Kerala seeking flexibility under the FRBM GS: 3 "EMPOWER IAS"

Kerala CM has urged the Centre to provide Kerala with flexibility under the Fiscal Responsibility and Budget Management (FRBM) Act so as to ensure that the State’s finances are not adversely impacted.

Why is Kerala seeking flexibility under the FRBM?

Kerala was one of the earliest States to announce an economic package of ₹20,000 crore to mitigate the impact on livelihoods and overall economic activity.
Kerala’s current fiscal position means that it can borrow about ₹25,000 crore during the financial year 2020-21.
However the State government is understandably concerned that the stringent borrowing cap under the fiscal responsibility laws should not constrain its borrowing and spending ability over the remaining 11 months.
This is a crucial period when the state would have to meet other expenditure for routine affairs related to the running of the State’s socio-economic programmes as well as the post pandemic recovery.

FRBM Act:

Fiscal Responsibility and Budget Management (FRBM) Act enacted in 2003 by the Indian parliament aims at bringing financial discipline on government expenditure.
Aimed primarily to bring a check on revenue deficit, the act strives to improve the overall management of public finance by controlling unchecked borrowings and imparting financial discipline.
When it was introduced for the first time, its target was to bring down the fiscal deficit to 3 percent of the GDP by 2008.
However, the act suffered several challenges, such as the global financial crisis of 2007, when it came to implementation due to several reasons.
On more than one occasion, the target planned to be achieved was relaxed or time frame was extended.

Features of the FRBM Act

It was mandated by the act that the following must be placed along with the Budget documents annually in the Parliament:

NK Singh Committee:

A committee was set up under NK Singh in 2016 to review the act.
The committee on its part recommended that the government should target a fiscal deficit that is 3 percent of the GDP by 2020 and bring it down to 2.5 percent by 2023.

Report Highlights:

“States’ gross fiscal deficit (GFD) has remained within the FRBM threshold of 3 per cent of gross domestic product (GDP) during 2017-18 and 2018-19. This has, however, been achieved by sharp retrenchment in expenditures, in particular, capital expenditure.
For 2019-20, states have budgeted for a consolidated GFD of 2.6 per cent of GDP with a marginal revenue surplus (as against revenue deficits in the previous three years).
The report said sharp reduction in capital expenditure by states has potentially adverse implications for the pace and quality of economic development, given the large welfare effects of a much wider interface with the lives of people at the federal level.
“Currently, states employ about five times more people and spend around one and a half times more than the Centre. Moreover, public expenditure by states influences the quality of physical and social capital infrastructure of the economy
“States’ revenue prospects are confronted with low tax buoyancies, shrinking revenue autonomy under the GST framework and unpredictability associated with transfers of IGST and grants.

Fiscal Indicators

It was proposed that the four fiscal indicators be projected in the medium-term fiscal policy statement viz.

Different types of deficits

Fiscal is the excess of what the amount the government plans to spend over what the government expects to receive.
Obviously, to make up this gap, the government has to borrow money from the market.But all government expenditure is not of the same kind.
For instance, if the expenditure is for paying salaries then it is counted as “revenue” expenditure but if it goes into building a road or a factory – that is, something that in turn increases the economy’s capacity to produce more – then it is characterized as “capital” expenditure.
The fiscal deficit is another key marker and it maps the excess of revenue expenditure over revenue receipts.
The difference between fiscal deficit and revenue deficit is the government’s capital expenditure.

What FRBM says on deficits?

As a broad rule, it is considered fiscally imprudent for a government to borrow money for “revenue” purposes.
As a result, the FRBM Act of 2003 had mandated that, apart from limiting the fiscal deficit to 3% of the nominal GDP, the revenue deficit should be brought down to 0%.
This would have meant that all the government borrowing (or fiscal deficit) for the year would have funded only capital expenditure by the government.

Why prefer capital expenditure over revenue expenditure?

In any economy, when the government spends money or cuts taxes it has an impact on the economic activity of the country.
But this impact (also called the “Multiplier” effect) is quite different for revenue expenditure and capital expenditure.
In other words, when the government spends Rs 100 on increasing salaries in India, the economy grows by a little less than Rs 100.
But, when the government uses that money to make a road or a bridge, the economy’s GDP grows by Rs 250.
The question then is: How to get governments to switch from revenue expenditure to capital expenditure? That’s where the FRBM Act comes in handy.

What is the significance of an FRBM Act?

The popular understanding of the FRBM Act is that it is meant to “compress” or restrict government expenditure. But that is a flawed understanding.
The truth is that FRBM Act is not an expenditure compressing mechanism, rather an expenditure switching one.
In other words, the FRBM Act – by limiting the total fiscal deficit (to 3% of nominal GDP) and asking for revenue deficit to be eliminated altogether – is helping the governments to switch their expenditure from revenue to capital.
This also means that – again, contrary to popular understanding – adhering to the FRBM Act should not reduce India’s GDP, rather increase it.

What has been India’s record on adhering to FRBM Act?

Between 2004 and 2008, the Indian government had made giant strides on reducing both revenue deficit and fiscal deficit.
But this process was reversed thereafter thanks largely to the Global Financial Crisis and a domestic slowdown.
Since then, there have been several amendments to the Act essentially postponing the targets.
But the worst development happened in 2018 when the Union government stopped targeting revenue deficit and instead focussed only on fiscal deficit.

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