Hindustan Times Leadership Summit 2022: Meeting challenges of resetting the pillars of fiscal architecture
Hindustan Times Leadership Summit 2022: Many envisage a return to fiscal rules to strengthen credibility. But today’s situation offers an opportunity to rethink fiscal rules and the underlying fiscal frameworks.
The Covid-19 pandemic brought significant challenges to public finances and necessitated the suspension of fiscal rules across the world. The costs needed to deal with the pandemic — well beyond the stimuli during the Global Financial Crisis (GFC) — raised global debt to record-high levels. The Russia-Ukraine conflict has now compounded this crisis.
The road immediately ahead carries many risks, and the related fiscal policy trade-offs are complex.
First, we are looking at a landscape with much higher public and external debt across the global economy and tightening financial conditions and growing borrowing costs across countries. At the same time, private debt has risen sharply across countries as lockdowns in 2020 closed businesses.
Second, governments face record multi-decade high inflation and urgent demands from food and energy crises, the climate agenda, and population-ageing realities.
Third, evidence is becoming clear that higher inflation is creating new inequalities and higher poverty, compounded by the effects of the pandemic on sectors and income brackets, mainly affecting low-income earners.
Fourth, with fiscal space diminishing, essential services such as health care, education and social safety nets are compromised, especially affecting the most vulnerable, including in advanced countries — exemplified by the recent “Nation’s Report Card” for the United States.
Fiscal policy is now at a critical juncture. The challenge is to carefully manage and communicate to markets a budgetary strategy that addresses debt sustainability while catalysing economic activity and meeting the overdue structural and human capital needs critical for rebuilding growth potential.
Many envisage a return to fiscal rules to strengthen credibility. But today’s situation offers an opportunity to rethink fiscal rules and the underlying fiscal frameworks. How can governments make fiscal policy more agile, especially in responding to crises, without undermining fiscal sustainability?
The fiscal architecture is the framework that supports fiscal sustainability. It comprises the fiscal strategy specified in numerical rules or qualitative standards, which needs to be supported by public financial management (PFM) processes and independent fiscal institutions (IFIs).
As we emerge from the pandemic, the challenge arises of resetting the pillars of the fiscal architecture. Should countries return to resetting their fiscal rules in their present form? With productivity and growth falling and inequalities rising, this is not the time to deliver austerity and further affect competitiveness. Instead, a new fiscal strategy is needed. Until recently, international experience supported the view that numerical fiscal rules helped strengthen the credibility of governments’ commitment to fiscal sustainability. However, the challenges to achieving these outcomes were apparent even before the pandemic. For instance, numerical fiscal rules had become pro-cyclically biased, and were not preventing a large debt build-up over time.
The pandemic evidence suggests that overly stringent numerical fiscal stability measures can do more harm than good. This prompted the modification of existing rules and the revamping of escape clauses during the pandemic.
In countries like India, numerical fiscal rules have been effectively circumvented — both at the Centre and the states — through off-budget fiscal operations and inconsistent budget classification and accounting standards. This is attributable to deficiencies in the underlying PFM systems. This suggests that numerical fiscal rules need a rethink, and the overall fiscal framework also requires strengthening.
Countries need to consider a framework that integrates fiscal sustainability with an institutional set-up that leaves room for discretion, flexibility (for managing shocks), and a clear process to decide whether prescribed standards are being met.
Adopting a principles-based approach to fiscal framework involves three key steps.
First, moving from numerical fiscal rules to enduring principles of fiscal responsibility contained in a fiscal strategy ensures a high probability that public debt will remain sustainable.
Second, setting criteria and procedures to decide whether the standards are met.
Third, specifying the institutions responsible for its surveillance and determining ex-post compliance with the fiscal responsibility principles.
New Zealand’s experience demonstrates that opting for a principles-based framework, rather than enforcing legislatively prescribed numerical rules, is more likely to provide effective incentives for governments to conduct responsible fiscal policy.
However, implementing such a principles-based fiscal strategy would require countries to adopt certain practices to make them credible.
First, political commitment to the standards and principles of responsible fiscal management in a fiscal strategy act that would include a medium-to-long-term fiscal sustainability report, comprising elements such as an investment statement and a listing of prioritised medium-term programmes and projects.
Second, the annual publication of a fiscal strategy explaining how its annual fiscal plan is consistent with the budgetary standards set out in the law and backed up by comprehensive medium-term budgets consistent with objectives.
Third, to ensure compliance with these standards, they need to be supported by transparent and timely public reporting through strengthened PFM systems (generally through an overarching PFM Law) and periodic public review of the government’s fiscal plans by independent fiscal institutions (IFIs).
Fourth, in federal countries like India, identifying these problems and designing and implementing these reforms must be carried out in close collaboration between national and subnational governments.
To conclude, for countries to recover from the fiscal stress of the pandemic and move towards their full potential for economic growth and development, they need to improve the quality and efficiency of their public spending. For this, instead of returning to their existing or suspended numerical-based fiscal rules, countries should opt for a principles-based fiscal strategy that combines rules, standards, and strengthened PFM processes overseen by IFIs. This would help countries strike a better balance between flexibility and credibility.
(Anoop Singh was member, 15th Finance Commission of India. The views expressed are personal.)