Editorial Plus

FRBM act and escape clause

30 March, 2020
9 Min Read

FRBM Act

Part of: GS Prelims and GS-III- Economics

Recently, the State government of Kerala has sought flexibility under the Fiscal Responsibility and Budget Management (FRBM) Act.

This is to ensure that fiscal stimulus in the wake of COVID-19 does not get deterred by FRBM considerations.

Reasons for Seeking Flexibility

According to Kerala’s current fiscal position, Kerala can borrow about? 25,000 crore during the financial year 2020-21.
Kerala has announced an emergency relief package worth Rs. 20,000 crores to mitigate the impact on livelihoods and overall economic activity from the sweeping steps taken to battle the COVID-19 pandemic, including the latest 21-day nationwide lockdown.
The State has proposed to borrow as much as? 12,500 crore from the market at the start of the financial year (April -March).
The government is concerned that the stringent borrowing cap under the fiscal responsibility laws should not constrain its borrowing and spending ability over the remaining 11 months.
- During the 11 months, the government will have to take not only COVID-19 mitigation measures but would also have to meet other expenditures for routine affairs related to the running of the State’s socio-economic programmes as well as the post-pandemic recovery.

FRBM Act

It was enacted in August 2003.
It aims to make the Central government responsible for ensuring inter-generational equity in fiscal management and long-term macro-economic stability.
The Act envisages the setting of limits on the Central government’s debt and deficits.
- It limited the fiscal deficit to 3% of the GDP.
To ensure that the States too are financially prudent, the 12th Finance Commission’s recommendations in 2004 linked debt relief to States with their enactment of similar laws.
- The States have since enacted their own respective Financial Responsibility Legislation, which sets the same 3% of Gross State Domestic Product (GSDP) cap on their annual budget deficits.
It also mandates greater transparency in fiscal operations of the Central government and the conduct of fiscal policy in a medium-term framework.
- The Budget of the Union government includes a Medium Term Fiscal Policy Statement that specifies the annual revenue and fiscal deficit goals over a three-year horizon.
The rules for implementing the Act were notified in July 2004. The rules were amended in 2018, and most recently to the setting of a target of 3.1% for March 2023.
The NK Singh committee (set up in 2016) recommended that the government should target a fiscal deficit of 3% of the GDP in the years up to March 31, 2020, cut it to 2.8% in 2020-21 and to 2.5% by 2023.

Relaxation under the FRBM Act

Escape Clause: (PT SHOT)
- Under Section 4(2) of the Act, the Centre can exceed the annual fiscal deficit target citing certain grounds.
- The grounds include
  - National security, war
  - National calamity
  - Collapse of agriculture
  - Structural reforms
  - The decline in real output growth of a quarter by at least three percentage points below the average of the previous four quarters.
The lockdown could cause a severe contraction in economic output and the COVID-19 pandemic could be considered as a national calamity.
Also, the government has already made the use of escape clause this year.

Instances of the FRBM Norms been Relaxed in the Past

During the Budget 2020-21 presentation:
- The reductions in corporate tax were cited as structural reforms that triggered the escape clause. This implies that this year the government has already made use of the escape clause
- This enabled the government to adjust the fiscal deficit target for 2019-20 to 3.8%, from the budgeted 3.3%.
- It was also cited that the impact of the reforms would also necessitate a reset for 2020-21: from the earlier deficit target of 3% to 3.5%.
During the global financial crisis in 2008-09:
- The Centre resorted to a focused fiscal stimulus: tax relief to boost demand and increased expenditure on public projects to create employment and public assets, to counter the fallout of the global slowdown.
- This led to the fiscal deficit climbing to 6.2%, from a budgeted goal of 2.7%.
- Simultaneously, the deficit goals for the States too were relaxed to 3.5% of Gross State Domestic Product(GSDP) for 2008-09 and 4% of GSDP for fiscal 2009-10.

NK Singh FRBM review committee

The FRBM Review Committee headed by former Revenue Secretary, NK Singh was appointed by the government to review the implementation of FRBM. In its report submitted in January 2017, titled, ‘The Committee in its Responsible Growth: A Debt and Fiscal Framework for 21st Century India’, the Committee suggested that a rule-based fiscal policy by limiting government debt, fiscal deficit and revenue deficits to certain targets is good for fiscal consolidation in India.

Why a rethinking on FRBM was needed?

After nearly twelve years into running of the FRBM (2003) legislation, there was a big debate on whether India has to continue with a fiscal deficit target or not. One group argued that in a developing country, the government has to make lot of expenditure and an upper ceiling will reduce government involvement. The opposite group countered that loosening the target will lead to excess expenditure, government debt, inflation and several other macroeconomic problems besides creating intergenerational inequality. The responsibility of the NK Singh Committee thus was to suggest a way out. Specifically, the Committee has to make suggestions on a commonly raised idea of a fiscal deficit range than a fixed target (like 3% of GDP). Similarly, the committee should suggest changes required in FRBM in the context of rising global uncertainties.

The general perspective of the FRBM Review Committee

Before going into the point-by-point presentation of the NK Singh Committee’s suggestions, it is important to look at the overall perspective adopted by it about the borrowing run (fiscal deficit) government budget in the Indian context.

The FRBM Review Committee’s philosophy is visible in its report throughout and is that in a country like India, where budgets are framed by accommodating populist pressures, activist or discretionary fiscal policy with a high fiscal deficit has limitations.

“The maxim that “you cannot spend your way to prosperity” is now widely accepted. Fiscal policies must therefore be embedded in caution than exuberance. In restraint than profligacy.” The Committee cited evidence that in the recent past, the economy faced troubles whenever the government made high expenditures by shooting over the FRBM targets.

At the same time, when some crisis like 2007-08 appears, fiscal policy should have some flexibility. Here, the Committee suggested a carefully crafted escape clause allowing higher fiscal deficit. This escape clause is ‘rule based’ (smart rules) and not ‘discretionary’. Following are the main recommendations of the NK Singh Committee.

1. Public debt to GDP ratio should be considered as a medium-term anchor for fiscal policy in India. The combined debt-to-GDP ratio of the centre and states should be brought down to 60 per cent by 2023 (comprising of 40 per cent for the Centre and 20% for states) as against the existing 49.4 per cent, and 21per cent respectively.

2. Fiscal deficit as the operating target: The Committee advocated fiscal deficit as the operating target to bring down public debt. For fiscal consolidation, the centre should reduce its fiscal deficit from the current 3.5% (2017) to 2.5% by 2023.

Justifying the target of 2.5% to be realized in the next six years, the Committee observed that debt sustainability analysis (DSA) conducted for the central government suggests such a target (for fiscal deficit) will help to achieve the public debt target of 40% for the centre by 2023.

3. Revenue deficit target

The Committee also recommends that the central government should reduce its revenue deficit steadily by 0.25 percentage (of GDP) points each year, to reach 0.8% by 2023, from a projected value of 2.3% in 2017.

The Committee advised the government to follow the golden rule here ie., not to finance the government’s day-to-day expenditure through borrowings. Revenue deficit implies financing of government’s day to day activities from borrowings.

Table: Fiscal roadmap for 2023 and the targets for the Centre (figures are as a percent of GDP) FD is fiscal deficit and RD is revenue deficit.

Year Debt/GDP FD RD

2017 49.4 3.5 2.3

2023 38.7 2.5 0.80

Source: NK Singh Committee Report

4. Formation of Fiscal Council to advise the government.

The Committee advocated the formation of institutions to ensure fiscal prudence in accordance with the FRBM spirit. It recommended setting up an independent Fiscal Council. The Council will provide several advisory functions. It will forecast key macro variables like real and nominal GDP growth, tax buoyancy, and commodity prices. Similarly, it will do a monitoring role, besides advising about the use of escape clauses and also specifying a path of return.

5. Escape Clause to accommodate counter cyclical issues:

The NK Singh Committee points out that there are disadvantages with set fiscal deficit target if some economic instabilities like an external crisis affects the Indian economy. For example, the government has to spend more during the time of a recession and hence it need not restrict its borrowing to keep the fiscal deficit target. Hence, the committee advocates countercyclical covers in fiscal policy while following the FRBM.

Here, the committee recommends fiscal flexibilities to go above or below the fiscal deficit targets in the form of ‘escape clauses. The Committee set 0.5% as an escape clause for the fiscal deficit target.

What is an escape clause?

The flexibility to adjust to cyclical fluctuations (boom/recession) is incorporated under the “escape clause” (in the case of recession) where temporary and moderate deviations can be made from the baseline fiscal path. This can be permitted under exceptional circumstances and in reaction to external shocks. To ensure that these “escape” clauses are not misused, the Committee suggests several specific guidelines. The escape clause can be used only during the time of following essential circumstances:

• Over-riding consideration of national security, acts of war, calamities of national proportion and collapse of agriculture severely affecting farm output and incomes.

• Far-reaching structural reforms in the economy with unanticipated fiscal implications.

• Sharp decline in real output growth of at least 3 percentage points below the average for the previous four quarters.

Deviation from the stipulated fiscal deficit target shall not exceed 0.5 percentage points in a year.

The Escape Clauses can be invoked:

(a) by the Government after formal consultations and advice of the Fiscal Council.

(b) with a clear commitment to return to the original fiscal target in the coming fiscal year.

6. Buoyancy: What the government has to do with fiscal deficit target when higher economic growth occurs?

The Committee also advocates that that the policy responses to sharp changes in output growth should be symmetric (to that of the escape clause). This implies that during higher economic growth, fiscal deficit should be reduced accordingly. (Here, in the case of growth fall, fiscal deficit target can be raised using the escape clause).

7. Fiscal consolidation responsibility for states

The Committee observes that state government’s fiscal position is important after greater resource transfer to them (Fourteenth finance Commission award). Now, total state expenditures (as a percent of GSDP) is now even greater than the Centre. Hence, fiscal consolidation should also be made by the states. They should bring down their debt target to 20% of GDP from the current 21%.

8. Congruence of Fiscal and Monetary Policy

The FRBM Review Committee observed that both monetary and fiscal policies must ensure growth and macroeconomic stability in a complementary manner. For this, the Inflation Targeting (IT) regime and Fiscal Rules (FRs) have to interact with each other.

Source: TH