The Fiscal Responsibility & Budget Management Act.. The Kerala Story (May 2024)

The Fiscal Responsibility and Budget Management Act (FRBM Act) of 2003 is?an Act of the Indian Parliament that aims to improve the management of public funds, reduce the fiscal deficits, and strengthen fiscal prudence.?? Mr. Yashwant Sinha, the then Finance Minister of India introduced the Act in Parliament.? The Act carried with it a bouquet of laudable objectives that over a period of time seem to have diminished its lustre. We will be running ahead of the story if we decide to sit on judgment on the efficacy of the Act before even understanding the nuances associated with the Act itself especially since the objectives of the Act and the time it came to be implemented are taken into consideration.? When the FRBM Act was brought in by the Government, the memory of an Indian Government pledging the country’s family silver abroad was still fresh in the minds of India and Indians.? Before we go further, it is necessary for us to dwell on the noble objectives of the Act and also the benefits expected from the Act.? It is not every day that a group of politicians get together and take a solemn pledge to put voluntarily restrictions on themselves. It is, therefore, necessary to first understand the FRBM Act that was enacted to ensure long term macroeconomic stability in a country with a federal structure of governance and intergenerational equity in fiscal management.

The objectives of the Act, inter alia, included a) eliminating the endemic practice of driving up revenue deficits while preparing the annual financial budgets of the country; b) reducing the practice of running fiscal deficits unmindful of their consequences to the country’s fiscal health; c) it was also expected to transit from a highly secretive budget preparation exercise to a transparent fiscal management system based on sound rationale and financial logic; d) the Act sought to introduce a more equitable distribution of India’s unbridled debt over time by focusing on introducing transparent systems to ensure long term stability; and e) one of the key objectives of the new Act was to arm the country’s Central Bank the much-needed flexibility to rein in the scourge of inflation.? The FRBM Act also made it mandatory for the government to place the following along with the Budget documents to the Parliament on annual basis, viz., a) Medium Term Policy Statement, b) Macroeconomic Framework Statement and c) Fiscal Policy Strategy Statement.? These statements were intended to focus on the state of financial health of the economy and also to ensure how the government of the day has performed on the given parameters as contained in the FRBM Act. Additionally, it was also proposed that revenue deficit, fiscal deficit, tax revenue and the total outstanding liabilities are projected as a percentage of Gross Domestic Product (GDP) in the medium-term fiscal policy statement.? The targeted goals as contained in the Act, however, could be exceeded by the government of the day in exceptional circumstances involving national security, natural calamities, etc.

Setting stringent targets and goals in an economy under the normal circumstances is one thing; adhering to the same set of standards in a difficult year could be another matter. The Government realised this problem before long. ?In 2013, the government introduced a change and inserted the concept of “effective revenue deficit”. The effective revenue deficit would be equal to revenue deficit minus grants to states for the creation of capital assets. With mounting pressures in implementing proposed changes, a committee under N K Singh, an Economist and a former bureaucrat was set up in 2016 to suggest changes to the Act on the premise that the targets set under FRBM Act previously were too rigid for easy implementation.? The Committee in its wisdom made certain recommendations such as:?

i)??????????????????? Targets:?The committee suggested using debt as the primary target for fiscal policy and set a target that the proposed goals must be achieved by 2023.

ii)?????????????????? Fiscal Council:?The committee proposed to create an autonomous Fiscal Council with a chairperson and two members appointed by the Centre (not employees of the government at the time of appointment).

iii)???????????????? Deviations:?The Committee suggested that the grounds for the government to deviate from the FRBM Act targets should be clearly specified.

iv)???????????????? Borrowings:?According to the suggestions of the committee, the government must not borrow from the RBI except when the Centre has to meet any temporary shortfall in receipts and that RBI should be allowed to subscribe to government securities to finance any deviations and it should also be allowed to purchase government securities from the secondary market.

The Government set itself such (over) ambitious targets like: (i) limiting the fiscal deficit to 3% of the GDP by 31st March 2021. Though there was a such a huge gap between the target and actual figures, it could be explained away because of Covid related exigencies that affected the economy and the global financial crisis of 2009. ??The Government also committed itself to limiting the debt of the Central Government to 40% of the GDP by 2024-25. When last heard the Union Government had pledged to reduce the government’s deficit to 6.9% of GDP for 2021-22 and 6.4% for 2022-23!? The soothsayers of the government are optimistic that the fiscal deficit would fall to 4.5% of GDP by 2025-26.

Here is a quick explainer.? A fiscal deficit is the difference in the income of a government as compared to its spendings.?It is the difference between the total income of the government and the total expenditure incurred by it.?This difference is generally filled by government borrowings.? By looking at this deficit the economists calibrate the inflation expectations in the economy. The fiscal affairs of a government are of direct concern to its citizens and to international parties which interact with it.

An important part of the FRBM Act is the financial division of powers and entitlement inter se between the Centre and States in the federal structure of government in India. In the general scheme of things under the FRBM Act, the Centre is always projected to be a responsible entity and it has also not spared any effort to project the States as profligates.? This needs a closer examination based on some number crunching.? According to Prasanna Mohanty, an economist and an opinions writer, the Debt to GDP and Fiscal Deficit numbers demonstrate states are actually more prudent than the Centre!? Mohanty has the figures to back up his position. The past few days have seen a flurry of news reports stating of the Centre and RBI ae warning state governments against their off-budget borrowings and borrowings against future revenues creating an impression that the latter are fiscally profligate and irresponsible.? The RBI went to the extent of telling banks to stop funds to states using future revenues. According to Mohanty the official statistics do not bear out this proposition. The amendments made in 2018 to the FRBM Act, provided that: “The Central Government shall (a) take appropriate measures to limit the fiscal deficit up to 3% of GDP by 31st March 2021; (b) endeavour to ensure that (i) the general Government debt does not exceed 60%; (ii) the Central Government debt does not exceed 40% of GDP by the end of financial year 2024-25. The day of reckoning is here and now.? Going by the percentage of deviations in the past four fiscals, the annual average deviation works out to 12.6 percentage points for the Centre as against 8.5percentage points for States. That indicates that the States have performed better than the Centre consistently. For the entire eleven fiscals (pre pandemic and pandemic) of FY 2012-22, the annual average fiscal deficit for the Centre was 4.9% and for the States it was 2.8%.? Believe it or not, this demonstrates that the States are more fiscally prudent and responsible vis-a-vis the Centre. With this in the background, let us now examine the case of Kerala that it has brought to the Supreme Court.

The State of Kerala is not only the most literate but also the most litigious. The State now is knocking on the doors of the Supreme Court alleging that the Centre is interfering in the management of the State’s finances by imposing arbitrary limits on its borrowings.? The Supreme Court referred this to a Constitution Bench to determine the question raised by Kerala whether a State has an “enforceable right” to raise its borrowing limits from the Union government and other sources. The Court wants a five-judge Bench to decide important questions of law, including whether “fiscal decentralisation” was an aspect of Indian federalism and if Central regulations fixing net borrowing ceilings on states were a violation of the principles of federalism itself. The Division Bench also sought the Constitution Bench to examine if the borrowing restrictions of the Centre were in conflict with the role assigned to the Reserve Bank of India as the “public debt manager”. The reference came on the basis of an original suit filed by Kerala accusing the Union government of arbitrarily restraining its borrowing limits, due to which the state is skirting on the brink of a financial emergency as it is unable to pay salaries, pensions and fulfil its other essential financial commitments.? In the process, however, the apex Court also cautioned that “if the State has essentially created financial hardship because of its own financial mismanagement, such hardship cannot be held to be an irreparable injury that would necessitate an interim relief against the Union.? Such step might set a bad precedent in law that would enable the states to flout fiscal policies and still successfully claim additional borrowings.? The state of Kerala argued that it had approached the apex court against the arbitrary shackles put on it by the Centre that was nothing short of a blatant attack on federalism and a ruse to bring about a breakdown of the constitutional machinery in the state. The state had also argued that the borrowing limits ought to be fixed by the states themselves.? ?A five-judge Bench will now decide whether ‘fiscal decentralisation’ is an integral aspect of Indian federalism and if so, are Central regulations fixing borrowing limits on states a violation of the principles of federalism.

The State argued in the apex Court that the Centre’s authority is limited to regulating loans sought by the state from the Central Government and it does not extend to other borrowings of the state. It was the state’s case that liabilities arising from the Public Account and State-Owned businesses do not form part of state’s borrowings. The state needed INR 26,226 crores to meet the obligations for pension schemes, financial aids and living allowances. It was also the state’s case that as per the Comptroller and Auditor General of India, the State had not fully utilised its permitted borrowing capacity in the past three years (2020-2021, 2021-2022, and 2022-2023) leaving INR 24,434 crores unutilised. The state was seeking permission to utilise the underutilised borrowing space from the previous years and nothing more. The state contended that it should be allowed to borrow up to the maximum allowable fiscal deficit based on the 15th Finance Commission Report. The state also made a telling point that its debts were eminently sustainable as they had strictly adhered to the Domar Model indicating that the state’s Gross State Domestic Product (GSDP) is growing at a faster rate than its effective interest rate. (The Harrod-Domar model is?a Keynesian model to explain economic growth. This model is used widely in development economics to explain an economy's growth rate).

The Centre on the other had asserted that the management of public funds is of national importance, giving it the necessary authority to oversee all borrowings by the states to safeguard the financial health of the nation. It was contended by the Centre that certain debts of the State from specific public accounts and businesses should also be considered as part of its borrowing, potentially circumventing borrowing limits. According to the Centre the plaintiff had previously exceeded borrowing limits by INR 14,479 crores, contradicting the state’s claim of underutilising borrowing by INR 2,941.82 crores until the fiscal year 2022-2023.? The Centre’s arguments were grounded in the regulations outlined in the Report of the 14th Financial Commission, which stipulated that if a state over-borrows in a year, the excess amount should be deducted from its borrowing limit in the subsequent fiscal year. It was argued by the Centre that the financial strain and outstanding dues of the State of Kerala are a result of its financial mismanagement and not because of the borrowing regulations enforced by the Union Government.? The Centre also contended that any excessive borrowing in one fiscal year should be acknowledged and adjusted for in the subsequent year. The Centre argued that granting further borrowing leeway to the state could potentially endanger and undermine the financial well-being of the entire country.

When state institutions make these claims and counter claims it is time to look at our Constitution dealing with this subject.? Article 293 of the Constitution of India deals with the powers of the states in terms of what is permitted.? This Article stipulates as follows:

(1) Subject to the provisions of this article, the executive power of a State extends to borrowing within the territory of India upon the security of the Consolidated Fund of the State within such limits, if any, as may from time to time be fixed by the Legislature of such State by law and to the giving of guarantees within such limits, if any, as may be so fixed.

(2) The Government of India may, subject to such conditions as may be laid down by or under any law made by Parliament, make loans to any State or, so long as any limits fixed under article 292 are not exceeded, give guarantees in respect of loans raised by any State, and any sums required for the purpose of making such loans shall be charged on the Consolidated Fund of India.

(3) A State may not without the consent of the Government of India raise any loan if there is still outstanding any part of a loan which has been made to the State by the Government of India or by its predecessor Government, or in respect of which a guarantee has been given by the Government of India or by its predecessor Government.

(4) A consent under clause (3) may be granted subject to such conditions, if any, as the Government of India may think fit to impose.

After the initial arguments and after examining the provisions of the Constitution the apex Court formulated the following issues for discussion and decision:

1.????? Can the Plaintiff-State receive an interim injunction while constitutional questions concerning financial management and borrowing restrictions are pending?

2.????? Is the Plaintiff-State experiencing financial hardship due to alleged mismanagement by the Union, warranting urgent relief?

3.????? To what extent can the court engage in Judicial Review of fiscal policies that seemingly conflict with the essence of Article 293 of the Constitution?

4.????? Does Article 293(3) of the Constitution encompass borrowing by government-owned businesses and debts from the Public Account?

5.????? Is fiscal decentralisation a component of Indian Federalism? Do the Defendant’s actions potentially breach Article 14 of the Constitution by exhibiting ‘manifest arbitrariness’?

During the hearing in the Court senior advocate Kapil Sibal representing Kerala argued that the Centre's restrictions constituted nothing less than executive overreach.? He emphasised Kerala's constitutional authority to determine its own budget and borrowing needs. Sibal also highlighted the significant reduction in Kerala's borrowing from the Union government post-liberalisation and objected to the Union's interference in the state's financial matters.? In response, additional solicitor general N. Venkataraman contested Kerala's claims, alleging misrepresentation of figures and pointing out the state's consistent over-borrowing in recent years. He raised concerns about Kerala's macroeconomic stability and the potential adverse effects of granting the requested??10,000 crore.? According to the Union government, any financial stress faced by Kerala was due to its mismanagement citing substantial financial resources provided to the state including payments to meet the GST compensation shortfall.? Kerala had initially requested the Centre's approval to borrow??19,351 crore. While the Centre had agreed to allow an additional borrowing of??13,608 crores, it insisted that Kerala withdraw the legal suit. However, the Court intervened on this issue stating that the Centre cannot impose conditions on Kerala for withdrawing the lawsuit. The Court examined the arguments presented by both parties and observed that the case raised significant constitutional questions requiring authoritative interpretation. It referred the case to a five-judge bench for further deliberations.? Regarding the interim relief sought by Kerala, the Court applied the Triple-Test principle (a prima facie case, balance of convenience, and irreparable loss or harm). While Kerala failed to establish a prima facie case for under-utilization of borrowing space, the Court found that the balance of convenience favoured denying the relief. The Court noted that Kerala had already received substantial borrowing concessions during the proceedings.? The Supreme Court's decision to refer a case filed by the Kerala government to a Constitution Bench is an important event in Centre-State relations especially in matters of federalism and state finances.?The case is about the Union of India's interference in the state's finances by imposing a ceiling on borrowings.?The Supreme Court further observed that fiscal mismanagement by states is an issue that the Union government must be concerned with as it impacts the nation's economy.?The Court advised the Centre and the Kerala government to iron out their differences.? The dynamics of Centre-State relations in India are defined by the allocation of powers and responsibilities between the central government and state governments.?These intergovernmental relations, guided by constitutional provisions, hold significant importance in the operation of the federal structure.? The last word has not been spoken on this issue yet in this Kerala Story.? Watch this space.

Thank you.

Venkat R Venkitachalam