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concerned over the worsening of fiscal situation, in 2000, the Government of India had set up a

committee to recommend draft legislation for fiscal responsibility. Based on the

recommendations of the Committee, Government of India introduced the Fiscal Responsibility

and Budget Management (FRBM) Bill in December 2000. In this Bill numerical targets for

various fiscal indicators were specified. The Bill was referred to the Parliamentary Standing

Committee on Finance. The Standing Committee recommended that the numerical targetsproposed in the Bill should be incorporated in the rules to be framed under the Act. Taking intoaccount the recommendations of the Standing Committee, a revised Bill was introduced in April

2003. The Bill was passed in Lok Sabha in May 2003 and in Rajya Sabha in August 2003. After

receiving the assent of the President, it became an Act in August 2003. The FRBM Act 2003 wasfurther amended.

Image Credits Rob Kroenert.

The FRBM Bill / Act provides rules for fiscal responsibility of the Central Government. The

FRBM Act 2003 (as amended) became effective from July 5, 2004. Under this Act, Rules areframed relating to fiscal responsibility of the Central Government, which came into force on 5th

July 2004.

Objectives of FRBM Act 2003

The main objectives of FRBM Bill / Act are :-

1. To reduce fiscal deficit

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2. To adopt prudent debt management.3. To generate revenue surplus.

Features of FRBM Act 2003

1. Revenue Deficit

The first important feature of Amended FRBM bill 2000 or FRBM Act 2003 is that the central

government should take certain specific measures related with reduction of revenue deficit.

Measures relating to reduction of revenue deficits are:-

1. The government should reduce revenue deficit by an amount equivalent to 0.5 percent ormore of the GDP at the end of each financial year, beginning with 2004-2005.2. The revenue deficit should be reduced to zero within a period of five years ending on

March 31, 2009.

3. Once revenue deficit becomes zero the central government should build up surplusamount of revenue which it may utilised for discharging liabilities in excess of assets.

2. Fiscal Deficit

The second important feature of Amended FRBM bill 2000 or FRBM Act 2003 is that the centralgovernment should take certain specific measures related with reduction of fiscal deficit.

Measures relating to reduction of fiscal deficits are:-

1. The government should reduce Gross fiscal deficit by an amount equivalent to 3.3% ormore of the GDP at the end of each financial year, beginning with 2004-2005.

2. The central government should reduce Gross Fiscal deficit to an amount equivalent to 2%of GDP upto March 31 2006.

3. Exceptional Grounds

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The third important feature of Amended FRBM bill 2000 or FRBM Act 2003 is that it clearly

stated that the revenue deficit and fiscal deficit of the government may exceed the targets

specified in the rules only on the grounds of national security or national calamity faced by thecountry.

4. Public Debt

The fourth important feature of Amended FRBM bill 2000 or FRBM Act 2003 is that the centralgovernment should ensure that the total liabilities (including external debt at current exchange

rate) should not exceed 9% of GDP for the financial year 2004-2005. There should be

progressive reduction of this limit by atleast one percentage point of GDP in each subsequent

year.

5. Borrowing from the RBI

The fifth important feature of Amended FRBM bill 2000 or FRBM Act 2003 is related withborrowings done by central government from R.B.I. The Amended FRBM bill 2000 or FRBM

Act 2003 clearly states that the central government shall not normally borrow from the R.B.I.

However the central government may borrow from R.B.I. by way of advances to meet temporary

excess of cash payments over the cash receipts during any financial year in accordance with theagreements which may entered into by the government with the R.B.I.

6. Fiscal Transparency

The sixth important feature of Amended FRBM bill 2000 or FRBM Act 2003 is related withfiscal transparency. The Amended FRBM bill 2000 or FRBM Act 2003 clearly stated two

important measures to ensure greater transparency in fiscal operations of the government.

These two important features are as follows :-

1. The central government should minimize as far as possible secrecy in preparation ofannual budget.

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2. The central government at the time of presentation of the annual budget shall disclose thesignificant changes in accounting standards, policies and practices likely to affect the

computation of fiscal indicators.

7. Limit On Guarantees

The seventh important feature of Amended FRBM bill 2000 or FRBM Act 2003 is that itrestricts the guarantees given by the central government to 0.5% of GDP in any financial year

beginning with 2004-2005.

8. Medium term fiscal policy statement

The eighth important feature of amended FRBM bill 2000 or FRBM Act 2003 is that the centralgovernment should present medium term fiscal policy statement in both houses of parliament

along with annual financial statement. The medium term fiscal policy statement should project

specifically for important fiscal indicators.

These fiscal indicators are as follows :-

1. Revenue deficit as percentage of GDP.2. Fiscal deficit as percentage of GDP.3. Tax revenue as percentage of GDP.4. Total outstanding liabilities as percentage of GDP.

9. Compliance of rules

Finally the ninth important feature of Amended FRBM bill 2000 or FRBM Act 2003 is related

with measures to enforce compliance of rules.

These measures are as follows :-

1. The FRBM bill clearly states that the Finance Minister shall review every quarter, thetrends in receipts and expenditure in relation with the budget and place it before both

houses of parliament the outcome of such reviews.

2. The finance minister shall also make statement in both houses of parliament if there isany deviations in meeting the obligations of the central government.

3. If deviations are substantial then the Finance Minister will declare the remedial measureswhich the central government proposes to take in future period of time.

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4. The rules mandate the central government to take appropriate corrective action in case ofrevenue & fiscal deficit exceeding 45% of the budget estimates or total non-debt receipts

falling short of 40% of the budget estimates at the end of first half of the financial year.

10. Task force on implementation of FRBM Act

Following the enactment of FRBM Act, Government constituted a Task Force headed by Dr.Vijay Kelkar for drawing up the medium term framework for fiscal policies to achieve the

FRBM targets.

The task force proposed the following measures :-

1. Widening the tax base through removal of exemptions.2. An All-India goods and service-tax (GST) on the basis of a "grand bargain" with States,

whereby States will have the concurrent powers to tax service, subject to certainprinciples that will help foster a national common market.

3. Income tax exemption limit to be increased to Rs.1,00,000.4. A two-tire rate structure of 20 percent tax for income of Rs. 1,00,000 to Rs. 4,00,000 and

30% for income above Rs. 4,00,000 for individuals and elimination of standard deduction

available to the salaried taxpayer.5. A reduction in the corporate income tax to 30% for domestic companies and the

reduction in depreciation rates from 25 to 15%.

6. A 3-tier custom duty rates of 5, 8 and 10% to bring down tariffs to ASEAN levels.7. Allocation of greater portion of expenditure to legitimate public goods by revisiting the

classification of expenditure.

8.

Empowering panchayats / local bodies through reserve transfer.

The task force stated that under the reforms measures recommended by it, tax GDP ratio of the

central government should be raised from 9.2% in 2003 to 13.2% of GDP in 2008-09. A revenue

surplus of 0.2% of GDP is estimated to emerge in 2008-09. Fiscal deficit estimated to fall from4.8% of GDP in 2003-04 to 2.8% of GDP in 2008-09.

The above features of Amended FRBM bill 2000 or Fiscal Responsibility and Budget

Management Act 2003 clearly points out that the government intends to create a strong

institutional mechanism to restore fiscal discipline at the level of the central government.

Similarly the government wants to introduce greater transparency in fiscal operations of the

central government.

Criticism / Limitations ofFRBM Act 2003

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Though the Fiscal Responsibility and Budget Management Act 2003 or Amended FRBM bill

2000 is a credible effort by the government to fix responsibility on the government to reduce

fiscal deficit and bring transparency in fiscal operations of the government it has certainlimitations.

These limitations of Amended FRBM Bill 2000 or FRBM Act pointed out by various economistsare as follows :-

1. Target regarding GFD very stringent

The Bill stipulates that by March 31, 2006, the Gross Fiscal Deficit (GFD) as a proportion ofGDP must be 2%. This, of course, means that the government can borrow from the economy

only to the extent of 2% of GDP, whatever be the level of savings. Given the present need ofgovernment borrowings, 2% limit is very low.

The increase in public investment helps to increase the level of effective demand and increases

private investment in the economy. According to Dr. Raja Chelliah the ratio of Gross FiscalDeficit (GFD) to GDP should be 4% to 5% of GDP as public investment on infrastructure sector

is essential to boost economic growth.

2. Neglect of equity and growth

According to critics the Amended FRBM Bill 2000 or FRBM Act 2003 is heavily loaded againstinvestment in both human development and infrastructure sector. One of the major ommission of

amended FRBM Bill 2000 or FRBM Act 2003 was complete absence of any target for time

bound minimum improvement in areas of power generation, transport, etc. which is veryimportant both from the point of equity and higher economic growth.

3. Non-Coverage of State Governments

The provisions of the bill impose restrictions on only the central government but stategovernments are out of its scope. But, deficits of state governments are as much or even a greater

problem. For instance, the State of Maharashtra has already crossed the deficit of Rs. 1 lakh

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crore as on December 2004 (the second State after Up to cross deficit of Rs. 1 lakh crore).

Therefore, there is a need for fiscal responsibility legislation for the State Governments as well.

4. Neglect of Development Needs

Today, the levels of capital expenditures by the government are miserably low in India. These

capital expenditures increase the efficiency and productivity of private investment and thus

contribute to the development process in the country. If Revenue Deficit is to be reduced to zeroand GFD to be 2% of GDP as per the requirement of FRBM Bill, it is the capital expenditure

which will be sacrificed and thus will hinder further development of the country.

5. Need to Increase Revenue

Revenue deficits are determined by the interplay of expenditure and revenues, both tax and non-

tax. Too often, attention gets focused only on the expenditure side of the identity to the neglect

of the revenue side. Increasing non-tax revenue requires that public sector services beappropriately priced, which may be difficult as the present society has got used to the subsidised

education, health, food items, etc.

6. Neglect of Social Sector

The FRBM bill does not mention anything relating to social sector development. However,

investment in social sector such as health, education, etc is very vital for the economic

development of the nation.

7. Problem of Subsidies

The government may be able to reduce revenue deficit by reducing subsidies. However, it is

quite likely that the government will be under severe pressure to continue the subsidies. It means

the expenditure on the productive areas may be reduced due to subsidies.

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8. Stable Growth Deficit

Chelliah points out that given the household financial savings in India, the overall fiscal deficittermed as stable growth deficit of the government sector as a whole should be pegged at 6% of

GDP with revenue deficit being gradually phased out. Thus, the target of 2% of fiscal deficitGDP ratio stated in FRBM bill is not desirable from the point of view of productive investment

according to Chelliah.

9. False Assumptions

The FRBM Bill is based on the following assumptions :-

1. Lower fiscal deficit lead to higher growth.2. Larger fiscal deficit lead to higher inflation3. Larger fiscal deficit increase external vulnerability of the economy.

These assumptions have been rejected by C.P. Chandrashekhar and Jayanti Ghosh who have

given the following arguments :-

1. If the deficit is in the form of capital expenditure it would contribute to future growth.2. Fiscal deficit is not only the cause for higher inflation. During the late 1990s the rate ofinflation has fallen even when the fiscal deficit was as high as 5.5% of GDP.

3. Higher fiscal deficit need not necessarily cause external crisis. The external vulnerabilitydepends more on capital and trade account convertibility. In India we have managed to

build large foreign exchange reserves, though fiscal deficit has not come down.

Conclusion on FRBM Act 2003

The Amended FRBM Bill 2000 or FRBM Act 2003 despite above criticism can play a veryimportant role in controlling fiscal deficit and in bringing transparency in fiscal operation of thegovernment if it is implemented effectively in letter and spirit by the concerned government.

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FISCAL POLICY VS MONETARY POLICY

I. THE BUSINESS CYCLE

Market economies have regular fluctuations in the level of economic activity which we call the

business cycle. It is convenient to think of the business cycle as having three phases. The firstphase is expansion when the economy is growing along its long term trends in employment,

output, and income. But at some point the economy will overheat, and suffer rising prices and

interest rates, until it reaches a turning point -- apeak-- and turn downward into a recession (the

second phase). Recessions are usually brief (six to nine months) and are marked by fallingemployment, output, income, prices, and interest rates. Most significantly, recessions are marked

by rising unemployment. The economy will hit a bottom point -- a trough -- and rebound into a

recovery (the third phase). The recovery will enjoy rising employment, output, and income while

unemployment will fall. The recovery will gradually slow down as the economy once againassumes its long term growth trends, and the recovery will transform into an expansion.

II. ECONOMIC POLICY AND THE BUSINESS CYCLE

The approach to the business cycle depends upon the type of economic system. Under acommunistsystem, there is no business cycle since all economic activities are controlled by the

central planners. Indeed, this lack of a business cycle is often cited as an advantage of a

command economy. Bothsocialistandfascisteconomies have a mix of market and command

sectors. Again, the command sector in these economies will not have a business cycle -- whilethe market sector will display a cyclical activity. In a full marketeconomy -- like the United

States -- the nation can suffer extreme swings in the level of economic activity.

The economic policies used by the government to smooth out the extreme swings of the business

cycle are called contracyclical or stabilization policies, and are based on the theories of JohnMaynard Keynes. Writing in 1936 (the Great Depression), Keynes argued that the business cyclewas due to extreme swings in the total demand for goods and services. The total demand in an

economy from households, business, and government is called aggregate demand.

Contracyclical policy is increasing aggregate demand in recessions and decreasing aggregatedemand in overheated expansions.

In a market economy (or market sector) the government has two types of economic policies tocontrol aggregate demand -- fiscal policy and monetary policy. When these policies are used to

stimulate the economy during a recession, it is said that the government is pursuing expansionary

economic policies. And when they are used to contract the economy during an overheated

expansion, it is said that the government is pursuing contractionary economic policies.

III. FISCAL POLICY AND MONETARY POLICY

Fiscal policy is changes in the taxing and spending of the federal government for purposes of

expanding or contracting the level of aggregate demand. In a recession, an expansionary fiscalpolicy involves lowering taxes and increasing government spending. In an overheated expansion,

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a contractionary fiscal policy requires higher taxes and reduced spending. According to Keynes,

a recession requires deficit spending while an overheated expansion requires a budget surplus.

1) Discretionary Fiscal Policy. The first way this can be done is through the federal budget

process. However, this process takes so long -- 12 to 18 months -- that it is difficult to match

discretionary fiscal policy with the business cycle. The expansionary Kennedy tax cut of 1964and later the contractionary Ford tax increase of 1974 hit the economy just when the opposite

contracyclical policy was needed. As a result, the federal government will only use discretionary

fiscal policy in a severe recession, such as 1981-82 and 2008-09. In both cases, the federalgovernment resorted to a large fiscal stimulus tax cuts in 1981-82 and increased spending in

2008-09. Both policies created large deficits, which is the appropriate stabilization policy during

a severe downturn.

2) Automatic Stabilizers. A second type of fiscal policy is built into the structure of federal taxes

and spending. This is referred to as "nondiscretionary fiscal policy" or more commonly as

"automatic stabilizers". The progressive income tax (the major source of federal revenue) and the

welfare system both act to increase aggregate demand in recessions, and to decrease aggregatedemand in overheated expansions. These automatic changes in spending and taxes will generate

a deficit in recessions and a surplus in overheated expansions. The size of these automaticchanges can be quite large. In the 2008-09 recession the deficit stimulus due to the automatic

stabilizers was much larger than the stimulus created by the legislative changes in taxes and

spending (discretionary fiscal policy).

Monetary policy is under the control of the Federal Reserve System (our central bank) and is

completely discretionary. It is the changes in interest rates and money supply to expand or

contract aggregate demand. In a recession, the Fed will lower interest rates and increase themoney supply. In an overheated expansion, the Fed will raise interest rates and decrease the

money supply.

These decisions are made by the Federal Open Market Committee (FOMC) which meets every

six to seven weeks. The policy changes can be done immediately, although the impact on

aggregate demand can take several months. Monetary policy has become the major form ofdiscretionary contracyclical policy used by the federal government. A source of conflict is that

the Fed is independent and is not under the direct control of either the President or the Congress.

This independence of monetary policy is considered to be an important advantage compared tofiscal policy.

Note that expansionary monetary policy is commonly called "easy money" while contractionarymonetary policy is called "tight money". Other terms are also used.

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