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Harish KUMAR
Hirdesh KUMAR
Dharmesh MAKWANA
Raman KRISHNAN
Lakhan Singh MEENA
9/14/2014
A study of the different mechanisms in place in the European Union member states for achieving fiscal
discipline in budget formulation, passage through the parliament and execution, followed by a
discussion of the prevalent system followed in India. We analyze the revenue deficit data of each annual
central budget from 1971-72 to 2013-13. Based on our analysis we recommend a model to be adopted
by India.
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2.
Introduction ........................................................................................................................................... 1
3.
3.2.
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7.
Bibliography ................................................................................................................................................ 16
1. Executive Summary
This report studies the various forms of fiscal governanceprevelant in the European Union
member states. It begins with a brief discussion on the importance of fiscal discipline and
hence the need for fiscal governance.The models of fiscal governance have been proposed
by Hallerberg et al (2007). Two models of fiscal governance have been described, viz. the
delegation form and the contract form. We examine the specific conditions under which
each of these forms of fiscal governance is most effective. We then describe the model of
fiscal governance followed by the Central Government in India. We analyze the data of
revenue deficit for a period of 43 years from 1971-72 to 2013-14 and try to determine
whether there is an underlying pattern which relates to the models described by Hallerberg
et al (2007). We conclude that there is a need to institutionalize fiscal governance in India;
and we submit our recommendations for the same.
2. Introduction
Fiscal Discipline is a much discussed term across the globe both in the developed as well
as the developing world. The financial crisis which broke out in 2008, and continues to have
an impact on the world economy even today, specifically emphasizes the relevance of fiscal
discipline in the context of the crisis faced by several countries of the European Union (EU)
such as Greece, Ireland, Spain and Portugal. However, the need for fiscal discipline was
realized much earlier and Hallerberg et al (2004) have observed that interest in fiscal rules
is a reaction to the experience in many countries of rapidly rising debt levels and
unsustainable deficits in the 1970s and 1980s.
The fiscal deficit is one indicator of the degree of fiscal discipline followed by a government.
It is essentially the excess of the total expenses of the government over the total revenues.
While the Government on the one hand is obliged to provide certain services to its citizens,
it is also constrained by the extent to which it can raise the money required for these
expenses through taxes. Governments resort to borrowing to make up the gap i.e. the fiscal
deficit. A high level of fiscal deficit might result in doubts rising about the ability to repay the
loans, i.e. the risk of default. This would be especially worrisome if a significant amount of
borrowings are from external (foreign) debtors. The cost of future borrowings would also
increase, as reflected through increasing bond yields, thus further exacerbating the
problem. Apart from this, such debts burden future generations and can be perceived as
unsustainable.
Fiscal deficit comprises of two components, the revenue deficit and the capital deficit.
Revenue deficit is the net of revenue income less revenue expenses, while capital deficit is
the net of capital inflow less capital outflows. A fiscal deficit by itself is not always bad,
especially if moderate. For example if the entire fiscal deficit is owing to capital expenditure,
then we could expect that the assets created through such expenditure would help boost
economic growth. This would in fact turn out to be good for the economy. In fact, Keynesian
economic theory calls for such counter cyclical expenditure by the government, to boost the
economy out of recessionary output gaps. Therefore, it is usually the revenue deficit which
is to be pegged down to reasonable levels.
The trend of fiscal deficit in the EU states for the period from 2002 to 2013 is shown in
figure 1, and the trend for India for the period from 1970-71 to 2014-15 is shown in figure 2.
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Figure 2: Trend of Gross Fiscal Deficit for India from 1970-71 to 2014-15
A comparison of the two graphs reveals that the fiscal deficit in India has ranged between
around 5% to about 6.5% of GDP and the lowest fiscal deficit achieved was 2.54% in the
year 2007-08. In contrast, the selected EU states in figure 1, display much higher diversity.
Germany sets the highest standard for fiscal discipline with deficits below 1% in the recent
past and a peak deficit of about 4.2% in 2010. On the other hand, the fiscal deficit of
Greece, the prodigal child of the EU, has plunged from 4.8% in 2002 to 15.7% in 2009
before making a mild recovery to 12.7% in 2013. Portugal and Spain, two other countries
who face the brunt of the global economic crisis, have less alarming levels of fiscal deficit
when compared to Greece. France has been included in the analysis to indicate that fiscal
deficit levels which are moderately high are not necessarily a cause for alarm. This is
because France has a highly educated and productive workforce and a strong service
sector. India shares both of these characteristics with France.
We now turn to examine the cumulative fiscal deficit, as a ratio of GDP, for Germany,
France, India and Greece in figure 3.
Figure 3: Debt to GDP Ratio for Selected EU member states and India
Source: http://www.tradingeconomics.com/country-list/government-debt-to-gdp
We note that the cumulative debt burden for India as percentage of GDP is not as alarming
as that of Greece. In fact it is even lower than corresponding figures for Germany and
France.
However, what needs to be examined is whether India is in position to reduce her debt.
Producing regular budgets with a deficit will add to the debt. To reduce the debt, we would
need a budget surplus. For this, we now take a look at the trade deficits. These are shown
in figure 4for Germany, France, Greece and India respectively.
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France
Greece
India
-5
2010
2011
2012
-10
-15
Figure 4: Current Account Balance as percentage of GDP
Source: http://data.worldbank.org/indicator/BN.CAB.XOKA.GD.ZS
We note that Indias current account balance as a percentage of GDP reflects unfavorably
with respect to both France and Germany. Greece, which had a much higher current
account deficit (as a percentage of GDP) as compared to India, has taken significant steps
to prune it down. Seen in this light, Indias current account balance is a cause for concern.
The fundamental identity of macroeconomics, S I + T G = X M tells us that for an
economy with a fiscal deficit, and a given level of savings, investments must drop for a
given level of GDP, i.e. we observe the crowding out effect. On the other hand, if
investments do not fall, then the net exports must drop. With India looking to play catch up
with the west, there is a need to make significant investments in infrastructure, which will in
turn help in making Indian exports competitive by improving efficiencies.
Therefore, we cannot expect to see a decline in the gross debt, in the above scenario,
unless we establish strong institutions which encourage fiscal discipline. Seen in this light, it
is clear as to why Greece faces a debt crisis, Germany has comfortably weathered the
storm, while Frances boat is rocking albeit gently.
The purpose of this paper is to analyze the fiscal governance models followed in various EU
member states and examine the feasibility of adopting these for further improving the quality
of fiscal governance in India.
Hallerberg et al (2010) point out that:
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Hallerberg et al (2010) cite the work of Alt and Lassen (2006) and Tanzi and Schuknecht
(2000) to emphasize the importance of transparency in the budget process. They observe
that countries with more transparent fiscal institutions have lower levels of debt.
We now take a look at the different forms of fiscal governance models in the EU member
states to gain more insights into the matter.
Existence of off-budget funds used to finance government activities, for example the
use of pension funds to defray government expenses of finance government
activities.
Spreading non decisions in the budget process, for example, automatically indexing
spending programs to price levels.
Existence of mandatory spending, for example laws other than the budget make
certain government expenditure compulsory.
Government enters into contingent liabilities, such as bailing out of banks, industries
etc.
The authors argue that greater centralization of the budget process increases fiscal
discipline and that the deviations listed above occur on account of certain level of
decentralization existing in the budget process.
In the European Union, the treaty of Maastricht, adopted by the member states of the EU in
1997 was the first attempt to establish uniform norms for fiscal discipline as a prerequisite
for joining the European Monetary Union (EMU). The Stability and Growth Pact (SGP)
required that each member state ensure a maximum annual budget deficit of 3% of
GDP, and that each maintain a cumulative national debt lower than 60% of
GDP.
Hallerberg et al (2009) note that: the structure of the bargaining process within the cabinet,
affects the size of the budget. They cite the common pool resource problem to explain that
policy makers do not consider the full tax implications of their spending. It is also an
example of the prisoners dilemma, in that all players are better off if they collaborate, while
each individual sees the benefit of defecting.
With this background, Hallerberg et al (2009) describe two models viz. the Delegation form
of fiscal governance and the Negotiation of fiscal contracts. Hallerberg et al (2007), describe
the models as follows.
full tax burden. The contract enforces the spending minister to adhere to his spending limit.
The contract is multi-annual for the entire tenure of the parliament and includes
contingencies for what to do if underlying assumptions about the economy are inaccurate.
The contract provides a medium-term orientation for fiscal policy and includes numerical
targets for specific budget items. In contrast to his role under delegation, the minister of
finance in this case monitors and enforces the fiscal contract but has little power at the
planning stage of the budget. At the approval stage in parliament, the legislature has strong
information rights, which enable it to monitor the executive's compliance with the budgetary
targets and the performance of individual ministries. At the implementation stage, the
contract approach resembles the delegation approach. It vests the finance minister with
strong monitoring capacities regarding the execution of the budget and the power to correct
deviations from it, Hallerberg (2009).
Hallerberg et al (2007) observe that determining as to which model is more appropriate to
address the externality problem of the budget process in a given country is a question that
arises in this context. We now compare the two forms of fiscal governance in the next
section to understand this aspect.
Delegation
Benefit from trusting one central
player
One-Party Majority Government,
Two Parties Closely Aligned
Generally good if institutions
consistent
tend to be overly optimistic
Not common (although now
coming)
Contracts
Benefit from Explicit Fiscal
Targets
Multi-Party
Generally good if institutions
consistent
tend to be pessimistic
common
Year
1970-71
1971-72
1972-73
1973-74
1974-75
1975-76
1976-77
1977-78
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
1984-85
1
Revenue Deficit
Majority
Government
-0.34
0.20
0.03
-0.35
-0.95
-1.02
-0.32
-0.41
-0.25
0.55
1.36
0.22
0.67
1.11
1.65
Year
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
Revenue Deficit
Coalition Government
2.37
3.17
2.41
2.40
3.67
2.97
2.42
2.30
2.95
3.71
3.34
3.91
4.25
4.25
3.46
The exception is the ministry of Railways, which has traditionally prepared its own budget since 1935. The Union
Minister of railways presents the Railway Budget a few days before the Finance Minister presents the Union
(General) Budget
Revenue Deficit
Majority
Government
Year
1985-86
1986-87
1987-88
1988-89
2.03
2.40
2.48
2.41
Year
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
2012-13
2013-14
Revenue Deficit
Coalition Government
2.42
2.50
1.87
1.05
4.50
5.23
3.24
4.38
3.60
3.26
Table 2: Annual Revenue Deficits Of the Government of India Grouped by Type of Government
We first conducted a test for the variances of the two groups. The test indicated that the two
groups are not significantly different, with F=1.484, p=0.1807. Accordingly we performed a
two sample t-test for equal variances. The t-test revealed that the mean revenue deficit of
budgets (M=0.604 SD= 1.156, N= 19) presented by Majority Governments is significantly
lower that the revenue deficit of budgets (M=3.185, SD=0.949, N=25) presented by coalition
governments. The t statistic with equal variances for the data is t (42) = -8.132.
The details are presented in table 3 below.
F-Test Two-Sample for
Variances
Mean
Variance
Observations
df
F
P(F<=f) one-tail
F Critical one-tail
RD M
0.603684211
1.337446784
19
18
1.484826725
0.18077955
2.05433062
RD C
3.185
0.901
25
24
Mean
Variance
Observations
Pooled Variance
Hypothesized Mean
Difference
df
t Stat
P(T<=t) one-tail
t Critical one-tail
P(T<=t) two-tail
t Critical two-tail
RD M
0.603684211
1.337446784
19
1.087901574
RD C
3.185
0.901
25
0
42
-8.13205767
1.83122E-10
1.681952357
3.66245E-10
2.018081703
Table 3: Results for test for equality of variance and t-test for data in table 2
We thus reject the null hypothesis in favor of our alternative hypothesis, and conclude that
the revenue deficit in budgets presented by coalition governments in India is indeed higher
when compared to the revenue deficits of budgets presented by majority governments.
Hallerberg and Yloutinen (2010) conclude that the more countries diverge from their
expected form of fiscal governance, the greater the increase in a countrys debt burden.
The need for formal rules for fiscal regulation in budgeting has been realized by the
Government of India quite some time. The Fiscal Responsibility and Budget Management
Act (FRBM) was passed by the Indian Parliament in July 2004. The act is modeled after the
Stability and Growth Pact (SGP) of the European Union, in that it envisaged the elimination
of revenue deficit by 31 March 2008 by setting annual targets for reduction starting from day
of commencement of the act.
The act was intended to introduce transparency in fiscal management systems in the
country, introduce a more equitable and manageable distribution of the country's debts over
the years and achieve fiscal stability in the long run. After the act took effect, fiscal deficit fell
to below 3% of the GDP in 2007-08. However, the act was suspended in 2009, citing the
global financial crisis as the reason for the governments inability to meet the requirements
of the act.
Hallerberg and Yloutinen (2010) predicted this scenario when they observed that while the
imposition of a formal rule may have a short-term effect, over the medium term decisionmakers are resourceful in devising ways to get around such formal rules.
StutiKhemani (2006), in a World Bank research brief, observes that national ruling parties in
India have weak incentives for fiscal discipline even when they lead majority governments.
She calls for setting up of an institutional mechanism that promotes credible commitment of
all parties, viz. an independent nonpartisan agency to enforce constraints on fiscal
aggregates such as the consolidation of government deficit and debt level.
Therefore we are of the view that:
1. The delegation for of fiscal governance, has worked reasonably well when majority
governments are in power but has not produced satisfactory results with respect to
the revenue deficit for the periods when coalition governments were in place.
2. The FRBM was in force during the time when coalition governments were in power.
We find that though it did bring about positive results, the FRBM was suspended by
a coalition government. Thus, the enactment of the FRBM by itself has not resulted
in long term fiscal discipline being followed in the budgeting process.
3. Contract form of fiscal governance will not be an appropriate solution in the Indian
context, since the possibility of a majority government being in place cannot be ruled
out, as witnessed in the 2014 general elections.
4. There is a need to institutionalize the fiscal governance process, irrespective of the
type of government in place, i.e. majority or coalition.
In this context, we note that the institution of the Finance Commission has worked well in
India insofar as distribution of tax revenues to the states is concerned. Article 280 of the
Indian Constitution, requires the President of India to set up a Finance Commission. The
Finance Commission is headed by a Chairman and has four other members, all of whom
are appointed by the President of India.They have a five year tenure. After lapse of their
tenure, a new Finance Commission is set up by the President. So far fourteen fourteenth
Finance Commissions have been constituted. The tenure of the Fourteenth Finance
Commission lapses on 31st October 2014, and their recommendations come into force from
1st April 2015, for a period of five years. The role of the Finance Commission is to give
recommendations on distribution of tax revenues between the Union and the States and
amongst the States themselves.
We recommend that the scope of the Finance Commission be expanded and that it be
empowered to impose fiscal constraints that are to be mandatorily followed by the
government in power. These fiscal constrains would inter alia cover the fiscal deficit and
broad sector wise expenditure plans. These recommendations would cover a span of five
years, in line with the other recommendations made by the Finance Commission at present.
Thus, it would bring in a mid-term perspective to the budget process, which is lacking at
present.
It could be argued that such a mandate to a non-political body would undermine the
democratic principles. This argument is accepted. Accordingly we recommend that the
Finance Commission, set overall targets for revenue deficits, and that the budget proposal
be vetted by the finance commission before being presented in the parliament.
This will ensure sufficient space for the political executive to formulate policies that are
consistent with their political mandate, while also ensuring fiscal discipline.
In fact, as far as monetary policy is concerned, such separation has already been carried
out through the setting up of central banks. In the European Union too, the concept of
Independent Fiscal Councils has been adopted by countries adopting either models of fiscal
governance, viz. the delegation form or the contractual form.
We propose that the institution of the Finance Commission be the designated independent
fiscal council for the Indian Government. The Finance Commission will thus act as an
advisory body to the Finance Minister and strengthen his hand. This support will be
especially useful when coalition governments are in place. A flow diagram indicating a
macro level view of the budget process indicating the role of the Finance Commission is
indicated in figure 5 below.
The effectiveness of fiscal councils in bringing about fiscal discipline itself has been
questioned by scholars and therefore we realize the need to build in adequate safeguards
to the model we propose. These include the following Xavier and Keiko (2011):
They should be fully owned by the local political sphere in terms of their objectives
and modus operandi
They should have their own staff and ring-fenced long-term resources their
management should enjoy formal guarantees of independence from elected officials
Their remit should be strictly limited to informing budget preparation and fiscal policy
formulation
To sum up, we conclude that of the two models of fiscal governance followed in the EU
member states, the delegation model has a better fit in the Indian context. However, we
also note that when coalition governments are in place, then the delegation model does not
lend itself to ensuring adequate fiscal discipline. To overcome this problem, we propose that
the Finance Commission, which is a respected and well established institution in India, be
strengthened to act as an advisory body to the finance minister.
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