The N.K. Singh-led Fifteenth Finance Commission (FFC) may allow states to invoke an “escape clause” to breach their mandated fiscal deficit target by half a percentage point, giving them flexibility to respond to economic shocks similar to the option available to the Centre.
If accepted by the central government, the change may give states much-needed fiscal space to raise resources by borrowing funds at a time when their revenues have been under pressure because of reduced avenues for raising taxes and a tepid growth in goods and services tax collections. Under the Fiscal Responsibility and Budget Management (FRBM) Act, states are mandated to keep their fiscal deficit at 3% of gross domestic product.
Based on the recommendations of a review committee headed by Singh in 2018, the FRBM Act was amended to make debt-to-GDP ratio the principal macroeconomic anchor of fiscal policy for the central government. The panel also provided for an “escape clause”, for deviations in fiscal deficit up to half a percentage point of GDP to the central government. The trigger for taking recourse to the escape clause included “far-reaching structural reforms in the economy with unanticipated fiscal implications”, which finance minister Nirmala Sitharaman invoked in her 1 February budget to widen fiscal deficit to 3.8% of GDP for the current fiscal. States have been demanding a similar option.
“The escape clause did not exist in the earlier FRBM version, it is in the version of 2018. If states wish to move over to a new architecture of fiscal framework, that’s the time when they can consider a similar provision to make it symmetric (with the Centre),” Singh said on Thursday. “The obligation will be to take debt as an anchor and use fiscal deficit as an operational tool and then some of the other features (escape clause) of the amended FRBM Act will be available to them. The option comes with an obligation to have a credible debt trajectory.”
FFC will soon constitute a committee under Singh to prescribe a fiscal consolidation road map for both the Centre and states in its final report to be submitted in October. The committee will include representatives from the Comptroller and Auditor General, Controller General of Accounts, Reserve Bank of India (RBI), state governments and a few members of the earlier FRBM committee.
States have been historically more prudent in their fiscal management than the Centre, largely remaining within the prescribed fiscal deficit target of 3% of GDP. “This has, however, been achieved by sharp retrenchment in expenditures, in particular, capital expenditure,” RBI said in its State Finances report for 2019-20.
For 2019-20, states have budgeted for a consolidated fiscal deficit of 2.6% of GDP with a marginal revenue surplus as against revenue deficits in the previous three years. However, outstanding debt of states has risen over the last five years to 25% of GDP, posing medium-term challenges to its sustainability.
RBI warned that incipient risks to debt sustainability emanate from losses at power distribution utilities as well as potential invocation of guarantees. “Revenue generation holds the key to prudent debt management and can act as a circuit breaker in perverse debt spirals, highlighting the need to raise tax buoyancy and capitalize on technology-enabled efficiency gains, while exploiting the scope for raising user charges wherever possible, with reduced reliance on borrowings,” the central bank added.
In a 5 February interview, expenditure secretary T.V. Somanathan said giving an escape clause option to states could put additional pressure on the bond market. “The FRBM laws of the state are different from the FRBM law at the Centre. This is an issue which we have not considered. The Finance Commission will have to give its input on that. The problem is we are all borrowing from the same pool of funds. Adding another 0.5 percentage point will be a pressure on the bond market and there will be crowding-out effects. It is something that I am not able to pronounce on at this moment,” he added.