India Needs to Keep Its Deficit Target Flexible

General Studies Paper -3

Context: As India aims to become a developed nation by 2047, it is crucial to adopt a more flexible approach to fiscal deficit targets to ensure long-term investments without compromising fiscal prudence.

Understanding the Fiscal Deficit Target

• A fiscal deficit occurs when a government’s total expenditure exceeds its total revenue, excluding borrowings.
• In India, the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 initially set a fixed target for the fiscal deficit to ensure fiscal discipline.
• However, evolving macroeconomic conditions and economic shocks have led policymakers to consider a more flexible approach—termed the Flexible Deficit Target.
• It allows for adjusting fiscal deficit goals based on economic cycles, external shocks, and investment priorities.

Key Components of Flexibility

• Counter-Cyclicality: Allowing higher deficits during economic downturns and consolidation during high-growth periods.
• Expenditure Prioritization: Focusing on essential spending such as infrastructure and welfare while cutting non-urgent outlays.
• Revenue Considerations: Adapting targets based on tax collection efficiency, disinvestment proceeds, and other fiscal inflows.
• Escape Clauses: Built-in mechanisms to deviate from deficit targets during crises (e.g., pandemic, global shocks).

Evolution of Flexible Deficit Targeting in India

• FRBM Act and Amendments:
• FRBM Act, 2003: Mandated reducing the fiscal deficit to 3% of GDP.
• FRBM Review Committee (2017, N.K. Singh Panel): Recommended a more flexible approach, with a 2.5% – 3% target and an escape clause allowing deviation of 0.5% in exceptional circumstances.
• COVID-19 Impact (2020-21): The government increased the fiscal deficit target to 9.5% of GDP, demonstrating the necessity of flexibility in fiscal management.
• Union Budget 2021-22 & Beyond: The government set a medium-term goal of reducing the deficit to 4.5% of GDP by FY2025-26, instead of enforcing an immediate return to pre-pandemic levels.
  • Allowed for higher spending on infrastructure and social welfare to boost economic recovery.
  • The government emphasized pragmatic fiscal management over strict adherence to targets.
    • Capex boost to sustain economic growth.
    • Gradual deficit reduction instead of aggressive fiscal tightening.
    • A willingness to recalibrate targets based on economic needs.
    • It signals a de facto shift towards flexible deficit targeting.

Why India Needs a Flexible Deficit Target?

• Economic Shocks & Global Uncertainty: Events like COVID-19, geopolitical tensions, and oil price volatility demand fiscal space for counter-cyclical measures.
  • A rigid deficit target could limit government intervention during crises.
• Investment-Driven Growth Strategy: The government’s capital expenditure (CapEx) push requires sustained spending on infrastructure, which may exceed fixed deficit limits.
  • Flexible targets allow the government to borrow strategically rather than enforcing arbitrary spending cuts.
• Counter-Cyclical Fiscal Policy: During economic slowdowns, the government should increase spending to boost demand.
  • In periods of high growth, deficit targets can be tightened to maintain fiscal discipline.
• Infrastructure and Social Sector Needs: Developing economies like India require continuous investment in infrastructure, health, and education.
  • A rigid deficit target could force spending cuts in these critical areas.
• Private Sector Confidence: A balanced approach — where fiscal discipline is maintained without excessive rigidity — can boost investor confidence.
  • The key is ensuring that fiscal expansion is targeted and productive.

Challenges of Flexible Deficit Targeting

• Risk of Fiscal Indiscipline: A lack of strict targets may lead to uncontrolled borrowing, increasing debt-to-GDP ratios and risking credit rating downgrades.
  • Markets and credit rating agencies prefer clear deficit targets for policy predictability.
• Market Perception & Investor Confidence: International investors prefer fiscal predictability. Frequent adjustments to deficit targets could create policy uncertainty, affecting bond markets and FDI flows.
• Inflationary Pressure: Increased government borrowing may fuel inflation, especially when supply-side constraints exist.
• Higher Interest Costs: Persistent high deficits lead to increased government debt and interest payments, limiting funds for development projects.
• Welfare Programme Constraints: States with extensive welfare models, like Kerala and Tamil Nadu, struggle to expand services like healthcare and education.

International Best Practices

• USA: Adopts countercyclical fiscal policies, allowing higher deficits during recessions and aiming for gradual consolidation during growth phases.
• Germany: Traditionally follows strict fiscal discipline but relaxed its ‘debt brake’ during COVID-19.
• Japan: Prioritizes economic growth and employment stability, despite a 200% debt-to-GDP ratio.
• Australia: It uses public-private partnerships (PPP) to finance infrastructure, reducing its reliance on public debt.

Way Forward: Balancing Flexibility with Responsibility

• Strengthening Fiscal Rules: Introducing a clear range-based deficit target (e.g., 2.5% – 4% of GDP) rather than a strict fixed number.
• Institutional Oversight: Setting up an independent Fiscal Council to ensure responsible deficit deviations.
• Gradual Deficit Reduction: Committing to a credible glide path toward fiscal consolidation without abrupt spending cuts.

Conclusion

• India’s shift towards a Flexible Deficit Target reflects the need for adaptive economic policies in an unpredictable world.
• While flexibility helps manage crises and promote growth, it must be implemented prudently to maintain long-term fiscal sustainability.
• A balanced approach—allowing temporary deviations while maintaining a clear medium-term fiscal roadmap—is key to ensuring both economic stability and development.