Context

• The management of fiscal deficit and government debt is a critical aspect of economic policy in any country, and India is no exception.
• The balance between government expenditures and revenues plays a pivotal role in determining the overall health of the economy.
• Therefore, it is important to explore the complexities of managing fiscal deficit and debt in India, particularly in the context of recent developments and historical precedents.

The 1980s Fiscal Crisis

• The 1980s marked a period of economic difficulty for India, characterised by a rising fiscal deficit and escalating government debt.
• This situation led to a severe balance of payments crisis and a high ratio of interest payments to revenue receipts.
• The government was forced to borrow progressively more to meet its developmental expenditures, which worsened the debt situation.
• This period highlighted the dangers of allowing fiscal imbalances to persist, as the government found itself trapped in a cycle of borrowing and debt repayment that left little room for productive investments or economic growth.

The 2024-25 Union Budget Fiscal Targets and Gaps in the Announcement

• Fiscal Targets
  • In the final Union Budget for 2024-25, the Indian government acknowledged the need to address fiscal imbalances and set forth ambitious targets for reducing the fiscal deficit and government debt.
  • The finance minister announced that starting from 2026-27, the government's goal would be to ensure that the central government debt is on a declining path as a percentage of GDP.
  • Specifically, the Budget projected a reduction in the fiscal deficit to 4.5% of GDP by 2025-26, down from the budgeted level of 4.9% in 2024-25.
  • At this level, the debt-GDP ratio is estimated to be 54% by 2025-26, assuming a nominal GDP growth rate of 10.5% over the next two years.
• Unclear Roadmap for Achieving Sustainable debt-GDP Ratio
  • Beyond these immediate targets, the government has not provided a clear roadmap for achieving a sustainable debt-GDP ratio in the long term.
  • The decision to abandon the Fiscal Responsibility and Budget Management (FRBM) Act's 2018 target of reducing the debt-GDP ratio to 40% for the central government and 60% for the combined government indicates a shift in fiscal policy.
  • Instead of adhering to a fixed target, the government now aims to maintain a gradually declining debt-GDP ratio, which could stretch well into the future.

An Overview of the Combined Fiscal Deficit and Its Economic Implications

• The Combined Fiscal Deficit
  • India's fiscal responsibility framework is not limited to the central government; it extends to the states as well.
  • Under their respective Fiscal Responsibility Legislations (FRLs), state governments are required to maintain a fiscal deficit target of 3% of their Gross State Domestic Product (GSDP).
  • These targets are designed to ensure that states maintain fiscal discipline, control their borrowing, and contribute to the overall economic stability of the country.
  • If both the central and state governments maintain fiscal deficits of 4.5% and 3% of GDP respectively, the combined fiscal deficit could reach 7.5% of GDP for several years.
  • Such a high combined deficit has profound implications for the broader economy, particularly in terms of investment and economic growth.
• Crowding Out Private Investment
  • The concept of crowding out refers to a situation where increased government borrowing leads to higher interest rates, which in turn reduces private sector investment.
  • In India's current context, where household financial savings have been on the decline, this crowding-out effect could be particularly pronounced.
  • For instance, in 2022-23, household financial savings were 5.3% of GDP, a significant drop from 7.6% in the preceding four years (excluding the COVID-19 year of 2020-21).
  • With only 5.3% of household savings and approximately 2% of net inflow of foreign capital, the available investible surplus of 7.3% would be fully absorbed by the government's combined fiscal deficit of 7.5% of GDP.
• Fiscal Imbalances and Long-term Economic Stability
  • The high combined fiscal deficit also raises concerns about long-term economic stability.
  • Persistent fiscal imbalances can lead to a vicious cycle of increasing debt and rising interest payments.
  • As the government borrows more to finance its deficit, the debt level increases, leading to higher interest payments.
  • These interest payments, in turn, consume a larger share of government revenue, leaving less available for other essential expenditures such as infrastructure development, education, and healthcare.
• Risks of Fiscal Indiscipline at the State Level
  • One of the risks of the central government's shift in fiscal policy is that it may set a precedent for fiscal indiscipline at the state level.
  • State governments might perceive the central government's abandonment of strict fiscal targets as a signal that they too can relax their fiscal discipline without facing serious consequences.
  • This could lead to a situation where states accumulate higher levels of debt without a clear plan for repayment, ultimately exacerbating the overall fiscal burden on the country.

International Comparisons, Challenges and Policy Recommendations

• International Comparisons and Challenges Before India
  • International comparisons reveal that India’s interest payments to revenue receipts ratio is much higher than that of other countries with similar or even higher levels of government debt-GDP ratios.
  • For example, during 2015-19, Japan, the United Kingdom, and the United States had interest payment to revenue receipts ratios of 5.5%, 6.6%, and 8.5%, respectively.
  • In contrast, India's combined interest payment to revenue receipts ratio averaged 24% during the same period, with the central government's post-transfer ratio averaging 49%.
• Policy Recommendation: The Need for Coordinated Fiscal Discipline
  • To prevent such outcomes, it is crucial that both the central and state governments adhere to a coordinated approach to fiscal discipline.
  • While some flexibility in fiscal policy may be necessary to respond to economic shocks or development needs, this should not come at the cost of long-term fiscal sustainability.
  • The central government should work closely with states to ensure that any relaxation of fiscal targets is temporary and accompanied by a clear plan for returning to sustainable debt levels.
• Incentives for States
  • Additionally, the central government could consider providing incentives for states that adhere to fiscal discipline, such as access to additional grants or favourable borrowing terms.
  • By aligning the interests of the central and state governments, India can achieve a more balanced and sustainable fiscal policy that supports economic growth without jeopardising financial stability.

Conclusion

• While the government's recent fiscal targets are a step in the right direction, the lack of a clear roadmap for achieving a sustainable debt-GDP ratio raises concerns.
• Furthermore, the high levels of interest payments relative to revenue receipts, coupled with declining household financial savings, limit the available investible surplus for the private sector, potentially hindering economic growth.
• Moving forward, it is crucial for India to adopt a more disciplined fiscal approach, with a focus on reducing the fiscal deficit and debt-GDP ratio to sustainable levels, thereby ensuring long-term economic stability.