the sovereign right of an elected government. 

However, it can provide independent estimates of the public debt trajectory, the new anchor of Indian fiscal policy. These estimates should be released publicly to improve the credibility of the next generation of fiscal rules.