ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Fiscal Deficits and Fiscal Responsibility Act

Fiscal authority should make a distinction between cyclical and structural movements in the fiscal deficit, for otherwise its policy actions may lead to an increase in the amplitude of cycles experienced by the economy.

In India, over the last several years, public debate with respect to fiscal policy reforms has proceeded at three distinct levels: at the microeconomic level, where discussion has centred on the base and structure of tax rates and the distribution of government expenditures across alternative end uses; at the administrative level, where concern has been expressed with respect to the quality of government expenditures, the delivery of its services and the inefficiencies inherent within its tax collecting bureaucracies; and at the aggregate, macroeconomic level, where attention has focused on the size of the government’s fiscal deficits (and its various counterparts) and the implications this carries for real interest rates, inflation, investment and growth. This note concerns itself primarily with the last aspect, that is, with the macroeconomic and monetary aspects of the government of India’s budgetary operations. Specifically, it points to certain weaknesses in the Fiscal Responsibility Act (FRA), as it is currently conceived,1 which, if not rectified, may lead to fiscal policy actions that have a serious deleterious effect on the macroeconomic health of the country.

As is well known, in a world characterised by perfect competition, the absence of externalities (in production and consumption), complete (intra- and inter-temporal) markets and the availability of lump sum tax/subsidy instruments, the time path of government taxes and expenditures carries no material implications for the real economy. The level or, present discounted value, of government expenditures does matter. What does not matter is whether these expenditures are financed by current, as opposed to future taxes, or borrowing. This, in a nutshell, is the famous Ricardian Equivalence Proposition (REP): the size of a country’s fiscal deficit, or its national debt, at any point in time is irrelevant to any economic issue of consequence.

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