20 February 2017

Need for an independent Fiscal Council

Anupam Manur

Budgets are essentially about the future — collecting revenue and then spending it. Since, it is about the future, budget allocations have to be based on forecasts. But, these budget forecasts are almost always wrong and sometimes they are wrong by a big margin. This can have a significant impact on the actual receipts and expenditure and thus, on the fiscal deficit.

In this year’s budget, for example, Mr. Jaitley’s budget exercise was almost completely in the dark. He worked with data from only the first half of 2016–17. There are also structural breaks in the data that were not considered. The first break was in November 2016 due to demonetisation and the second break will come when the Goods and Services Tax (GST) regime takes over. In what seems like a silly error, Mr. Jaitley has projected revenue collections from cesses and surcharges over the full year (amounting to Rs. 2.96 lakh crores). However, these cesses and surcharges are most likely to disappear when the GST is rolled out sometime in July 2017.

There are two main reasons for inaccuracies in budgetary forecasts. One, by its very nature, economic forecasting is an imprecise science. It is dependent on other forecasts, which are equally imprecise, such as economic growth and the weather. Further, forecasters are notoriously ineffective in predicting the next wave of technological breakthrough or the “sudden” change in the business cycle. Throw in the unpredictability of the monsoon, which has a non-trivial impact on the Indian economy, and one can understand the mistrust of budget forecasts. Two, the Finance Minister is always incentivised to make projections that are favourable. The announcement of a big government scheme will be better sold if the Finance Minister can justify it with a projection of increased revenue collections due to higher GDP growth. This explains why the fiscal deficit target set in the budget for the coming year is rarely met. In six of the last eight years, revenue forecasts of the government fell short by around 10 per cent, due to overestimation.

To counter this, many countries have set up an independent body to cross-check the numbers before the budget is presented and also analyse the fiscal impact of the budget. These bodies, popularly known as fiscal councils, are essentially fiscal watchdogs, which exist to check the inherent deficit bias of governments. The Congressional Budget Office in the United States has been providing this service since 1974, while many European countries established their fiscal councils only in the latter half of the 2000s. In 2014, as many as 19 EU members had an operational fiscal council.

There is no universal consensus on the range of functions that a fiscal council should undertake. The broad mandate for most fiscal councils is to ensure compliance with a numerical fiscal rule and thereby ensure sustainability of long term fiscal policy. Apart from that, there is divergence on the the quantity and kind of normative advice and the means of fiscal forecasting. Only about half of them provide independent fiscal projections and again, just about half of them provide normative advice.

The idea of a fiscal council in India has been floated for some time now. India decided to move to a rule based fiscal policy in 2003 with the passing of the Fiscal Responsibility and Budget Management Act (FRBMA), though it was modified several times thereafter and it was only post 2010 that successive budgets attempted to contain the fiscal deficit within the targets set by the FRBM. Given the temptation of governments to break the fiscal rules, an independent body should be established to enforce the budget targets.

The 13th Finance Commission initially proposed the idea of setting up a fiscal council and it has been reiterated in the 14th Finance Commission recommendations as well.
It recommended an “amendment to the FRBM Act inserting a new section mandating the establishment of an independent fiscal council to undertake ex-ante assessment of the fiscal policy implications of budget proposals and their consistency with fiscal policy and Rules.” Further, it urged the Union Government to “take expeditious action to bring into effect Section 7A of the FRBM Act for the purposes of ex-post assessment”.

The Finance Commission thus, mandates both ex-ante evaluation and ex-post assessment. This means that the fiscal council will verify the projections, and importantly check for the viability of the various schemes of the government. For example, the fiscal council would check the estimates of schemes such as One Rank, One Pension or the NREGA and work out the actual liabilities for the government.

While few people disagree about the need for an independent fiscal council, there is still a bit of uncertainty over the exact form and shape it should assume. Irrespective of the final form, there are certain important prerequisite conditions for it to be effective, as proposed by the European Central Bank:

1. Be strictly independent from political interference in order to build up or maintain institutional credibility;

2. Have a comprehensive mandate, which also allows them to initiate their own assessments;

3. Have sufficient resources to deliver their mandate; and

4. Have a public voice, so that they are able, if necessary, to effectively mobilise public opinion in order to counteract political incentives for unsound fiscal policies.

This can be one of the big structural reforms that the government can take up to make the FRBM effective and to prevent the launch of populist schemes that have long term negative effects on the economy. The fiscal council can also help the government in diverting responsibility. During the OROP protests, the government could have simply diverted the matter to the fiscal council and acted in accordance with its advice.

Anupam Manur is a Research Fellow at the Takshashila Institution and tweets at @anupammanur

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