India’s twenty-first century fiscal architecture should be built on three mutually reinforcing pillars.
-Fiscal rules across all levels of government which set the institutional and budgetary framework for fiscal sustainability.
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-A public financial management (PFM) system which provides complete, consistent, reliable and timely reporting of the fiscal indicators that are part of the first pillar; and
-An independent assessment mechanism so as to provide assurance and advice on the working of the other two pillars.
The use of information technology and computing capacities which India has developed in last few decades already provides a strong backbone to support such a fiscal architecture.
India was one of the early adopters of fiscal rules among emerging market countries. Through a number of amendments, the Union government has updated the Fiscal Responsibility and Budget Management (FRBM) Act, adopted multiple fiscal indicators as target indicators, and has tried to bring India into the second generation of fiscal rules. As such, the Centre as well as all states have their fiscal rules and numerical targets in place.
However, there are gaps and inconsistencies in these rules. For instance, the fiscal deficit defined in the FRBM Act (as the balance of operations incurring into the Consolidated Fund of India) falls short of the newly legislated debt ceiling that covers a broader definition of accounts and implementing agencies that deliver public services on behalf of the government. In practice, this has led to the fiscal rules being effectively circumvented, in particular by the use of off-budget fiscal operations, inconsistent budget classification and accounting standards, and improper use of the public accounts for budgetary purposes. Effectively, this is because the underlying public financial management system meets only a fraction of best practice standards.
In short, having a fiscal rule raises the bar on the needed strength of the underlying public financial management processes and institutions. Let’s now look at the PFM framework and assess the inconsistencies that have built.
India’s current public financial management (PFM) processes are defined at the highest level in the Constitution itself. However, many policies and operational details have evolved over time through a plethora of practices. Compliance with best practices envisaged in the fiscal rules remains challenging as a majority of the practices affecting budget formulation, execution, and reporting are still without legislative strength — being governed instead by a multiplicity of constitutional provisions, executive rules, orders, and manuals. There is also lack of consistency in practices across the levels of government, resulting in marked differences in the way PFM systems at the Union and the states have emerged.
A central lesson from international experience is to define the PFM framework for India and its constituents, strengthen budgetary institutions at key stages of the fiscal process, prescribe the accounting framework and precise definitions for target fiscal indicators, and ensure consistency of the fiscal rules across all levels of government. The lack of progress in these areas continues to distort the alignment of the budget and expenditures with government policy priorities, hinders effective expenditure control, raises the public costs of inefficiency on fiscal management, and creates opportunities for creative accounting and biased forecasts; in this regard, it helps that progress is being made in bringing the food subsidy more fully on-budget in the recent budget.
Looking ahead, PFM reforms at the sub-national level should be consistent with reforms at the Union government level, especially in terms of a clear PFM framework, ensuring consistent and well-defined targets and accounting standards, timely and reliable reporting of sub-national fiscal operations, and strengthening automatic correction mechanisms and sanctions for non-compliance. States should seek to define sub-national debt targets that are consistent with general government debt reduction targets.
India has tried, over time, to take individual and incremental reforms to successive parts of the PFM system. These have generally been stand-alone in nature, focusing on particular (and dispersed) dimensions of public financial management, that have been difficult to integrate and sustain. A comprehensive legal framework as adopted by many countries in the world may be the best way forward for India.
To support, advise, and assess the first two pillars of the fiscal architecture, we need a third pillar which is an institutional mechanism commonly known as an independent fiscal council. Experience suggests that such an institution has contributed to assessing and monitoring fiscal policy, ensuring the effective implementation of fiscal rules, and strengthening fiscal performance. Independent scrutiny makes for better compliance with fiscal rules through their influence on the accuracy of budget forecasts. Several experts’ bodies and committees have recommended setting up of an independent fiscal council in India. Most recently, the FRBM Review Committee as well as previous finance commissions have recommended establishing such an institution with suggested functions and structure. As India emerges from the covid-induced crisis, it is a key step toward improving the credibility of fiscal management.
The mandate of a fiscal council could be broadened to cover not only the production of macroeconomic and fiscal forecasts to inform the budget, but also to advise on setting and re-calibrating fiscal targets and rules at national and sub-national levels, as well as monitoring compliance with such targets and rules. The fiscal council can also work towards improving the quality of fiscal statistics at all levels of government.
Such reforms may typically take several years for completion of all of its elements. Regular monitoring will help decision-makers keep track of reforms over time. It will also help track progress and performance across states. Hence, there is need for an institutional mechanism driving budgetary and public financial management reforms in a coordinated, transparent and inclusive way across levels of government to deliver consistency, transparency and accountability. Information technology can play a crucial role in making PFM more transparent, reliable and real-time by integrating and digitalizing the entire PFM value chain. Many states have already started digitalizing their budgetary, treasury and accounting processes through Integrated Financial Management Systems (IFMS). However, it requires further integration and comprehensive coverage to really unlock its full potential.
Toward this end, as the Fifteenth Finance Commission has recommended, the ministry of finance could launch the process of stakeholder consultations and prepare a time-bound plan for the implementation of comprehensive public financial management reforms at all levels of government. To bring states into these discussions, such a process could also become part of the discussion agenda of existing forums of Union-state consultations, such as the Inter-State Council or the governing council of NITI Aayog.
Anoop Singh is a distinguished fellow at Centre for Social and Economic Progress, New Delhi and was a member of the Fifteenth Finance Commission. Kandarp Patel is a civil servant and was a director in the Fifteenth Finance Commission. Views expressed are personal.
This is the concluding part of a two-part special series on India’s fiscal architecture.