MANAGEMENT DEVELOPMENT INSTITUTE, GURGAON

SCIENCES PO, PARIS

AND

HERTIE SCHOOL OF GOVERNANCE, BERLIN

Prevalent Models of Fiscal Governance in the European Union

The applicability of these models in the Indian context

Harish KUMAR

Hirdesh KUMAR

Dharmesh MAKWANA

Raman KRISHNAN

Lakhan Singh MEENA

9/14/2014

A study of the different mechanisms in place in the European Union member states for achieving fiscal discipline in budget formulation, passage through the parliament and execution, followed by a discussion of the prevalent system followed in India. We analyze the revenue deficit data of each annual central budget from 1971-72 to 2013-13. Based on our analysis we recommend a model to be adopted by India.

1. Executive Summary ............................................................................................................................... 1

2. Introduction ........................................................................................................................................... 1

3. Forms of Fiscal Governance Models Followed in the EU ...................................................................... 6

3.1. The Delegation form of fiscal governance ...................................................................................... 7

3.2. The Negotiation of fiscal contracts model ..................................................................................... 7

4. Comparison of the two models ............................................................................................................. 8

5. Fiscal Governance rules in India ............................................................................................................ 9

6. Selecting the appropriate model ......................................................................................................... 11

7. Conclusion and recommendations ...................................................................................................... 13

Bibliography ................................................................................................................................................ 16

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1. Executive Summary This report studies the various forms of fiscal governanceprevelant in the European Union member states. It begins with a brief discussion on the importance of fiscal discipline and hence the need for fiscal governance.The models of fiscal governance have been proposed by Hallerberg et al (2007). Two models of fiscal governance have been described, viz. the delegation form and the contract form. We examine the specific conditions under which each of these forms of fiscal governance is most effective. We then describe the model of fiscal governance followed by the Central Government in India. We analyze the data of revenue deficit for a period of 43 years from 1971-72 to 2013-14 and try to determine whether there is an underlying pattern which relates to the models described by Hallerberg et al (2007). We conclude that there is a need to institutionalize fiscal governance in India; and we submit our recommendations for the same.

2. Introduction Fiscal Discipline is a much discussed term across the globe both in the developed as well as the developing world. The financial crisis which broke out in 2008, and continues to have an impact on the world economy even today, specifically emphasizes the relevance of fiscal discipline in the context of the crisis faced by several countries of the European Union (EU) such as Greece, Ireland, Spain and Portugal. However, the need for fiscal discipline was realized much earlier and Hallerberg et al (2004) have observed that interest in fiscal rules is a reaction to the experience in many countries of rapidly rising debt levels and unsustainable deficits in the 1970s and 1980s.

The fiscal deficit is one indicator of the degree of fiscal discipline followed by a government. It is essentially the excess of the total expenses of the government over the total revenues. While the Government on the one hand is obliged to provide certain services to its citizens, it is also constrained by the extent to which it can raise the money required for these expenses through taxes. Governments resort to borrowing to make up the gap i.e. the fiscal deficit. A high level of fiscal deficit might result in doubts rising about the ability to repay the loans, i.e. the risk of default. This would be especially worrisome if a significant amount of borrowings are from external (foreign) debtors. The cost of future borrowings would also increase, as reflected through increasing bond yields, thus further exacerbating the problem. Apart from this, such debts burden future generations and can be perceived as unsustainable.

Fiscal deficit comprises of two components, the revenue deficit and the capital deficit. Revenue deficit is the net of revenue income less revenue expenses, while capital deficit is the net of capital inflow less capital outflows. A fiscal deficit by itself is not always bad, especially if moderate. For example if the entire fiscal deficit is owing to capital expenditure, then we could expect that the assets created through such expenditure would help boost economic growth. This would in fact turn out to be good for the economy. In fact, Keynesian economic theory calls for such counter cyclical expenditure by the government, to boost the economy out of recessionary output gaps. Therefore, it is usually the revenue deficit which is to be pegged down to reasonable levels.

The trend of fiscal deficit in the EU states for the period from 2002 to 2013 is shown in figure 1, and the trend for India for the period from 1970-71 to 2014-15 is shown in figure 2.

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Figure 1: Fiscal Deficit in Selected EU member states as a percent of GDP

Source: Eurostat http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&language=en&pcode=tec00127&plugin=1

Figure 2: Trend of Gross Fiscal Deficit for India from 1970-71 to 2014-15

Source: Reserve Bank of India, figures for 20014-15 are projected

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A comparison of the two graphs reveals that the fiscal deficit in India has ranged between around 5% to about 6.5% of GDP and the lowest fiscal deficit achieved was 2.54% in the year 2007-08. In contrast, the selected EU states in figure 1, display much higher diversity. Germany sets the highest standard for fiscal discipline with deficits below 1% in the recent past and a peak deficit of about 4.2% in 2010. On the other hand, the fiscal deficit of Greece, the prodigal child of the EU, has plunged from 4.8% in 2002 to 15.7% in 2009 before making a mild recovery to 12.7% in 2013. Portugal and Spain, two other countries who face the brunt of the global economic crisis, have less alarming levels of fiscal deficit when compared to Greece. France has been included in the analysis to indicate that fiscal deficit levels which are moderately high are not necessarily a cause for alarm. This is because France has a highly educated and productive workforce and a strong service sector. India shares both of these characteristics with France. We now turn to examine the cumulative fiscal deficit, as a ratio of GDP, for Germany, France, India and Greece in figure 3.

Figure 3: Debt to GDP Ratio for Selected EU member states and India

Source: http://www.tradingeconomics.com/country-list/government-debt-to-gdp

We note that the cumulative debt burden for India as percentage of GDP is not as alarming as that of Greece. In fact it is even lower than corresponding figures for Germany and France. However, what needs to be examined is whether India is in position to reduce her debt. Producing regular budgets with a deficit will add to the debt. To reduce the debt, we would need a budget surplus. For this, we now take a look at the trade deficits. These are shown in figure 4for Germany, France, Greece and India respectively.

http://www.tradingeconomics.com/country-list/government-debt-to-gdp

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Figure 4: Current Account Balance as percentage of GDP

Source: http://data.worldbank.org/indicator/BN.CAB.XOKA.GD.ZS We note that Indias current account balance as a percentage of GDP reflects unfavorably with respect to both France and Germany. Greece, which had a much higher current account deficit (as a percentage of GDP) as compared to India, has taken significant steps to prune it down. Seen in this light, Indias current account balance is a cause for concern. The fundamental identity of macroeconomics, S I + T G = XM tells us that for an economy with a fiscal deficit, and a given level of savings, investments must drop for a given level of GDP, i.e. we observe the crowding out effect. On the other hand, if investments do not fall, then the net exports must drop. With India looking to play catch up with the west, there is a need to make significant investments in infrastructure, which will in turn help in making Indian exports competitive by improving efficiencies. Therefore, we cannot expect to see a decline in the gross debt, in the above scenario, unless we establish strong institutions which encourage fiscal discipline. Seen in this light, it is clear as to why Greece faces a debt crisis, Germany has comfortably weathered the storm, while Frances boat is rocking albeit gently. The purpose of this paper is to analyze the fiscal governance models followed in various EU member states and examine the feasibility of adopting these for further improving the quality of fiscal governance in India.

Hallerberg et al (2010) point out that:

The purpose of fiscal rules, at the planning stage, is to promote agreement on budget spending and deficit targets among all actors involved, thus ensuring fiscal discipline. Elements of centralization at this stage should ensure that they constrain executive decisions effectively and are applied consistently. Conflict resolution is one of the key issues in this regard. Uncoordinated and ad-hoc conflict resolution involving many actors simultaneously promotes logrolling and, hence, fragmentation.

-15

-10

-5

0

5

10

Germany France Greece India

Current account balance (% of GDP)

2009

2010

2011

2012

http://data.worldbank.org/indicator/BN.CAB.XOKA.GD.ZS

Centralization is increased if conflict resolution is the role of senior cabinet committees or the prime minister.

At the legislative approval stage, the common resource pool problem becomes even bigger, with the opposition parties too coming into the picture. Fragmentation will be high if the parliament can significantly amend the budget proposal, narrow and dispersed committees arrive at spending decisions and when the prime minister or speaker has little role in guidance of the parliament.

Centralization helps in ensuring fiscal discipline in the implementation stage since it constraints the spending of the executive.

Hallerberg et al (2010) cite the work of Alt and Lassen (2006) and Tanzi and Schuknecht (2000) to emphasize the importance of transparency in the budget process. They observe that countries with more transparent fiscal institutions have lower levels of debt.

We now take a look at the different forms of fiscal governance models in the EU member states to gain more insights into the matter.

3. Forms of Fiscal Governance Models Followed in the EU Hallerberg et al (2009) have described the prevailing models for fiscal governance in Europe. They observe that the budget process is a system of formal and informal rules governing the decision making process that leads to the formulation of the budget by the executive, its passage through the legislature and its implementation. According to the authors, a budget process can fulfil its constitutional role effectively only if all conflicts among competing claims on public finances are resolved within its framework. They further note that there are four possible ways in which deviations to the process may occur. These are:

Existence of off-budget funds used to finance government activities, for example the use of pension funds to defray government expenses of finance government activities.

Spreading non decisions in the budget process, for example, automatically indexing spending programs to price levels.

Existence of mandatory spending, for example laws other than the budget make certain government expenditure compulsory.

Government enters into contingent liabilities, such as bailing out of banks, industries etc.

The authors argue that greater centralization of the budget process increases fiscal discipline and that the deviations listed above occur on account of certain level of decentralization existing in the budget process.

In the European Union, the treaty of Maastricht, adopted by the member states of the EU in 1997 was the first attempt to establish uniform norms for fiscal discipline as a prerequisite for joining the European Monetary Union (EMU). The Stability and Growth Pact (SGP)

required that each member state ensure a maximum annual budget deficit of 3% of

GDP, and that each maintain a cumulative national debt lower than 60% of

GDP.

Hallerberg et al (2009), observe that a framework such as the one defined by the SGP, has three weaknesses as detailed below:

Little is known about how budget institutions function in practice in comparative fashion and over time.

It is assumed that budget institutions have the same effect in all political settings. However, a fiscal institution that functions well in one setting is ineffective or even counterproductive in another. For example, a requirement that a majority vote against the budget will bring down the government can leave a coalition government hostage to one or more coalition partners

It is not known as to why some states choose a given budgetary institution and others do not. An understanding of how governments choose institutions leads to a better understanding of which reforms are, and are not, possible in different settings.

Hallerberg et al (2009) note that: the structure of the bargaining process within the cabinet, affects the size of the budget. They cite the common pool resource problem to explain that policy makers do not consider the full tax implications of their spending. It is also an example of the prisoners dilemma, in that all players are better off if they collaborate, while each individual sees the benefit of defecting. With this background, Hallerberg et al (2009) describe two models viz. the Delegation form

of fiscal governance and the Negotiation of fiscal contracts. Hallerberg et al (2007), describe

the models as follows.

3.1. The Delegation form of fiscal governance The model is based on delegation of significant strategic powers by each minster to a

decision-maker who is less bound to special interests than the ministers themselves. In

European governments, this is typically the minister of finance. The delegation approach

gives the finance minister strong agenda-setting powers over the other members of the

executive during the initial budget planning stage. At the subsequent approval stage in

parliament, the approach lends strong agenda-setting powers to the executive over the

legislature to protect the finance minister's budget proposal against significant parliamentary

amendments. In the final implementation stage, the delegation approach vests the finance

minister with strong monitoring capacities in the implementation of the budget and the

power to correct any deviations from the budget plan. Before consolidating the budget

proposal and submitting it to the parliament, the finance minister conducts one-on-one

discussions with each spending minster and here a negotiated budget for the ministry is

arrived at. The finance minister has the authority to unilaterally cut spending both during the

budgets proposal and its execution, Hallerberg et al (2009).

3.2. The Negotiation of fiscal contracts model The contract approach is based on an agreement among the relevant parties at the start of

the budgeting process. The agreement is the basis for deciding the broad budgetary outlay

for each ministry. The parties negotiate spending limits for every ministry, and they include

these spending limits in the coalition agreement. The negotiations are made considering the

full tax burden. The contract enforces the spending minister to adhere to his spending limit.

The contract is multi-annual for the entire tenure of the parliament and includes

contingencies for what to do if underlying assumptions about the economy are inaccurate.

The contract provides a medium-term orientation for fiscal policy and includes numerical

targets for specific budget items. In contrast to his role under delegation, the minister of

finance in this case monitors and enforces the fiscal contract but has little power at the

planning stage of the budget. At the approval stage in parliament, the legislature has strong

information rights, which enable it to monitor the executive's compliance with the budgetary

targets and the performance of individual ministries. At the implementation stage, the

contract approach resembles the delegation approach. It vests the finance minister with

strong monitoring capacities regarding the execution of the budget and the power to correct

deviations from it, Hallerberg (2009).

Hallerberg et al (2007) observe that determining as to which model is more appropriate to

address the externality problem of the budget process in a given country is a question that

arises in this context. We now compare the two forms of fiscal governance in the next

section to understand this aspect.

4. Comparison of the two models Hallerberg et al (2010) note that: delegation is the proper approach for single-party governments, while contracts are the proper approach for coalition governments.

They point out that the delegation approach relies on hierarchical structures within the executive and between the executive and the legislature, while the contracts approach builds on a more even distribution of authorities in government.

Fiscal targets can range from mere declarations of intent to legal multi-annual budget plans containing detailed expenditure targets. Hallerberg et al (2007), have analyzed the fiscal data and budgeting processes for EU countries over a period of ten years and have concluded that delegating budgetary decision-making to the minister of finance effectively improves fiscal discipline in countries which typically have one-party governments or coalition governments formed by closely aligned parties, while stringent fiscal targets are effective in states with a considerable degree of ideological dispersion in government.

The salient features of the two models are presented in table 1 below.

Type of Governance Delegation Contracts

Political Imperative Benefit from trusting one central player

Benefit from Explicit Fiscal Targets

Type of Government One-Party Majority Government, Two Parties Closely Aligned

Multi-Party

Overall Performance Generally good if institutions consistent

Generally good if institutions consistent

Bias in Forecasts tend to be overly optimistic tend to be pessimistic

Independent Fiscal Councils

Not common (although now coming)

common

Table 1: Delegation versus Contract

5. Fiscal Governance rules in India In India, the delegation process is followed for the budget process. The finance minister is vested with the responsibility of formulating the budget for all the ministries

1. This model is

followed irrespective of whether there is asingle party in power or a coalition of parties. By and large India has been under a single majority party rule since independence in 1947 till 1989. From 1989 till 2014, a coalition of parties held power at the national level. Given the above, the question arises that in light of the conclusions drawn by Hallerberg et al (2010) that the more countries diverge from their expected form of fiscal governance, the greater the increase in the countries debt burden, does data from the Indian budgets support the hypothesis? In other words, we hypothesize as follows: : There is no significant difference in the average revenue deficit between budgets presented by single party governments and coalition governments. : The revenue deficit in budgets presented by coalition governments is significantly higher than that of single party governments. We collected data of the revenue deficits for each year since 1970-71 till 2013-14 and grouped the data into two categories. The first category contains the revenue deficit as a percentage of GDP when the budget was presented by a single party government. The second category contains data of revenue deficits for budgets presented by coalition governments. The data is presented in table 2.

Year

Revenue Deficit Majority Government Year

Revenue Deficit Coalition Government

1970-71 -0.34 1989-90 2.37

1971-72 0.20 1990-91 3.17

1972-73 0.03 1991-92 2.41

1973-74 -0.35 1992-93 2.40

1974-75 -0.95 1993-94 3.67

1975-76 -1.02 1994-95 2.97

1976-77 -0.32 1995-96 2.42

1977-78 -0.41 1996-97 2.30

1978-79 -0.25 1997-98 2.95

1979-80 0.55 1998-99 3.71

1980-81 1.36 1999-00 3.34

1981-82 0.22 2000-01 3.91

1982-83 0.67 2001-02 4.25

1983-84 1.11 2002-03 4.25

1984-85 1.65 2003-04 3.46

1 The exception is the ministry of Railways, which has traditionally prepared its own budget since 1935. The Union

Minister of railways presents the Railway Budget a few days before the Finance Minister presents the Union (General) Budget

Year

Revenue Deficit Majority Government Year

Revenue Deficit Coalition Government

1985-86 2.03 2004-05 2.42

1986-87 2.40 2005-06 2.50

1987-88 2.48 2006-07 1.87

1988-89 2.41 2007-08 1.05

2008-09 4.50

2009-10 5.23

2010-11 3.24

2011-12 4.38

2012-13 3.60

2013-14 3.26

Table 2: Annual Revenue Deficits Of the Government of India Grouped by Type of Government

We first conducted a test for the variances of the two groups. The test indicated that the two

groups are not significantly different, with F=1.484, p=0.1807. Accordingly we performed a

two sample t-test for equal variances. The t-test revealed that the mean revenue deficit of

budgets (M=0.604 SD= 1.156, N= 19) presented by Majority Governments is significantly

lower that the revenue deficit of budgets (M=3.185, SD=0.949, N=25) presented by coalition

governments. The t statistic with equal variances for the data is t (42) = -8.132.

The details are presented in table 3 below.

F-Test Two-Sample for Variances

RD M RD C

Mean 0.603684211 3.185

Variance 1.337446784 0.901

Observations 19 25

df 18 24

F 1.484826725 P(F

Thus, the significantly higher revenue deficit presented by coalition governments, by adopting the delegation model in India should be a matter for concern. Tronzano (2013), observes that the Indian fiscal policy is weakly sustainable. He argues for a need to pursue a policy of fiscal consolidation, since the public debt to GDP ratio for India is larger when compared to other emerging market countries.In another paper, Tronzano (2014) recommends for widening the tax base and calls for structural reduction in inefficiencies in government spending. Hallerberg and Yloutinen (2010) point out that, formal rules such as an overall debt limit have their use, but they say nothing about how the decision-making process is structured. This now brings us in a position to answer the question: What should be done to institutionalize fiscal discipline in India? We attempt to answer this question in the next section.

6. Selecting the appropriate model

The need for formal rules for fiscal regulation in budgeting has been realized by the

Government of India quite some time. The Fiscal Responsibility and Budget Management

Act (FRBM) was passed by the Indian Parliament in July 2004. The act is modeled after the

Stability and Growth Pact (SGP) of the European Union, in that it envisaged the elimination

of revenue deficit by 31 March 2008 by setting annual targets for reduction starting from day

of commencement of the act.

The act was intended to introduce transparency in fiscal management systems in the

country, introduce a more equitable and manageable distribution of the country's debts over

the years and achieve fiscal stability in the long run. After the act took effect, fiscal deficit fell

to below 3% of the GDP in 2007-08. However, the act was suspended in 2009, citing the

global financial crisis as the reason for the governments inability to meet the requirements

of the act.

Hallerberg and Yloutinen (2010) predicted this scenario when they observed that while the imposition of a formal rule may have a short-term effect, over the medium term decision-makers are resourceful in devising ways to get around such formal rules.

StutiKhemani (2006), in a World Bank research brief, observes that national ruling parties in

India have weak incentives for fiscal discipline even when they lead majority governments.

She calls for setting up of an institutional mechanism that promotes credible commitment of

all parties, viz. an independent nonpartisan agency to enforce constraints on fiscal

aggregates such as the consolidation of government deficit and debt level.

Therefore we are of the view that:

1. The delegation for of fiscal governance, has worked reasonably well when majority

governments are in power but has not produced satisfactory results with respect to

the revenue deficit for the periods when coalition governments were in place.

2. The FRBM was in force during the time when coalition governments were in power.

We find that though it did bring about positive results, the FRBM was suspended by

a coalition government. Thus, the enactment of the FRBM by itself has not resulted

in long term fiscal discipline being followed in the budgeting process.

3. Contract form of fiscal governance will not be an appropriate solution in the Indian

context, since the possibility of a majority government being in place cannot be ruled

out, as witnessed in the 2014 general elections.

4. There is a need to institutionalize the fiscal governance process, irrespective of the

type of government in place, i.e. majority or coalition.

In this context, we note that the institution of the Finance Commission has worked well in

India insofar as distribution of tax revenues to the states is concerned. Article 280 of the

Indian Constitution, requires the President of India to set up a Finance Commission. The

Finance Commission is headed by a Chairman and has four other members, all of whom

are appointed by the President of India.They have a five year tenure. After lapse of their

tenure, a new Finance Commission is set up by the President. So far fourteen fourteenth

Finance Commissions have been constituted. The tenure of the Fourteenth Finance

Commission lapses on 31st October 2014, and their recommendations come into force from

1st April 2015, for a period of five years. The role of the Finance Commission is to give

recommendations on distribution of tax revenues between the Union and the States and

amongst the States themselves.

We recommend that the scope of the Finance Commission be expanded and that it be

empowered to impose fiscal constraints that are to be mandatorily followed by the

government in power. These fiscal constrains would inter alia cover the fiscal deficit and

broad sector wise expenditure plans. These recommendations would cover a span of five

years, in line with the other recommendations made by the Finance Commission at present.

Thus, it would bring in a mid-term perspective to the budget process, which is lacking at

present.

It could be argued that such a mandate to a non-political body would undermine the

democratic principles. This argument is accepted. Accordingly we recommend that the

Finance Commission, set overall targets for revenue deficits, and that the budget proposal

be vetted by the finance commission before being presented in the parliament.

This will ensure sufficient space for the political executive to formulate policies that are

consistent with their political mandate, while also ensuring fiscal discipline.

In fact, as far as monetary policy is concerned, such separation has already been carried

out through the setting up of central banks. In the European Union too, the concept of

Independent Fiscal Councils has been adopted by countries adopting either models of fiscal

governance, viz. the delegation form or the contractual form.

7. Conclusion and recommendations With improved fiscal discipline, we may expect a crowding in effect. This is because, a

reduced fiscal deficit, or a net fiscal surplus will reduce government borrowings, thus

reducing bond yields. The reduced cost of borrowing in the market will boost investments in

the private sector. With a huge pool of human capital available, India can establish a strong

manufacturing sector which will help boost its trade surplus through exports.

The European Commission defines independent fiscal institutions as follows:

Independent fiscal institutions are defined as non-partisan public bodies, other than the

central bank, government or parliament that prepare macroeconomic forecasts for the

budget, monitor fiscal performance and/or advise the government on fiscal policy matters

(Source:

http://ec.europa.eu/economy_finance/db_indicators/fiscal_governance/independent_institutions/index

_en.htm)

We propose that the institution of the Finance Commission be the designated independent

fiscal council for the Indian Government. The Finance Commission will thus act as an

advisory body to the Finance Minister and strengthen his hand. This support will be

especially useful when coalition governments are in place. A flow diagram indicating a

macro level view of the budget process indicating the role of the Finance Commission is

indicated in figure 5 below.

http://ec.europa.eu/economy_finance/db_indicators/fiscal_governance/independent_institutions/index_en.htmhttp://ec.europa.eu/economy_finance/db_indicators/fiscal_governance/independent_institutions/index_en.htm

Figure 5: Proposed budget process flow chart

The effectiveness of fiscal councils in bringing about fiscal discipline itself has been

questioned by scholars and therefore we realize the need to build in adequate safeguards

to the model we propose. These include the following Xavier and Keiko (2011):

They should be fully owned by the local political sphere in terms of their objectives and modus operandi

They should have their own staff and ring-fenced long-term resources their management should enjoy formal guarantees of independence from elected officials

Their remit should be strictly limited to informing budget preparation and fiscal policy formulation

To sum up, we conclude that of the two models of fiscal governance followed in the EU member states, the delegation model has a better fit in the Indian context. However, we also note that when coalition governments are in place, then the delegation model does not lend itself to ensuring adequate fiscal discipline. To overcome this problem, we propose that the Finance Commission, which is a respected and well established institution in India, be strengthened to act as an advisory body to the finance minister.

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