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Budgetary Rules and Plan Financing

In the approach paper to the Eleventh Five-Year Plan, the Planning Commission has proposed a redefinition of the revenue deficit, concentration only on the primary and fiscal deficits as control variables, and an adjustment of the deficits for cyclical variations in gross domestic product. Importantly, the PC has also questioned the very compatibility of the targets under the Fiscal Responsibility and Budget Management Act with the imperatives of plan expenditure and its phasing over time. All these have drawn adverse criticism from the finance ministry and the Reserve Bank of India. After setting out the basics pertaining to the various budget deficits and the economic reasons for their targeting, this article examines the main issues in the debate among the three policy formulating bodies.

Fiscal Rasponsibility: A Raappraisal

Budgetary Rules andPlan Financing

Revisiting the Fiscal Responsibility Act

In the approach paper to the Eleventh Five-Year Plan, the Planning Commission has proposed a redefinition of the revenue deficit, concentration only on the primary and fiscal deficits as control variables, and an adjustment of the deficits for cyclical variations in gross domestic product. Importantly, the PC has also questioned the very compatibility of the targets under the Fiscal Responsibility and Budget Management Act with the imperatives of plan expenditure and its phasing over time. All these have drawn adverse criticism from the finance ministry and the Reserve Bank of India. After setting out the basics pertaining to the various budget deficits and the economic reasons for their targeting, this article examines the main issues in the debate among the three

policy formulating bodies.


“Good sense, sir, and rightmindedness Have little need to speak by rule. And if your mind on urgent truth is set, Need you go hunting for an epithet?” Goethe, Faust, Part I

I Introduction

he Eleventh Plan Approach Paper (EPAP) has made some interesting suggestions for revising the targets for revenue and fiscal deficits set under the Fiscal Responsibility and Budget Management Act (FRBMA). In view of the fact that under the current accounting practices, government grants for building tangible assets are treated as revenue, not capital, expenditure, EPAP toys with the idea of redefining revenue deficit to make it economically meaningful, but ultimately favours retaining the current definition and suggests that the government should abandon the “revenue deficit” altogether as a budgetary target and focus only on “the fiscal deficit and the primary deficit as the relevant control variables” [Government of India 2006]. Second, the paper recommends modification of the FRBMA rules so that targets for fiscal deficits are adjusted for cyclical variations in GDP. Third, the FRBMA targets for fiscal deficits, it is suggested, may be shifted “further out by say two years” in order to have an improved time profile of Eleventh Plan expenditure.

The EPAP proposals have drawn flaks from the ministry of finance (FM) as well as the Reserve Bank of India (RBI) (Financial Express, August 28, 2006). The suggestions relate primarily to financing the Eleventh Plan and its phasing, but they also involve more fundamental issues concerning the nature of fiscal targets appropriate for attaining basic social and economic goals. Resolution of these issues will be of great help in assessing the merits of the EPAP suggestions and their responses from the FM and the RBI. Hence, we reiterate1 in Section II some basics pertaining to budget deficits and the economic rationale of their targeting. In the light of this discussion Section III examines, in the Indian context, the main issues in the debate among the three policy-making bodies.

II Budget Deficits and Their Targeting

Budget Deficit:Accounting Convention andEconomic Significance

In economic theory, receipts and expenses of an economic agent during a year are treated as capital or current in accordance with whether they entail any change in the agent’s asset/liability position or stream of future receipts or payments. A surplus (deficit) in current account then reflects saving (dissaving) or addition to (fall in) the agent’s net assets.2 Since all expenses have to be met from current or capital receipts,3 saving (or revenue surplus) of the agent must necessarily equal net deficit on capital account.4 The counterpart of government’s fiscal deficit is gross borrowing of the agent which may be different from surplus in capital account due to non-debt creating capital account transactions.

The above definitions suggest that if one is interested in tracing temporal changes in the net worth position of an economic agent, the behaviour of the revenue balance rather than that of variations in gross indebtedness are of crucial significance. Indeed, debt financing of investment is often essential for the prosperity of business enterprises, though they need to keep a close watch on the cost of borrowing and the (risk-adjusted) return on investment. Even revenue deficits need not necessarily be a bad thing: a household may improve its (inter-temporal) utility through borrowing for purposes of consumption smoothing. Thus, running revenue deficits or piling up debt need not reflect profligacy or myopia, but may be optimal for maximising the agent’s objective function.

The above observations are not without relevance for government deficits either. The only caveat is that unlike that of private economic agents, the government’s objective function is inter-temporal social welfare, involving the well-being of both present and future generations. Hence, the significance of budget deficits lies in their welfare consequences arising through changes in the economy’s consumption, saving, investment or other relevant variables. It is from this perspective that one needs to evaluate the optimality of various fiscal targets.

Revenue Deficit: Social Cost-Benefit Calculus

Assume that (a) the measures of revenue deficit figuring in government budgets conform to economic principles; and (b) the economy operates close to full employment level. What then are the costs and benefits of revenue deficit?

The negative impact of a revenue deficit operates through three routes. First, since the deficit reflects dissaving due to budgetary operations,5 there is a fall in capital accumulation and growth.6 Second, internally held public debt does not, to be sure, represent the economy’s liability in the usual sense of the term; but since a larger debt involves higher deadweight loss of taxes required for its servicing, revenue deficits entail a diminution of future GDP. Third, though there is no capital stock against public debt due to revenue deficits, it is treated as wealth by private agents7 and hence leads to a lowering of investment and saving ratios. In order to correct for this distortion in private saving, the government needs to raise taxes,8 but these in their turn involve some deadweight loss for the economy.

Quite clearly, a cutback in revenue deficit raises future GDP and hence (future) social welfare through an increase in private and public consumption or an improvement in income distribution the government can effect through taxes and transfers.9

What about the cost of reducing a revenue deficit? Since the composition of a given revenue deficit and the mode of its cutback by a specified amount can vary enormously, it is necessary to have some bench-mark for purposes of comparison. It is natural in this connection to assume that given the (full employment) GDP and interest payments on outstanding debt, the levels of public consumption, redistributive expenditure and taxes are so chosen that the current social welfare is maximised. Under these conditions, the decline in current social welfare due to a reduction in the revenue deficit equals at the margin the loss on account of a rise in tax collections or of a fall in public consumption or redistributive expenditure.10 For assessing the desirability of a cutback in the revenue deficit, it is this loss of current social welfare that needs to be compared with the (maximum potential) increase in social wellbeing in the future arising from additional capital accumulation and lowering of the debt-GDP ratio. If this trade-off between current and future well-being is larger (smaller) than the society’s time preference, maximisation of inter-temporal social welfare requires the revenue deficit to be reduced (raised).

Given the above perspective, what is the rationale of targeting zero revenue deficit, as suggested under the golden rule? Since government saving under this rule is zero, it subsumes that private saving is socially optimal, or that social time preference is the same as that of private agents. There are several reasons why the rule may in fact violate optimality. Government policies, let us recall, are supposed to maximise inter-generational welfare, not welfare of only the present generation. Hence not only may the optimum revenue deficit in any period be positive or negative, but it is likely to vary over time. In a growing economy it may be welfare promoting to reduce (potential) consumption of the relatively wealthy posterity for alleviating acute the deprivation of the present generation. Again, since the marginal cost of raising tax revenue tends to go down with economic advancement, debt financing of a part of current government consumption and redistributive expenditure need not be reprehensible. Alternatively, the government may target a revenue surplus for supplementing private saving if the society as a whole values highly the international standing associated with rapid GDP growth,11 or people are collectively prepared to undergo privation for enriching posterity.12 Be that as it may, both the revenue deficit and its components form important control variables and require meticulous cost-benefit analysis for their targeting over time.

The targeting of the revenue deficit considered above is for an economy without any output gap. Economists of all hues (including those subscribing to the golden rule) agree that the target (applicable for a full employment economy) is to be attained on an average over a trade cycle, with below average deficits during booms and above average ones in times of depression. Such pro-cyclical adjustment of revenue balances promotes welfare through consumption smoothing and moderation of the cycle itself. Similar departures from the (full employment) deficit target are optimal in the case of agricultural cycles in countries like India. Finally, if the government finds itself saddled with large interest payments on account of public debt, the optimal provisioning of public goods and redistributive expenditure may involve a huge deadweight loss if the revenue deficit target is to be met at one go. Alternatively, there would be a huge cut in private consumption or serious worsening of income distribution. In such cases a gradual rather than big-bang adjustment of the revenue deficit (through a series of cutbacks in the primary revenue deficit) towards its target level would minimise the loss of social welfare.

Fiscal Deficit and Public Debt

The fiscal deficit represents an addition to public debt without any reference to what the borrowing is used for.13 This makes it difficult to relate the deficit to saving, capital accumulation and changes in the net asset position of the government and the economy. Hence arises the need for specifying the components of the deficit, especially the extent to which it represents debt financing of revenue or capital expenditure.14 Since we have already discussed the policy issues pertaining to revenue deficit, the rest of the section is devoted to an examination of a fiscal deficit incurred for meeting capital expenditure alone.

Note first that borrowing for asset creation does not entail the costs discussed in connection with the revenue deficit: it may cause some crowding out of private investment, but aggregate saving and investment of the economy tend to go up,15public debt as in the case of financial liabilities of the business sector is matched by assets,16 increased revenue from publicly funded capital stock can obviate the need for raising the tax-GDP ratio.17Does this mean, as the FM’s interpretation of the golden rule seems to suggest (Financial Express, August 28, 2006), that any amount of the fiscal deficit is alright so long as it finances capital expenditure? Since not only the FM’s but also the Twelfth Finance Commission’s (TFC18 ) and the RBI’s observations on the targets for fiscal deficit are far from illuminating, a few clarificatory words on the matter appear to be in order.

Optimum Deficit and Debt in aNeoclassical Economy

The golden rule bars government borrowing for revenue expenditure, but does not suggest that any amount of debt financed public investment is good for the economy. Here also we require a cost-benefit calculus for estimating the optimal levels of the

Economic and Political Weekly November 4, 2006

fiscal deficit19 and the debt-GDP ratio(s) associated with them. Let us first consider the determinants of optimum deficits and debt in a neoclassical full employment economy assuming that (a) private and social rates of time preferences are the same; and (b) there are no costs of taxation. While assumption (a) implies the golden rule and rules out debt financing of current expenditure,20 the implication of (b) is somewhat more complex and would be taken up when we examine how its relaxation affects the optimal fiscal policy rules. Under assumptions (a) and (b) the optimal levels of fiscal deficit and of government’s capital expenditure are the same. For examining their determinants it is useful to start with a neoclassical aggregate production function where human capital (Kh), infrastructural capital (K1) and other capital (K2) enter as separate arguments. For any given supply of labour and capital (K), or given the aggregate capital-labour ratio k(=K/L), there is an optimum combination of kh (=Kh/L), k1 (=K1/L) and k2 (=K2/L) at which GDP21 (per head) is maximum. Let the optimal ki’s be k*(i = h,1,2). Since

i the three capital stocks are non-fungible (in the short run), from an initial, suboptimum composition of K, ki’s can be adjusted to their optimum values only through differential rates of growth of Ki’s. When investment in a sector does not involve rising marginal cost of adjustment,22 under an efficient programme all investment should take place only in the*

sector23 (s) where k < k . Only after the

ii composition of capital stock has become optimal is it favourable to allocate investment such that all Ki’s grow at the same rate. With rising marginal cost, investment may be positive in all sectors during the adjustment process, but even so the larger share goes to the sector where actual ki*

falls short of ki .

What has the optimum investment programme suggested above got to do with policies concerning fiscal deficit and public debt? The clue to the answer lies in the (differential) gaps between social and private returns24 in different sectors and the consequent suboptimality of investment as well as the composition of the capital stock. The most glaring manifestation of this suboptimality is to be found in the huge shortfall of infrastructure and human capital in developing countries. In order to correct for the distortions the government can invest directly in these sectors, or support private investment through subsidies, viability grants or alternative forms of private-public partnerships (PPPs). While the best way of effecting the required increase in investment is a matter of detail and varies from sector to sector25 and over time, some of the important characteristics of the optimum time profile of government’s capital expenditure or fiscal deficit as a ratio of GDP26 are not too difficult to discern.

Consider first the targeted ratio of fiscal deficit (f) when the composition of the capital stock is optimum,27 f. The value

nof f is given by:


IgIgI1* * *

f = =⋅=s⋅ [λ k +λ k +λ k ]=s⋅λ

n hh 11 22


...(1) where Ig = capital expenditure of the government; Y = GDP; I = investment; s = optimum saving (and investment) ratio; λi = optimum share of government’s capital expenditure in the ith sector; and λ = optimal share of government investment in total investment.

Relation (1) suggests that greater the (overall) gap between social and private returns, the higher should be the value of λ for ensuring the optimal saving ratio; otherwise the return on foregone consumption will be lower and the saving ratio (driven by private preferences) less than its optimum. Again, since the gap between the social and private returns tends to be larger in social and infrastructural sectors,

λh and λ1 should be higher than λ2 under the optimum programme. It is thus obvious that the larger the optimum saving ratio


and greater the shares of kh and k1 in k, the higher should be the value of f.

nSecond, during the early phase of the government’s debt financed investment programme, f would be larger, the greater the shortfall of initial kh and k1 from their optimum values, the larger the aggregate saving ratio and the smaller the adjustment costs of sectoral investments. Third, f should initially be higher than

f. Over time f falls and approaches f

nn when (social) returns on the three types of capital have become equal. In case adjustment costs tend to fall over time,28 the time profile of the optimal fiscal deficit will be inverted U-shaped, rising over a period of time and then falling (to f), as

nthe composition of K moves towards its most efficient configuration. What about the optimum time trajectory of public debt? It is useful to consider first the steady state debt-GDP ratio, d, under

nthe optimal fiscal programme, remembering that public debt by itself does not impose any cost when (a) there is no

deadweight loss on account of taxation; and (b) the outstanding amount of debt reflects accumulated capital financed by the government. Since the steady state is characterised by an optimum composition of the capital stock,

⎛ KKK ⎞ K

h1 2

⎜λ⋅ +λ⋅ +λ⋅ ⎟⋅

dn=h 12

⎝ KK K ⎠ Y

= (λ ⋅α +λ⋅α+λ ⋅α)⋅ v

hh 11 22

= λv ...(2)

where αi = ratio of capital stock of sector i to total capital stock; v= (overall) capital-output ratio.29

Quite clearly, the larger the values of λ and v, the higher will be the long-run, optimum debt-GDP ratio. Thus if λ and v are one-third and 4.5 respectively (not outlandish values by any reckoning), the debt-GDP ratio would be 150 per cent! Since, v is positively impacted by saving and increasing importance of knowledge based activities requiring a whole host of infrastructural services tends to raise the optimum value of λ, a 150 per cent value of d is likely to be an underestimate.

nGiven some debt-GDP ratio (d1) to begin with, its behaviour over time is determined by the optimum time profile of the fiscal deficit and the GDP the growth associated therewith.30 During the adjustment of kh and k1 (and of k) toward their optimum levels, the growth rate of government investment exceeds that of GDP; but the gap between the two rates tends to disappear over time. The implication is that under the optimal programme of the fiscal deficit the debt-GDP ratio rises over time31 and approaches d.


Cost of Taxation

Since a part, often a major part, of the benefit from publicly funded investment in the social and infrastructural sectors does not directly accrue to the exchequer and all taxes involve some deadweight loss, it is important to consider how costs of taxation affect the aforementioned results relating to debt financing of government’s capital expenditure. The most important effect of these deadweight losses is to reduce the social return on investments which require raising tax for purposes of debt servicing. The additional tax often remains significant even allowing for the automatic increase in tax revenue (with little extra cost) as GDP rises32 with public investment. Let us see how the resulting, optimal fiscal deficit programme differs from the one considered above.

First and perhaps the most neglected in the ongoing discussion on debt and deficit, seigniorage33 now becomes a preferred mode of financing government investment. In the absence of any cost of taxation it does not matter whether the government borrows from the central bank or the public for purposes of capital expenditure so long as its social return exceeds the opportunity cost, viz, return on private investment:34 the net gain to the economy is the same in both cases. But when deadweight losses are large, substitution of borrowing from the public by seigniorage tends up to a point to raise economic welfare, given the level and composition of government’s capital expenditure. However, as we have discussed elsewhere [Rakshit 2005a], there is a limit beyond which relying on seigniorage becomes counterproductive. Even so, this source of funding can be quite significant: the optimum seigniorage35 as a ratio of GDP is around 2 per cent under a 6 per cent growth rate and can be more than 3 per cent if a well-designed public investment programme pushes the growth rate to 8.5 per cent or above.36

Second, the costs of taxation tilt the balance in favour of commercially viable investment projects and against those which are characterised by large positive externalities and high social returns, but do not yield commensurate revenue to the government. Some of the social sector investment may thus become suboptimal due to collection-cum-distortionary costs of raising tax revenue.

Third, costs of taxation reduce the (maximum attainable) social welfare, but can raise the need for debt financed government investment. The reason is that

(a) projects which directly raise the supply of public goods or improve income distribution on an enduring basis now tend to turn optimal; and (b) in many a PPP project government financing becomes superior to private funding, given the differential between the two borrowing rates. One or two illustrations may help to clarify the points.

Consider the optimum way of meeting the housing needs of government departments. Under the first best programme, the government may rent the required service from the market and meet the cost from tax revenue, remembering that there is little difference between social and private returns in respect of housing. However, when costs of taxation are significant, the government can improve social welfare through financing construction of its buildings, taking advantage of its relatively low borrowing rate. In many PPPs while harnessing the managerial and operational efficiency of private entrepreneurs, the government should remain responsible for providing the bulk of finance on grounds of optimality [Rakshit 2006]: the widely prevalent view that reduction of the fiscal deficit constitutes the raison d’etre of PPP is thus totally wrong. Or consider a project in some backward area which raises incomes of the indigent, but the additional output is somewhat lower than what would be generated by private sector investment of similar magnitude. The project should not be publicly funded under the first best situation – through taxes-and-transfers the indigent could then be made better off – but should form part of the government’s optimum fiscal programme when costs associated with taxes-and-transfers are factored in.

Fiscal Deficit under Business Cycles

We have already considered how targets for revenue deficits (under full employment) require anti-cyclical adjustments in the course of a business cycle. Such adjustments in revenue deficits automatically entail an anti-cyclical fiscal deficit. There are also other factors because of which it is welfare-promoting to adjust the fiscal deficit over trade cycles.

First, the government should in general try to implement its (optimal) investment programme without any reference to trade cycles: starting new investment projects when there is a slack and slowing down completion of ongoing projects for cooling the economy are inefficient and wasteful.37 Since cyclical variations are most pronounced for private investment, strictly time bound fiscal sops for fixed capital expenditure in times of unemployment would help the attainment of an optimum balance between private and public investment. On similar considerations it may be optimal to raise viability funding of PPPs.

Second, monetised financing of government expenditure should be anti-cyclical, with variations in borrowings from the central bank matching that in the fiscal deficit. This would be in tune with keeping (full employment) seigniorage at its optimum level.

Finally, cycles originating in supplyside shocks, e g, variations in the monsoon or oil prices, are often more important in developing countries than textbook cycles. This makes a higher fiscal deficit or providing larger support to investments that make the economy more resilient to such shocks optimal as a longer term strategy. So far as the cyclical components of the fiscal deficit are concerned, they would involve variations in external borrowing for smoothening domestic absorption – something which is not necessary when the cycles are demand driven.

III Planning Commission andIts Critics

In the light of our discussion in Section II, we now address the issues raised in the debate among the three policy-making bodies. These issues, let us recall, relate to redefinition of revenue deficits; focusing only on fiscal and primary deficits as control variables; adjustment of deficits for output gaps; and compatibility of FRBMA targets with the Plan expenditure and its phasing.

Revenue Deficit: Definition and Uses

The conventional measure of the revenue deficit is marred by two major deficiencies. Government expenditures routed through various agencies for creation of productive assets (as EPAP has noted) are treated as current, not capital; and so are all outgoes on human resources development (HRD). In view of the importance of these two categories of expenditure in the budget, the current definition of revenue deficit is quite inappropriate for examining the impact of the budget or framing policies. The solution lies not in abandoning the revenue deficit altogether as a target variable, but in having an estimate that conforms to economic logic: recall the crucial importance of the (properly defined) revenue deficit as a tool of promoting inter-temporal social welfare. Objections against such redefinition by all the three bodies – on grounds of (a) violation of long established, constitutionally recognised practices; and (b) loss of credibility of the government38 – do not appear well grounded. There is nothing sacrosanct about accounting practices that are seriously misleading. “Deficit financing” or the government budget deficit,39 once considered the most important source of inflation, has long ceased to figure in budget

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documents. Only since 1991 has the government started providing estimates of fiscal and primary deficits. Our suggestion is that (despite these precedents) let the budget, if the government so desires, continue to present conventional estimates of revenue deficit (RD) under the head RD0, but provide along with that two other measures of revenue deficit,40 RD1 and RD2, defined as follows: RD1 = RD0 – Government “revenue” expenditure for creation of tangible assets; RD2 = RD1 – Government expenditure for HRD.

Retention of RD0 would satisfy the official reverence for long-standing practices41 and be of no harm so long as it is not used for economic analysis or as a policy target. RD1 reflects government “dissaving” as defined in the system of national accounts (SNA), and forms part42 of CSO estimates of domestic saving. RD1, being comparable with other types of saving under SNA, is not irrelevant for analytical and policy purposes, especially if the focus is on accumulation of physical capital in a full employment economy. However, RD1 includes government expenditures on education and health, which practically all economists interested in analysing the sources of growth, have come to regard as (human) capital formation, not current consumption. Hence for an analysis of how far budgetary operations subtract from (or add to) the pool of domestic resources used for raising the productive capacity of the economy, RD2 is obviously superior to RD1. For the same reason RD2 must constitute an important fiscal target for attaining the optimum inter-temporal consumption profile.

Targeting Debts and Deficits

As a point of departure, consider the FRBMA and TFC targets. While the central government’s revenue and fiscal deficit targets under FRBMA, to be attained by 2008-09, are zero and 3.0 per cent respectively, TFC stipulations are more wideranging and for both the centre and states: between 2004-05 and 2009-10, the combined revenue, fiscal and primary deficits, and the debt-GDP ratio are to be reduced from 4.5, 8.9, 2.8 and 80.8 to zero, 6.0,

1.5 and 74.5 per cent respectively. The main instruments for attaining the TFC targets are (a) an increase in tax-GDP ratio by 2 percentage points; (b) freezing the primary expenditure-GDP ratio at 2004-05 level; and (c) a step-up in the ratio of government investment to GDP by 1 percentage point.

TFC’s is indeed an elaborate exercise, based on GDP growth projections at 7 per cent in real and 12 per cent in nominal terms; but the exercise is totally devoid of any cost-benefit calculus of the type suggested in Section II. Consider the most glaring deficiency of the targets. According to a World Bank report (2006), loss of manufacturing output on account of power shortage is 8.5 per cent in India, compared with less than 2 per cent in China and Brazil. Bottlenecks in transport, ports, and infrastructure are also estimated to cause significant losses in output, especially in export-oriented manufacturing units. The report goes on to suggest: the current gap in infrastructural stocks between China and India43 “is so large that for India to catch up only to China’s present levels of stocks per capita, it would have to invest 12.5 per cent of GDP per year through 2015” (italics added).

For its part, the EPAP has set a much more modest target: infrastructural investment as a ratio of GDP is to rise from 4.5 per cent in the Tenth Plan “to an average of around 7.5 per cent” [GoI 2006]. In fact, “public resources being limited”, the major part of the required finance is slated to come from the private sector. Both the aggregate investment in infrastructure and the government’s share in it, our earlier analysis suggests, fall far short of the optimum. The same can perhaps be said of the social sector expenditures suggested in EPAP. Add to that the misleading measures of debt44 and deficits under the current accounting practices, and it is difficult to appreciate how one can seriously suggest sticking to the FRBMA targets through thick and thin if the government’s objective is promotion of social welfare.

Churning out an alternative set of targets for debt and deficits is too difficult for an individual researcher; however, our earlier analysis suggests the need for radical changes in the exercise for estimating the fiscal targets and nature of their revision. First, instead of starting (like TFC and EPAP) with some projected GDP growth, one should start with the short-term full employment GDP and the historically given debt obligations, and work out the welfare implications of alternative levels of government’s primary expenditures (consisting of public consumption, subsidies and government investments) and modes of meeting these expenditures and interest payments. These welfare implications, as already noted, arise through the impact of the primary fiscal instruments on the current and (potential) future levels of public and private consumption and investment, their composition, and distribution of income. Since the future (full employment) GDP and public debt are affected by current fiscal measures, the optimality exercise involves working out the time profile of the targeted sets of fiscal variables, including revenue deficit, fiscal deficit, primary deficit and public debt as ratios of full employment GDP.

Second and related to the first, it cannot be overemphasised that some given set of deficits can have widely varying economic and welfare implications depending upon the primary instruments (e g, public consumption, government investment, tax, etc) through which they come about.

Third, apart from adjustments of fiscal targets to cycles (business or agricultural), revisions are also required where there are major, unforeseen demand or supply-side changes of an enduring nature.

Finally, for some back-of-the-envelope estimates of the required changes in fiscal targets over the next five years. As of now, there is not much scope of reducing public consumption expenditure. Substantial cut backs in various forms of subsidies (explicit and implicit) will be welfare enhancing45 and can total around 2 per cent of GDP. Given the huge infrastructural-cumhuman resources gap and the urgent need of raising the income earning capacity of the poor on an enduring basis, an optimal programme would involve raising government expenditure on (physical) investment to 10 per cent46 and on HRD by about 3 percentage points. The tax-GDP ratio can be raised by 3 percentage points if along with further rationalising of VAT the government reintroduces taxes on dividends, capital gains and inheritance. Such revisions in the primary fiscal targets implies a zero revenue deficit (when expenditures on HRD are treated as current). But the fiscal deficit jumps to 10 per cent.

The figures may appear alarming to many. Our submission is thus: let the official agencies lay their cards on the table, and make their inter-temporal optimality exercise available to the public for a fruitful debate. Churning out numbers from projections without factoring in the effects of policy instruments does not constitute good policy-making. Nor can any economist worth his or her salt seriously recommend adhering to targets when they are palpably suboptimal.




1 Even at the risk of some repetition of our earlier arguments in this journal [Rakshit 2001 and 2005].

2 Taking depreciation as part of current expenses even when there is no actual expenditure on this count.

3 Or drawing down cash balances or sale of assets.

4 The reason is that all capital account expenses must then exceed aggregate capital receipts by the agent’s net saving during the period.

5 Ignoring the indirect effects of these operations on private sector saving.

6 Though the fall in aggregate saving and capital accumulation is generally less than the revenue deficit.

7 Unless the Ricardian equivalence holds [Barro 1974], which is not generally the case, especially in developing economies with large capital market imperfections [Rakshit 2005a].

8 The increase in tax is over and above what is required to meet interest payments, remembering that tax financed interest payments leave the private disposable income unchanged and hence do not correct for the distortion in private saving.

9 Remembering that their distortionary costs tend to be moderate at relatively high GDP.

10 Since the marginal impact of the three fiscal variables on current social welfare is the same.

11 Which means that such a standing enters as an argument in the social welfare function.

12 In these cases there is an externality in the individual propensity to save: an individual is prepared to consume less for attaining the social goal provided others are also doing so. Hence the role of the government in stepping up aggregate saving. For further details see Rakshit (2001).

13 Or what is the scale and composition of capital receipts. Thus the borrowing may be used for meeting current or capital expenditure. Alternatively, given the level of government’s current and capital expenditure, a reduction in tax revenue matched by an equivalent amount of increase in non-debt creating capital receipts (e g, recovery of loans or disinvestment proceeds) leaves the fiscal deficit unchanged. Hence the problem.

14 Ignoring non-debt creating capital receipts of the government. See Rakshit (2000) for a discussion of some economic and policy implications of these receipts.

15 This comes about through a rise in the interest rate under the neoclassical mechanism: the associated increase in saving prevents one-toone crowding out.

16 So that the effects of public debt on the economy’s saving and investment are no different from that of the accumulated stock of the business sector’s financial liabilities.

17 We shall presently consider the case where this may not be so.

18 See Government of India 2005.

19 What the RBI calls a “neutral” fiscal deficit may at first appear akin to this “optimal” fiscal deficit. But apart from the fact that the RBI makes no mention of the short- and long-term costs of debt financing, the concept (as in the case of “neutral monetary policy”) seems to refer to that level of the deficit whose impact on aggregate demand is neutral, i e, neither expansionary, nor contractionary. The problem, as we have noted elsewhere [Rakshit 2005a], is that the fiscal deficit is often a poor measure of the expansionary impact of a budget: a deficit (surplus) can in fact be contractionary (expansionary) depending upon the scale and composition of government expenditure.

20 Alternatively, the socially optimum rate of saving is the same as the private rate of saving.

21 Though, strictly speaking, we should consider NDP rather than GDP.

22 In general, the marginal cost rises since if a given addition to installed capacity is to be accomplished within a shorter period, both the acquisition and installation costs tend to be higher. Implementing agencies often also require time to build up their capacity for handling large scale investment. In some cases, adjustment costs become prohibitive beyond a point: even if resources are available, construction of a new highway or a port within a year is not feasible (i e, entails infinite cost).

23 If k1 < k1* in (say) h and 1, k2 is automatically larger than k1*.

24 The important reasons for the gap are indivisibility of investment projects (especially in infrastructure); positive externality; high cost (private or social) of charging the beneficiaries; higher risk for an individual than for the economy as a whole; and gross imperfection of the capital market. The gap is yawning in the case of roads, communications and marketing facilities which reduce chronic underutilisation of resources, both human and physical [Rakshit 2006].

25 For an analysis of the optimum mode of investment in highways see Rakshit (2006).

26 Remembering that given the time profile of labour supply, technology and adjustment costs of sectoral investments, an optimum combination of kh, k1 and k2 imply some optimum combination of investment-GDP ratios in the three sectors.

27 Under this condition investment in the ith sector as a ratio of total investment would equal k1*, so that the composition of capital stock remains unchanged.

28 With learning and experience.

29 When αi’s are optimal.

30 Recall that (a) all interest payments are financed through taxes; and (b) the fiscal deficit itself affects GDP through improvement in allocative efficiency and saving (due to a higher return on capital). The latter effect does not however obtain in the steady state.

31 Assuming that the initial, historically given level of d does not exceed d .


32 Note that it is the additional income over what would have taken place in the absence of public investment (i e, with no crowding out of private investment) that is relevant here.

33 i e, printing money or borrowing from the central bank.

34 Note that seigniorage reflects addition to private asset in the form of reserve money. Hence under the golden rule it (seigniorage) should be used only for purposes of investment.

35 Which, given the demand for real balances, depends on GDP growth and the social cost of inflation [Rakshit 2005a].

36 In the official writings on deficit and debt, seigniorage is conspicuous by its absence and clubbed with borrowing from the public even though there is grave concern on rising interest payments on public debt. Particularly curious is the TFC report, which despite its extensive discussion of the need for reducing debt and deficit, makes no mention of the composition of debt and significance of seigniorage for the debt burden.

37 Only when the economy is caught in a liquidity trap, as Japan was during the 1990s, large-scale public investment even with some wastage may be justified.

38 The problem of credibility is hammered by the FM and the RBI, not the Planning Commission.

39 Reflecting the amount of government expenditure met through issue of treasury bills.

40 Following the practice of providing alternative measures of money supply that help greatly in analysing the behaviour of the macroeconomy and formulating monetary policies.

41 Unless they have long been given up by governments in the advanced western economies.

42 With a negative sign.

43 Though in 1980 “India had higher infrastructural stocks”.

44 So far as public debt is concerned, no distinction is made between the debt held by the public and RBI. In its comments on EPAP the Reserve Bank does consider the gross and net asset and liability position of the centre and draws attention to

  • (a) significantly larger debt-GDP ratio of the central government in India compared with that in Australia, Canada, South Africa and US;
  • (b) negative net asset position of the centre and its deterioration since 1990-91; and (c) low rates of return on assets compared with the cost of borrowing. The problem however is that intercountry comparison of the debt-GDP ratio without any reference to the composition of debt, the ratios of government owned and other productive assets created through debt financing, and structural characteristics of the economy, can be seriously misleading: thanks to huge accumulation of public debt supported by its central bank, the world’s second richest economy has been able to emerge from the decade long depression. Apart from the fact that conventionally measured assets, especially when valued at their historical costs of acquisition, can seriously distort the true picture; worsening of the centre’s net assets is in fact due to fiscal fetishism: sharp cutbacks in government’s capital expenditure in order to rein in the fiscal deficit even in the face of recessionary conditions on the one hand and growing infrastructural constraints on the other have been the main factor behind the fiscal woes [Rakshit 2006]. The improvement in the debt position over the last four years or so following government initiatives in various infrastructural sectors lends strong support to our diagnosis.
  • 45 Remembering that a substantial part of them is enjoyed by the rich.

    46 This implies that the optimal government investment is about one-third of the economywide investment. In the medium run, this figure

    Economic and Political Weekly November 4, 2006

    should go up to 50 per cent and above with an improvement in the government’s ability to effectively implement investment projects, and then come down to around 35 per cent as the infrastructural constraint is eased.


    Barro, R (1974): ‘Are Government Bonds Net Wealth?’ Journal of Political Economy, November.

    Government of India (2004): Report of the Twelfth Finance Commission (2005-10), New Delhi.

    – (2006): Towards Faster and More Inclusive Growth: An Approach to the 11th Five-Year Plan, Planning Commission, New Delhi, June 14.

    Rakshit, Mihir (2000): ‘On Correcting Fiscal Imbalances in the Indian Economy: Some Perspectives’, Money and Finance, July-September.

  • (2001): ‘Restoring Fiscal Balance through Legislative Fiat’, Economic and Political Weekly, June 9.
  • (2005): ‘Some Analytics and Empirics of Fiscal Restructuring in India’, Economic and Political Weekly, July 30.
  • (2005a): ‘Budget Deficit: Sustainability, Solvency and Optimality’ in A Bagchi (ed), Readings in Public Finance, Oxford University Press, New Delhi.
  • (2006): ‘Issues in Infrastructural Investment: National Highway Development Programme’, Money and Finance, January-July.
  • World Bank (2006): India: Inclusive Growth and Service Delivery – Building on India’s Success, Report No 34580-IN.

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