Fiscal Policy

Fiscal policy is the use of government spending and taxation to influence the economy. Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty.

Fiscal policy refers to the policy of government with relation to taxation, public expenditure, and management of public debt. In other words, fiscal policy refers to the financial activities undertaken by government to correct either inflation or deflation and promote growth of an economy.

Fiscal policy is,

• Budgetary policy of the government.
• It uses public expenditure and taxation as instruments; and
• Its objectives are to influence production and employment favorably.

• Full employment
• Price stability and Economic stability
• Optimum allocation of resources
• Equitable distribution of income and wealth
• Capital formation and growth

Expansionary fiscal policies are those that are used to “expand” economy (economic activity) and contractionary ones are those used to “contract” an economy (economic activity).

Fiscal policies are implemented by the government and is independent of actions by the central bank (monetary policy) in most cases although when both are implemented in a complimentary manner, goals can be achieved more efficiently and smoothly.

• Expansionary fiscal policies include measures such as reducing tax rates, increasing direct payments to consumers via tax refunds and increase government spending in order to increase economic activity when the economic activity via the private sector slows down.
• These policies contribute to an increase in aggregate demand and hence increasing aggregate supply leading to increased production and hence increased economic output.

Expansionary policies are usually accompanied by expansionary monetary policies such as reducing interest rates and increasing money supply in money markets thus making access to money easier. These policies are mainly used to maintain economic activity or boost it during a downturn (i.e., Recession).

• Contractionary fiscal policies on the other hand are used to slow down an economy by measures such as increasing taxes and decreasing government spending.
• One main reason to use this type of policy is to control inflation. This is also known as “cooling down” an economy as rapid economic growth induces higher inflation rates that could ultimately curtail economic activity in the long run.
• Contractionary policies reduce the aggregate demand and hence reducing the aggregate supply and in turn reducing production and, hence reducing economic output.
• Once again, contractionary policies are usually accompanied by contractionary monetary policies such as increasing interest rates and decreasing money supply in the money markets thus making access to money more difficult.

All sums of money. All revenues of the govt. the loans raised by it, receipts by way of repayment of loans. All expenditures are also incurred out of this fund. No amount can be withdrawn from this fund without the sanction of the parliament.

The fund is placed at disposal of the President to enable the government to meet the unforeseen emergencies. Prior sanction of the parliament is not required to spend from the fund.

Certain transactions are not included in the contingency fund. These include transactions relating to provident funds, small savings collections, other deposits etc. The money thus received is kept in public account. This money does not belong to the government. It has to be paid back to the persons and authorities who have deposited it. Hence, parliamentary approval is not required for payments.

The most important instrument of government intervention in the economy today is that of fiscal or budgetary policy.

Union Budget, which is a yearly affair, is a comprehensive display of the Government’s finances. It is the most significant economic and financial event in India. The Budget is the most extensive account of the Government’s finances, in which revenues from all sources and expenses of all activities undertaken are aggregated. It comprises the revenue budget and the capital budget. It also contains estimates for the next fiscal year called budgeted estimates.

Barring a few exceptions — like elections – Finance Minister presents the annual Union Budget in the Parliament on the first working day of February.

The budget of a government is a summary of the item wise intended/expected revenues and anticipated expenditures of the government during a fiscal year/financial year.

The term budget has been derived from a French word ‘bougette’ which means a leather bag or purse. As per Article 112 of Indian Constitution the Govt. has to present in the Parliament an annual financial statement showing estimates of revenue and expenditure.

Article 112 of the Indian Constitution says that every year “the President of India shall cause to be laid before both the houses of the parliament” the “Annual Financial Statement”. This is popularly known as Budget. “Cause to be laid” here means that the person through whom President acts, is Finance Minister of the country, who is known as the custodian of the nation’s Finances. The Budget gives the complete picture of the estimated receipts and expenditures of the Government of India for that year. This picture is actually based upon the budget figures of the previous years.

There are three main features of a government budget:

• It is a consolidated financial statement of expected expenditures and various sources of revenue of government.
• It relates to a financial year. And
• The expenditures and the sources of revenue are planned in accordance with the declared policy objectives of government.

Apart from the speech of the Financial Minister, the budget contains total around 14 to 16 documents. Among these, four documents are mandatory as per constitution of India, while four other documents are mandatory as per FRBM Act, 2003. Rest of the documents are either explanatory or as per recommendations of NITI Aayog or under some other initiatives.

Thus, we can divide these documents in three parts as follows:

Documents Mandated by Constitution

Annual Financial Statement [Article 112]: This document comprises the receipts and expenditures of the government of current year, previous year and budget year in three separate parts viz. Consolidated Fund of India, Contingency Fund of India and Public Account of India.

Demands for Grants [Article 113]: The estimates of expenditures are presented to Lok Sabha in the form of Demands for Grants. General there is one demand for grants per ministry but there can be more than one demands for grants also for a ministry depending on the type of expenditure. Further, the government presents separate demands for grants for union territories along with the ministries’ demands for grants.

Appropriation Bill [Article 114(3)]: The article 114(3) stipulates that no amount can be withdrawn from the Consolidated Fund of India without enactment of a law by parliament. So, once the demands for grants are vetted by the Lok Sabha, the Appropriation Bill is presented to withdraw amount from Consolidated Fund.

Finance Bill [Article 110(a)]: It is presented to enact a law for imposition, abolition, remission, alteration or regulation of taxes proposed in the Budget. A Finance Bill is a Money Bill as defined in Article 110 of the Constitution.

The budget consists of two parts:

(1) Receipts (2) Expenditure

The receipts of government show the different sources from which government raises revenue. These receipts are of two kinds:

Revenue receipts and Capital receipts.

Revenue receipts are current income receipts from all sources such as taxes, profits of public enterprises, grants, etc. Revenue receipts neither create any liability nor cause any reduction in the assets of the government. Capital receipts, on the other hand, are the receipts of the government which either create liability or cause any reduction in the assets of the government. e.g., borrowings, recovery of loan and disinvestment etc.

Revenue receipts are current incomes of government, which neither create liabilities nor cause any reduction in the assets of the government. These receipts are classified into

(i) Tax Revenue and

(ii) Non-tax Revenue.

Tax Revenue: It is the revenue collected from different items like corporation tax, income tax, wealth tax, customs, union excise, service, Taxes collected from both direct and indirect tax are considered in Tax Revenue.

Non-Tax Revenue: The incomes accruing to government from sources other than taxes are non-tax revenues. The major sources of non-tax revenues of the central government of India are:

(a) Commercial Revenue: It is received by government in the form of prices paid by people for goods and services that government provides e.g., people pay for electricity and for services of Railways, postal stamps, toll etc.

(b) Administrative Revenue: It arises on account of administrative services of the government.

They are as follow:

• fees in the form of passport fees, government hospital fees, education fees, court fee, etc.
• Fine and penalties: charged by government on lawbreakers for disobeying rules and regulations. License fee and permit
• Escheat: Income that government get by taking possession of property which has no legal claimant or legal heir.
• Interest receipts
• Profits of public sector undertakings.

As stated earlier, capital receipts are those receipts of the government which either create liability or cause any reduction in the assets of the government. The major sources of capital receipts of the central government are: (i) Borrowings (ii) Recovery of Loans and (iii) Disinvestment – Resale of shares of public sector undertakings.

(i) Borrowings: There are two sources from which the central government borrows. These borrowings are also called ‘Public Debt’.

Important Sources of Public Debt

• Borrowing from individuals.
• Borrowing from Non-Banking Financial Institutions. (Insurance companies, investment trusts, mutual funds etc.,)
• Borrowing from commercial banks.
• Borrowing from central banks.
• Borrowing from External sources (IMF, IBRD, ADB, Foreign Governments)

Important Sources:

(a) Domestic Borrowings: The government borrows from domestic financial market by issuing securities and treasury bills. It also borrows from people through various deposit schemes such as Public Provident Fund, Small Savings Schemes, and National Savings Scheme etc. These are borrowings of the government within the country.

(b) External Borrowings: In addition to domestic borrowings the government also borrows from foreign governments and international bodies like International Monetary Fund (IMF), World Bank etc. Foreign borrowings by the government bring in foreign exchange into the domestic economy.

(ii) Recovery of Loans: Quite often state and local governments borrow from the central government. The loans recovered by the central government from state and local governments are capital receipts in the budget because recovery of loans reduces debtors (assets).

(iii) Disinvestment – Resale of shares of public sector undertakings: This is a very recent source of capital receipts by which the central government has been mobilizing financial resources since 1991. Prior to 1991, the central government owned 100 percent of the shares of public sector undertakings. From 1991, the government adopted the policy of privatization of public sector undertakings. Consequently, it started selling its shares to general public and to financial institutions. This selling of shares of public sector undertakings by the government is known as ‘disinvestment of public sector undertakings.

”Investment refers to the conversion of money or cash into securities, debentures, bonds or any other claims on money. As follows, disinvestment involves the conversion of money claims or securities into money or cash.”

Disinvestment is defined as the action of an organization(or government) selling or liquidating an asset or subsidiary.

The following main objectives of disinvestment were outlined:

• To reduce the financial burden on the Government
• To improve public finances
• To introduce, competition and market discipline
• To fund growth
• To encourage wider share of ownership
• To depoliticize non-essential services

Different approaches to disinvestments are:

• A minority disinvestment is one such that, at the end of it, the government retains a majority stake in the company, typically greater than 51%, thus ensuring management control.
• A majority disinvestment is one in which the government, post disinvestment, retains a minority stake in the company i.e., it sells off a majority stake.
• Complete privatization is a form of majority disinvestment wherein 100% control of the company is passed on to a buyer.

Importance of Disinvestment

Presently, the Government has about Rs. 2 lakh crores locked up in PSUs. Disinvestment of the Government stake is, thus, far too significant. The importance of disinvestment lies in utilization of funds for:

• Financing the increasing fiscal deficit
• Financing large-scale infrastructure development
• For investing in the economy to encourage spending
• For retiring Government debt- Almost 40-45% of the Centre’s revenue receipts go towards repaying public debt/interest
• For social programs like health and education

Disinvestment also assumes significance due to the prevalence of an increasingly competitive environment, which makes it difficult for many PSUs to operate profitably. This leads to a rapid erosion of value of the public assets making it critical to disinvest early to realize a high value.

Government expenditure is classified in two ways:

(a) capital expenditure and revenue expenditure

(b) as plan expenditure and non-plan expenditure.

Capital Expenditure and Revenue Expenditure: When government incurs expenditure to create assets such as school and hospital buildings, roads bridges, canals, railway lines etc., or reduce its liability such as repayment of loan etc., such expenditure is known as capital expenditure. But when government incurs expenditure that neither creates any asset nor reduces any liability, such expenditure is known as revenue expenditure. For Example, payment of salaries to government employees, maintenance of public property, providing free education and health services to people, etc. constitute revenue expenditure. These do not create any public asset.

Plan Expenditure and Non-Plan Expenditure: After independence, our country adopted the path of planning to achieve economic development. Under planning, provisions were made in the government budget for expenditure that was to be incurred every year according to the priorities laid down in the five-year plans. Such expenditure is known as plan expenditure.

Beside plan expenditure, government also incurs routine expenditure such as expenditure on police, judiciary, water supply, sanitation and health, legislatures, defence, various government departments, etc. Such routine expenditure is termed as non-plan expenditure.

In 2010, a panel led by the former Prime Minister’s Economic Advisory Council Chairman C Rangarajan had also suggested doing away with the artificial classification and it said the focus should be on improving the quality of government spending by focusing on the end use of the funds. It means that under plan and non-plan expenditure focus is mainly on the expenditure targets not on the end use of the funds.

The 14th Finance Commission, headed by the former Reserve Bank of India (RBI) governor YV Reddy, has been pitching for the distinction to go.

Earlier, the plan expenditure was estimated after discussions with all ministries and the Planning Commission, now the government had dismantled the Planning Commission. So, there are no Five-year plans and government replaced them with medium- and long-term planning system under NITI Aayog. This new planning is not linked to budget expenditure targets but on end goals of development to reach.

Switching to capital and revenue spending classifications will help to create a clear and effective link between the government’s earnings, spending and outcome.

Hence from the financial year of 2017-18, the classification of Expenditure into plan and non-plan has been stopped and it is categorized as Scheme based and Non-Scheme Based Expenditure.

The changes in CSS started last financial year with higher tax devolution of 42 % recommended by the Fourteenth Finance Commission (FFC). This higher tax devolution without a corresponding increase in revenue receipts meant that the Union government restructured its approach of running a plethora of central schemes under state plans.

In response to the question of CSS restructuring, states had submitted to the FFC that proliferation of CSS impinges upon their fiscal autonomy as they do not have any say in design of these schemes and face many restrictions in their implementation.

To resolve this paradox on CSS, a sub-group of chief ministers on the rationalization of centrally sponsored schemes was constituted as part of NITI Aayog in March 2015.

The Sub-Group had examined 66 CSSs and a consensus was reached on many contentious issues not only between the States represented on the Sub- Group but other States/UTs also through regional consultations and meetings with Union Ministries/Departments.

The Guiding Principles of the Sub-Group had been to resolve the issues between Union and the States /UTs and to work as Team India in the spirit of Cooperative Federalism towards realization of the goals of VISION 2022 when we will celebrate the 75th year of Independence.

The objectives of the VISION are broadly:

(a) providing basic amenities to all citizens in an equitable and just manner for ensuring a life with self-respect and dignity, and

(b) providing appropriate opportunities to every citizen to realize his/her potential.

The rationalization of the CSSs would ensure optimum utilization of resources with better outcomes through area specific interventions. This would also ensure wider reach of the benefits to the target groups.

The major recommendations of the Sub-Group are as under:

a) No. of Schemes: The total number of schemes should not exceed 30.

b) Categorization of Schemes: Existing CSSs should be divided into Core and Optional Schemes.

Core schemes: Focus of CSSs should be on schemes that comprise the National Development Agenda where the Centre and States will work together in the spirit of Team India.

Core of the Core Schemes: Those schemes which are for social protection and social inclusion should form the core of core and be the first charge on available funds for the National Development Agenda.

Optional Schemes: The Schemes where States would be free to choose the ones they wish to implement. Funds for these schemes would be allocated to States by the Ministry of Finance as a lump sum.

Funding Pattern would be as follows:

Core of the Core Schemes: Existing Funding pattern of the Core of the Core Schemes would continue.

Core Schemes:

a) For 8 North Eastern States and 3 Himalayan States: Centre: State: 90:10

b) For other States: Centre: State: 60:40

c) For Union Territories (without Legislature): Centre 100% and for UTs with legislature existing funding pattern would continue.

Optional Schemes:

• For 8 North Eastern States and 3 Himalayan States: Centre: State: 80:20
• For other States: Centre: State: 50:50
• For Union Territories: (i) (without Legislature) – Centre 100 (ii)Union Territories with Legislature: Centre: UT:80:20

Flexibility and Flexi-funds to the States/UTs:

• While designing the CSS, the Central Ministries shall permit flexibility in the choice of components to the States as available under the Rashtriya Krishi Vikas Yojana (RKVY).
• Moreover, the flexi-funds available in each CSS has been raised from the current level of 10% to 25% for the States and 30% for the UTs of the overall annual allocation under each Scheme so that the implementation can be better attuned to the needs of individual State /UT.

Based on the balancing of revenue and expenditure, budgets are divided into Balanced Budget and Unbalanced Budget.

1. Balanced Budget: – A balanced budget is that over a period of time, revenue does not fall short of expenditure. i.e., revenue is equal to expenditure. (Revenue= Expenditure).
2. The Budget imbalance may be due to an excess of expenditure over income or an excess of income over expenditure. In other words, budget may either be surplus or deficit.

A budget is said to be surplus when public revenue exceeds public outlay. (Revenue>Expenditure).

3. A Deficit budget means a budget when expenditure exceeds revenue. (Revenue<Expenditure).

Revenue deficit is “the difference between revenue expenditure and revenue receipts which indicates increase in liabilities of the Central Government without increase in the assets of that Government.

Problems related to revenue deficit:

• It indicates the inability of the government to meet its regular and recurring expenditure in the proposed budget.
• It implies that government is dissaving, i.e., government is using up savings of other sectors of the economy to finance its consumption expenditure.
• It also implies that the government has to make up this deficit from capital receipts, i.e., through borrowings or disinvestments. It means, revenue deficit either leads to an increase in liability in the form of borrowings or reduces the assets through disinvestment.
• Use of capital receipts for meeting the extra consumption expenditure leads to an inflationary situation in the economy. Higher borrowings increase the future burden in terms of loan amount and interest payments.
• A high revenue deficit gives a warning signal to the government to either curtail its expenditure or increase its revenue.
• According to far-sighted approach, revenue receipts should always be more than revenue expenditures so that surplus can be used for development projects. However, Indian Budget is facing revenue deficit for the past several years.

It has been prescribed by an amendment to the FRBM Act by the Finance Act, 2012. Effective revenue deficit has been defined as the difference between “the revenue deficit and the grants for creation of capital assets”.

Revenue Deficit vs Effective Revenue Deficit: revenue expenditure indicates expenditure to finance day to day functions of the government. They are not productive. But according to the government some revenue expenditure creates assets and hence is productive. This revenue expenditure which creates assets is deducted to get Effective Revenue Deficit.

The difference between total revenue and total expenditure of the government is termed as fiscal deficit. It is an indication of the total borrowings needed by the government.

Debt Trap: Borrowings not only involve repayment of principal amount, but also require payment of interest. Interest payments increase the revenue expenditure, which leads to revenue deficit. It creates a vicious circle of fiscal deficit and revenue deficit, wherein government takes more loans to repay the earlier loans. As a result, country is caught in a debt trap.

Foreign Dependence: Government also borrows from rest of the world, which raises its dependence on other countries.

Hampers the future growth: Borrowings increase the financial burden for future generations. It adversely affects the future growth and development prospects of the country.

Crowding – out effect: Crowding out effect refers to a situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending.

Sometimes, government adopts an expansionary fiscal policy stance and increases its spending to boost the economic activity. This leads to an increase in interest rates. Increased interest rates affect private investment decisions. A high magnitude of the crowding out effect may even lead to lesser income in the economy.

With higher interest rates, the cost for funds to be invested increases and affects their accessibility to debt financing mechanisms. This leads to lesser investment ultimately and crowds out the impact of the initial rise in the total investment spending. Usually, the initial increase in government spending is funded using higher taxes or borrowing on part of the government.

Primary deficit refers to difference between fiscal deficit of the current year and interest payments on the previous borrowings.

Primary Deficit = Fiscal Deficit – Interest Payments

The total borrowing requirement of the government includes the interest commitments on accumulated debts. Primary deficit reflects the extent to which such interest commitments have compelled the government to borrow in the current period.

Implications of Primary Deficit: It indicates how much of the government borrowings are going to meet expenses other than the interest payments. The difference between fiscal deficit and primary deficit shows the amount of interest payments on the borrowings made in past. So, a low or zero primary deficit indicates that interest commitments (on earlier loans) have forced the government to borrow.

Primary Deficit is the root Cause of Fiscal Deficit: In India, interest payments have considerably increased in the recent years. High interest payments on past borrowings have greatly increased the fiscal deficit. To reduce the fiscal deficit, interest payments should be reduced through repayment of loans as early as possible.

• Revenue deficit = Revenue expenditure – Revenue receipts
• Fiscal Deficit = Total expenditure – total receipts except borrowings
• Primary Deficit = Fiscal deficit- Interest payments
• Effective revenue Deficit-= Revenue Deficit – Grants for the creation of capital assets
• Monetized Fiscal Deficit = that part of the fiscal deficit covered by borrowing from the RBI.

Budgetary Deficit is the difference between all receipts and expenditure of the government, both revenue and capital. This difference is met by the net addition of the treasury bills issued by the RBI and drawing down of cash balances kept with the RBI. The budgetary deficit was called deficit financing by the government of India. This deficit adds to money supply in the economy and, therefore, it can be a major cause of inflationary rise in prices.

The concept of budgetary deficit has lost its significance after the presentation of the 1997-98 Budget. In this budget, the practice of ad hoc treasury bills as source of finance for government was discontinued. Ad hoc treasury bills are issued by the government and held only by the RBI. They carry a low rate of interest and fund monetized deficit. These bills were replaced by ways and means advance. Budgetary deficit has not figured in union budgets since 1997-98. Since 1997-98, instead of budgetary deficit, Gross Fiscal Deficit (GFD) became the key indicator.

The Monetized Deficit is the extent to which the RBI helps the central government in its borrowing programme. In other words, monetized deficit means the increase in the net RBI credit to the central government, such that the monetary needs of the government could be met easily.

In Indian context, the origin of ‘automatic monetization’ can be found from the agreement made in January 1955 regarding creation of ad hoc Treasury Bills(91-day) between the central government and the RBI. This agreement specified that the central government shall maintain a certain minimum cash balance with the RBI and if the balance falls below the minimum agreed limit, the account would be automatically replenished by the creation of adhocs in favour of the RBI.

Over time, issuance of such adhocs became a continuously increasing means of financial support to the central government from the RBI. These adhocs constituted 19.0% of reserve money in 1982 and 77.3% of reserve money in 1991. As rising monetized deficit has implications for price level, the central government and the RBI felt the need to limit such credit extension. As a result, an agreement was signed in September 1994 to phase out the creation of adhocs by end of fiscal year 1996–97.

Monetized Fiscal Deficit is that part of the fiscal deficit financed out of borrowing from the RBI. It indicates borrowings form the RBI to run the budget. This practice was phased out in 1997. Hence, the MFD is not relevant now. MFD is highly inflationary.

The monetized deficit results in the increase in the net holdings of treasury bills by the RBI and also the RBI contribution towards the government’s market borrowings increases. With the issue of more money to the government, the money supply in the economy increases, as a result of which the inflationary pressure prevails. Hence, we can say that monetized deficits are the part of a fiscal deficit that leads to the inflation in the economy.

Thus, it can be concluded that monetized deficit occurs when the government takes a monetary support from the RBI to finance its debt obligations.

The Reserve Bank of India gives temporary loan facilities to the centre and state governments as a banker to government. This temporary loan facility is called Ways and Means Advances (WMA).

The WMA for the Central Government

The WMA scheme for the Central Government was introduced on April 1, 1997, after putting an end to the four-decade old system of adhoc (temporary) Treasury Bills to finance the Central Government deficit. The WMA scheme was designed to meet temporary mismatches in the receipts and payments of the government.

This facility can be availed by the government if it needs immediate cash from the RBI. The WMA is to be vacated after 90 days. Interest rate for WMA is currently charged at the repo rate. The limits for WMA are mutually decided by the RBI and the Government of India.

When the WMA limit is crossed the government takes recourse to overdrafts, which are not allowed beyond 10 consecutive working days. The interest rate on overdrafts would be 2 percent more than the repo rate.

The minimum balance required to be maintained by the Government of India with the Reserve Bank of India will not be less than Rs.100 crore on Fridays, on the date of closure of Government of India’s financial year and on June 30, the date of closure of the annual accounts of the RBI, and not less than Rs.10 crore on other days.

The cash management of GoI has considerably deteriorated in the recent past, with situations of large surplus and large deficit. This has put tremendous pressure of RBI with respect to liquidity management and conduct of monetary policy.

Under the WMA scheme for the State Governments, there are two types of WMA – Special and Normal WMA.

• Special WMA is extended against the collateral (mortgaging) of the government securities held by the State Government. After the exhaustion of the special WMA limit, the State Government is provided a normal WMA.
• The normal WMA limits are based on three-year average of actual revenue and capital expenditure of the state.

The withdrawal above the WMA limit is considered an overdraft. A State Government account can be in overdraft for a maximum 14 consecutive working days with a limit of 36 days in a quarter. The rate of interest on WMA is linked to the Repo Rate. Surplus balances of State Governments are invested in Government of India 14-day Intermediate Treasury bills in accordance with the instructions of the State Governments.

Deficit financing is the budgetary situation where expenditure is higher than the revenue. It is a practice adopted for financing the excess expenditure with outside resources. The expenditure revenue gap is financed by either printing of currency or through borrowing.

Nowadays most governments both in the developed and developing world are having deficit budgets and these deficits are often financed through borrowing. Hence the fiscal deficit is the ideal indicator of deficit financing. There are several methods of Deficit Financing such as:

1. Borrow from domestic or foreign sources
2. Draw upon its foreign exchange reserves
3. Print an equivalent amount of money.

How these factors influence the other economic factors:

• If the government borrows too much from abroad, it leads to a debt crisis. The money that has been borrowed from abroad comes on sovereign guarantee and is called Sovereign Debt. Governments usually borrow by issuing securities, government bonds and bills. However not all governments can borrow by these methods. The less creditworthy countries need to borrow directly from World Bank or other financial institutions. The debt may be short term or long term. Inability to service the debt may result in Sovereign Default which is another name of Debt Crisis.
• Excessive domestic borrowing by the government may lead to higher real interest rates and the domestic private sector being unable to access funds resulting in the “crowding out” of private investment.
• If the government draws down on its foreign exchange reserves, a Balance of Payments crisis may arise. Balance of payments (BoP) accounts are an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country’s exports and imports of goods, services, financial capital, and financial transfers. A BOP crisis, also called a currency crisis, occurs when a nation is unable to pay for essential imports and/or service its debt repayments. Typically, this is accompanied by a rapid decline in the value of the affected nation’s currency.
• In a general sense, excessive printing of money leads to inflation. This is because when government prints too much money, its purchasing power goes down and a situation of too much money choosing too few goods.

Why printing of currency is used as a last resort: Printing Currency is used by the Government as last resort in deficit financing. The printing of currency has its own side effects such as increasing inflation and pressure on the Government for upward revision of the wages. Further, printing currency does not meet the expenditures which are needed to be met with foreign currency only.

From the above discussion it makes clear that it is not prudent for a government to run an unduly large deficit. But at the same time, for a developing country like India, it is also not prudent to have surpluses at the cost of long-term growth.

This is because the need for infrastructure and social investments is substantial. So, the most developing country governments have the biggest challenge to meet infrastructure and social needs while managing the government’s finances in a way that the deficit or the accumulating debt burden is not too great.

• India is a developing country. It has not reached the limits of growth. There is a huge percentage of population that earn in the subsistence level. If India can increase the earnings of these people, it can increase its GDP per person. Now to increase the earning potential of these people India needs to make some investments in infrastructure and provide capital to the industries to provide employment for these people. The funds for such investments can either be sourced through fractional banking i.e., printing notes or through public debts. That is why India always has a deficit budget to make public investment.
• Moreover, with large proportion of people under Below Poverty Line (BPL) and making sure that all the necessary support be provided to them so that they can live a meaningful and just life is always a priority for any government. Because of this subsidies bill is increasing year-on-year. In recent times the discretionary subsidies have becoming duty-based subsidies (rights-based approach).

Example: Right to Education, Right to Work (MGNREGA) etc.

Another reason is fiscal populism practiced by many central and state governments, especially before the upcoming election.

 Problems in the long run:

• This Fiscal Populism in the long run would effectively erode the effectiveness of the fiscal policy and especially subsidies.
• As deficit bill is increasing, which simply equals to “borrowings”, these borrowings have to be financed by the future generations. So that the resources available for their own consumption will be less.
• Populism is a very dangerous act in Democratic Country especially country like India where large section of population is poor, for the reason that if any govt. reduces the subsidy bill for prudence considerations that particular govt. will be punished in the next elections. So, subsidies many times locked in upward spiral.
• On the other hand, taxpayers will somehow try to avoid paying taxes due to mindless nature of subsidies and lack of trust in the Govt. spending.

It means revenue and capital expenditure programs aimed at subsidizing a large, preferably majority, of the voting population. The “mindless” nature of populism that as per capita incomes have increased manifold, so has the percentage of the population subject to income tax. So, this financing class worries about the efficacy of the delivery of subsidies to the poor, and to themselves.

Generally, subsidies are for the poor and to some sections of the middle class. Indian subsidies are framed so obscurely that rich, poor and middle class are treated alike and, in the end, due to lack of effective delivery system poor does not get their quota and rich receiving a major part of subsidies.

Example: In India according to Tendulkar Committee (2005) 22% of people are Below Poverty Line (BPL). The national food Security Act (2013), which provides subsidized food grains less than 2 rupees, is for the 50% of the Urban population and 75% of Rural population which aggregately equals to 67% of the total population. This explains the “mindless” nature of the subsidies. Instead of providing subsidized food grains to only 22% BPL families, the act provides for 67% Population.

Fiscal profligacy would be when the government doesn’t care about its revenues and keeps borrowing money to spend. It would lead to a larger fiscal deficit which is not good for any economy. Fiscal profligacy is opposite of fiscal prudence.

The government policy of spending more than its tax revenues and the shortfall is met by taking loan (debt) from public. The shortfall continues to increase because of additional burden of interest and repayment of earlier loans. The government’s such a fiscal policy is called fiscal profligacy.

Fiscal consolidation is a term that is used to describe the creation of strategies that are aimed at minimizing deficits. In simple terms when govt try to reduce their unnecessary expenditure to improve the condition of govt account and save money this is called fiscal consolidation.

According to OECD “Fiscal consolidation is a policy aimed at reducing government deficits and debt accumulation.”

Fiscal consolidation is a process where government’s fiscal health is getting improved and is indicated by reduced fiscal deficit. Improved tax revenue realization and better aligned expenditure are the components of fiscal consolidation as the fiscal deficit reaches at a manageable level. In India FRBM act 2003 is the example of fiscal consolidation.

Fiscal prudence is Spending within budget. Fiscal prudence means when your expenses are according to your planned expenditure and your budget doesn’t suffer a deficit. Fiscal prudence has a lot in common with fiscal consolidation and/or “austerity”, where government takes stringent steps to curb the inflation and correct fiscal deficit. Governments around the globe follow ‘prudent fiscal policies’ such as Cutting government spending, increasing tax rate, limiting perks and allowances to government employees and trying to make PSUs profitable.

Internal debt comprises treasury bills, market stabilization schemes, ways and means advance, and securities against small savings.

Types of Public Debt: Government loans are of different kinds, they may differ in respect of time of repayment, the purpose, conditions of repayment, method of covering liability etc.

The kinds are:

Productive and Unproductive debts: The debts which are productive for the economy are known as productive, similarly the debts which do not benefit the economy are unproductive.

Voluntary and Compulsory Debt: Generally, the debts taken are voluntary, on the part of the government, known as voluntary debts whereas in times of wars or crisis there is a mandatory loan taken by the government known as compulsory debt. It is a rare phenomenon.

Internal and External Debt: Internal debt refers to public debt floated within the country; While external debt refers loans floated outside the country.

Short–Term, Medium–Term & Long-Term Debts: The debts maybe for short, medium, or long periods. Redeemable and Irredeemable Debts The debts which the government promises to pay at a future date are known as redeemable and Irredeemable is vice-versa. It does not have a maturity period.

Funded and Unfunded Debts: The funded debts are those which are paid after a long period of time with a fixed rate of interest. Unfunded debts are incurred to meet the temporary needs of the government. They are of a comparatively short period say a year.

Internal Debt: Market loan Treasury bills Bonds Special securities issue by RBI Ways and Mean Advances (To meet the short-term expenditure) Special floating and other loans.

External Debt: Bilateral borrowings multi-lateral borrowings Loans from international organizations like IMF, World Bank etc.

The Constitution of India gives the executive branch of Government the powers to borrow upon the security of the Consolidated Fund of India. Reserve Bank as an agent of the Government (both Union and the States) used to implement the borrowing program. The Reserve Bank draws the necessary statutory powers for debt management from Section 21 of the Reserve Bank of India Act, 1934.

While the management of Union Government’s public debt is an obligation for the Reserve Bank, the Reserve Bank undertakes the management of the public debts of the various State Governments by agreement.

The jurisdiction of various institutions responsible for public debt management is given below:

1. Reserve Bank of India – Domestic Marketable Debt i.e., dated securities, treasury bills and cash management bills.
2. Ministry of Finance (MOF); Office of Aid and accounts Division – external debt
3. Ministry of Finance; Budget Division and Reserve Bank of India – Other liabilities such as small savings, deposits, reserve funds etc.

For monetary and fiscal coordination, there is a cash and debt management committee which meets regularly.

The members comprise of officials from RBI and MOF.

In India, public debt refers to a part of the total borrowings by the Union Government which includes such items as market loans, special bearer bonds, treasury bills and special loans and securities issued by the Reserve Bank. It also includes the outstanding external debt.

The difference between receipts and disbursals is the net accretion to the public debt. Public debt can be split into internal (money borrowed within the country) and external (funds borrowed from non-Indian sources).

What is the need of the act: In 1980s, India saw a sharp deterioration of the fiscal situation, which ultimately culminated in the balance of payments crisis of 1991. Within a decade of economic liberalization, the fiscal deficit and debt situation again seemed to head towards unsustainable levels around 2000.

At that time, there was a need to institutionalize a new fiscal discipline framework. The FRBM Bill 2000 was introduced by previous NDA government in the parliament to institutionalize the fiscal discipline at both the centre and state level. However, the bill took three years to become an act and during this process, it lost most of its teeth.

The key provisions of the FRBM Act:

• Every year the government will bring down revenue deficit by 0.5% and eliminate it by 2007-08.
• Every year, the government will bring down fiscal deficit by 0.3% and bring it down to 3% by 2007-08.
• Total liabilities of the Union Government should not rise by more than 9% a year.
• Union Government would not give guarantee to loans raised by PSUs and State governments for more than 0.5% of the GDP in aggregate.
• Union Government would place three more documents along with the budget documents viz. Macroeconomic Framework Statement, Medium Term Fiscal Policy Statement and the Fiscal Policy Strategy Statement.
• At the end of second quarter, the finance minister would make a statement on the trend of fiscal indicators and corrective measures taken thereof.

However, due to the 2007 international financial crisis, the deadlines for the implementation of the targets in the act was initially postponed and subsequently suspended in 2009. In last few years, the act has been largely neglected.

Amendments to the Act were made after its initial version in 2003. This includes revision of the target realization year and introduction of the concept of effective revenue deficit. In 2012 and 2015, notable amendments were made. As per one provision of the amendment, a “Medium-term Expenditure Framework” statement should be prepared which will set a three-year rolling target for expenditure indicators.

As per the amendments in 2012, the Central Government has to take appropriate measures to reduce the fiscal deficit, revenue deficit and effective revenue deficit to eliminate the effective revenue deficit by the 31st of March, 2015 and thereafter build up adequate effective revenue surplus and thereafter as may be prescribed by rules made by the Central Government.

As per Finance Act 2015, the target dates for achieving the prescribed rates of effective deficit and fiscal deficit (3% fiscal deficit) were further extended by 3 years to March 2018.

In the 2014-15 budget speech, Finance Minister Arun Jaitley announced the constitution of Expenditure Management Commission (EMC). The Commission had been conceived as a recommendation body with the primary responsibility of suggesting major expenditure reforms that will enable the government to reduce and manage its fiscal deficit at more sustainable levels.

The EMC was formed as a five-member body composed of the former Reserve Bank of India (RBI) Governor Bimal Jalan, who has been appointed to Head the Commission, former Finance Secretary Sumit Bose, former Deputy RBI Governor Subir Gokarn and two other members.

The commission was mandated to evaluate proposals for reducing the three major subsidies (i.e., food, fertilizer and oil). The commission was to submit an interim report before the presentation of the Budget for 2015-16. The final report was to be submitted before the 2016-17 budget. But the Commission took a little more time.

The expenditure management commission, headed by former Reserve Bank of India (RBI) governor Bimal Jalan, submitted its first interim report in January 2017 to Finance Minister Arun Jaitley. The finer details will take time till Finance Minister and a team of policymakers examine it and make it public. However, the broad proposals suggest ways for the government to reduce administrative costs and disburse funds for various schemes more efficiently.

The Commission is anticipated to give following broad proposals in the report

• Ways for the govt to cut administrative costs
• Panel has suggested ways to spend budgetary allocation effectively
• Delivery mechanisms, technology, accounting methods being studied.

The Indian economy is facing demand and supply side shocks due to demonetization and a sluggish development in exports and Industrial sector which has reduced the growth forecast a little bit for the year 2017 and 2018. Government has implemented and OROP for defence personnel and the seventh pay commission for the government employees, which would have repercussions for the government expenditure.

Also, government’s announcement of recapitalization of banks in view of mammoth Non- Performing Assets as well proposal of increase in public sector investment in infrastructure, railways as well as rural development would also put pressure on government exchequer apart from various subsidies. The additional proceeds from Public Sector disinvestment is also uncertain.

As per the Union Budget 2016-17, the government constituted a committee headed by N K Singh to review the implementation of the FRBM Act. This was after a widely held view among experts that instead of fixed fiscal deficit targets.

During Budget speech in 2016, Mr. Jaitley expressed this debate: “There is now a school of thought which believes that instead of fixed numbers as fiscal deficit targets, it may be better to have a fiscal deficit range as the target, which would give necessary policy space to the government to deal with dynamic situations. There is also a suggestion that fiscal expansion or contraction should be aligned with credit contraction or expansion, respectively, in the economy.”

The committee submitted its report in January 2020 and it was made public in April that year. The major recommendations of the N.K.Singh Committee are discussed below.

• It proposed to replace the FRBM Act, 2003 with a Debt Management and Fiscal Responsibility Bill, 2017.
• Debt to GDP Ratio
  • The debt to GDP ratio should be 38.7% for the central government, 20% for the state governments together by the FY 2022 – 23.
• Fiscal deficit
  • By FY 2022 – 23, the fiscal deficitshould be 2.5% of GDP.
• The committee recommended achieving the above targets by a ‘glide path’, that is, a steady progress towards them, by achieving annual targets until 2023.
• Fiscal Council
  • It recommended the setting up of an autonomous Fiscal Council, whose role would be:
    • To prepare multi-year fiscal forecasts.
    • To improve fiscal data quality.
    • To suggest changes to the fiscal strategy.
    • To advise the government on fiscal matters.
  • The committee recommended that the government could deviate from the targets in the following scenarios:
    • National calamity, war, in considerations of national security, agricultural collapse affecting incomes and outputs.
    • Structural reforms in the economy having fiscal implications.
    • A decline in real output growth of at least 3% below the average of the previous four quarters.
  • The 15th Finance Commission should recommend the debt trajectory for each state based on their track record of fiscal health and prudence.
  • The centre should borrow from the Reserve Bank of India only when:
    • It has to meet a temporary shortfall in receipts.
    • RBI subscribes to g-secs to fund any deviation from the prescribed targets.
    • RBI buys g-secs from the secondary market.
  • Compatibility of monetary and fiscal policies
    • The committee recommended that both the monetary and fiscal policies must ensure macroeconomic stability and growth in a complementary manner.
    • To this end, the inflation targeting regime and fiscal rules have to interact with each other.

The origin of the railway budget goes back to a report by British politician William Ackworth in 1924. He recommended a separate railway budget, given that most of the infrastructure spending by the British government went towards building railway lines. Now, the railway budget size is quite small at Rs.1.21 trillion compared to India’s overall budget of Rs.19.8 trillion.

A committee headed by Niti Aayog member Bibek Debroy in his report on restructuring the public transport behemoth last year had recommended that the railway budget should be phased out progressively and merged with the general budget.

How is it beneficial:

• Railways will get exemption from payment of dividend to General Revenues and its Capital-at-charge would stand wiped off.
• The Capital at charge of the Railways on which annual dividend is paid by the Railways will be wiped off. Consequently, there will be no dividend liability for Railways from 2017-18 while Ministry of Railways continue to get Gross Budgetary support for capital expenditure. This will save Railways from the liability of payment of approximately 10,000 crore as annual dividend to the Government of India which after adjusting the subsidy in payment of dividend would give a net benefit of about 5000 crore to the Railways.
• The presentation of a unified budget will help present a holistic picture of the financial position of the Government
• Merger of Rail Budget with Union Budget would facilitate multimodal transport planning between highways, railways and inland waterways.

Background:

• Long-pending proposal to set up an independent agency to manage Central government borrowings.
• Setting up of Public Debt Management Agency (PDMA) will require amendments to the RBI Act.
• The need for an independent debt manager for the Centre is becoming more underlined as its borrowings cross over Rs 6 lakh crore and it is trying to lower its fiscal deficit to less than 4 per cent this fiscal.
• The rationale for PDMA is simple – it would permit the RBI to focus more fully on its responsibility of setting the monetary policy as well as do away with the conflict of its twin roles as the manager of government debt as well as its banker.
• The model is followed internationally in most developed economies including the United Kingdom and Sweden.

Setting up of Public Debt Management Cell:

Government has set up a Public Debt Management Cell (PDMC) with the objective of deepening bond markets in the country. PDMC will streamline government borrowings and better cash management for deepening bond markets.

Key Facts

• PDMC is an interim arrangement and will be upgraded to a statutory Public Debt Management Agency (PDMA).
• Thus, it is a requisite preparatory work for PDMA.
• It will allow separation of debt management functions from RBI to PDMA in a gradual and seamless manner, without causing market disruption.
• The Middle Office of the Budget Division in the Union Finance Ministry will be subsumed into PDMC with immediate effect.
• The Joint Secretary (Budget), Department of Economic Affairs of the Finance Ministry will be the overall in-charge of the PDMC.
• PDMC will have only advisory functions in order to avoid any conflict with the statutory functions of RBI.

Functions of PDMC

• Plan government borrowings, including market borrowings and other borrowings, like Sovereign Gold Bond (SGB) issuance.
• Manage government’s liabilities, improve cash forecasting, monitor cash balances, foster a liquid and efficient market for government securities.
• Advise government on matters related to capital market operations, investment, administration of interest rates on small savings etc.
• Develop an Integrated Debt Database System (IDMS) as a centralised data base for all liabilities of government, on a near real time basis.
• IDMC will be an integral part of PDMC.

Why needed?

• With establishing PDMA, Government seeks to divest the RBI of its dual and often conflicting roles as the banker and manager of the Central Government’s borrowing.
• It will also facilitate in better planning and management of domestic and foreign market borrowings of Central Government.
• It will help in strengthen bond market and help to promote investment.
• It will be in pursuance global practice of shifting public debt management from central bank to a debt management office.

Recently there was controversy regarding the proposal to establish the Public Debt Management Agency (PDMA) by the government. Many economists argue that it is prudent to leave debt management to the RBI alone. Analyse the issue. (200 Words)

 Why PDMA needed?

Fragmented jurisdiction in public debt management: Before the creation of PDMA, the central Bank or RBI used to manage the market borrowing programmes of Central and State Governments. On the other hand, external debt was managed directly by the Central Government. Establishing a debt management office would consolidate all debt management functions in a single agency.

PDMA can be the catalyst for wider institutional reform, including building a government securities market, and bring in transparency about public debt.

It is considered as an internationally accepted best practice that debt management should be disaggregated from monetary policy, and taken out of the realm of the central bank.

Arguments for PDMA

If debt management is with RBI, there will be conflict of interest. RBI has to reduce the cost of govt. debt (lower interest rate) and also manage inflation levels (higher interest rates)

Reports of Narsimhan committee, Vijay Kelkar and Percy Mistry committees, there is an emphasis on the formation of a separate agency.

Arguments against PDMA/ Challenges:

Previously RBI too had handled the debt management in a transparent and efficient manner. The present system of debt management is working good, as it has helped in maintaining debt at a manageable level always.

RBI is already prohibited from interfering in the primary market according to the FRBM act, and the govt. bonds are solely auction driven. So, a separate agency is not needed

Other countries like UK, had also reverted to assigning the debt management activity to national banks, after forming similar separate agencies

Mutual coordination can become difficult

RBI also manages states’ debts and the PDMA is not very clear on what happens to that function. PDMA under central government have implication for federal structure of India.

Even though if a separate public debt management agency is to be created, it must be done gradually and systematic fashion
This agency should be independent. Proposed agency is under the supervision of central government.