One of the first legislative actions of the UPA government was to notify the Fiscal Responsibility and Budget Management Act (henceforth FRBM Act). This Act was notified on 2 July to come into force on 5 July 2004, only three days before the presentation of the Annual Budget, thereby circumscribing the entire budgetary exercise from the start of the new government’s tenure.

The FRBM Act is apparently well-intentioned, designed to clean up public finances and put them on a sustainable footing. Thus, it requires the reduction of the fiscal deficit and the elimination of the revenue deficit of the Central Government by 31 March 2008 (the deadline is to be extended by a year). This would appear to be a way of forcing the government to adhere to a discipline which would thereby allow it to spend more on useful capital expenditure.

However, the actual implications of the working of the Act are much more serious and potentially adverse, than is generally understood. Some of the requirements of the FRBM Act and the associated rules mentioned in the notification, are described in Table 1.

The Act requires the Central Government to reduce the fiscal deficit by 0.3 per cent of GDP each year, and the revenue deficit by 0.5 per cent each year, beginning with this financial year. If this is not achieved through higher tax revenues, the necessary adjustment has to be made by cutting expenditures.
Table 1 >>

Further, the Act prohibits the Central Government from borrowing from the Reserve Bank of India (that is deficit financing, involving the printing of money) to meet its deficit, except for temporary cash advances. This effectively rules out a cheap source of borrowing and forces the government to borrow at much higher rates, for no evident reason. The RBI is even to be prohibited from making primary market purchases of government bonds.

But the limitation on borrowing from the RBI, or deficit financing, is not at all something that can be easily justified. The argument that deficit financing causes inflation is not just simply wrong. It is now widely acknowledged across the world to be ridiculous and completely unwarranted, especially in the financially sophisticated world we live in. Inflation control does not at all depend upon controlling the central government’s borrowing directly from the RBI.

So this directive does not serve any useful purpose. Instead, it unnecessarily forces the government to pay much higher interest on all its debt, instead of allowing for some low interest debt to the RBI. This raises the interest cost of the government and thereby the total revenue expenditure, perversely making it harder to achieve the revenue deficit targets. It is hard to understand why this portion of the Act has been retained even when earlier discussion in Parliament pointed to the absurdity of this condition.

Furthermore, as can be seen from Table 1, the FRBM Act and Rules require a continuous reduction in revenue and fiscal deficits over the next four years, regardless of the prevailing macroeconomic circumstances. This insensitivity even to more obvious patterns such as the business cycle (which typically affects tax revenues and therefore public deficits) makes the entire legislation excessively rigid and ties the government’s hands even in terms of responding to the needs of its citizens.

But the most worrying – and potentially undemocratic – part of the FRBM Act relates to compliance conditions. The Act states that “whenever there is a shortfall in revenue or excess of expenditure over the pre-specified levels….the Central Government shall take appropriate measures for increasing revenue or for reducing the expenditure (including curtailing of the sums authorised to be paid and applied for from and out of the Consolidated Fund of India under any Act so as to provide for appropriation of such sums).”

The notification spells this out even more clearly: “In case the outcome of the quarterly review of trend in receipts and expenditure…at the end of any financial year… shows that

then… the Central Government shall take appropriate corrective measures.”

This means that if any of these conditions holds (which is very likely in most years) the government will in effect be forced to cut expenditures even if they are essential for the economy, or required to enforce its popular mandate or to deliver the socio-economic rights of the citizens.

This is going to hit home much faster than many people realise. The Budget 2004-05 contains what are widely recognised to be inflated and highly optimistic revenue receipt projections. Also, the overwhelming part of additional resource mobilisation in the budget is backloaded, to be available only after September. In addition, the truant monsoon is bound to depress revenues. By September, it is not just likely but almost inevitable that the actual revenue receipts will fall short of the Budget estimates by 40 per cent or more.