Fiscal Federalism and the FRBM Act: Fiscal Deficit Targets and Post-COVID Revision
Fiscal federalism refers to the financial relationship between the Union and State governments — covering revenue sharing, expenditure responsibilities, and borrowing limits. In India, the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 provides the statutory framework for fiscal discipline at the Union level, while states have their own fiscal responsibility legislation. The COVID-19 pandemic triggered an unprecedented fiscal expansion, prompting a fundamental rethink of fiscal consolidation targets and the architecture of fiscal federalism.
The FRBM Act, 2003 required the Union government to reduce fiscal deficit to 3% of GDP. The N.K. Singh Committee (2017) recommended an escape clause mechanism and a debt rule-based approach. COVID-19 caused the fiscal deficit to surge to 9.2% of GDP in 2020-21. The Union Budget 2021-22 introduced a revised glide path targeting 4.5% by 2025-26. Budget 2025-26 set a new medium-term target of reducing the debt-to-GDP ratio to 50% (±1%) by 2030-31. For states, the 15th Finance Commission linked borrowing space to fiscal consolidation benchmarks.
📌 Revision Pointers
FRBM Act 2003: Mandates annual reduction in fiscal deficit; targets 3% of GDP.
N.K. Singh Committee (2017): Recommended debt as the primary anchor (60% of GDP by 2023); fiscal deficit as an operational target (3% by 2020); escape clause for crises.
Escape clause: Allows deviation of up to 0.5% of GDP from deficit target in exceptional circumstances — declared by RBI/government.
COVID impact: Fiscal deficit jumped to 9.2% (Centre) in 2020-21 from 3.5% target.
Revised glide path (2021): Trajectory to reach below 4.5% of GDP by 2025-26.
Budget 2025-26: Fiscal deficit target of 4.4% of GDP; debt-to-GDP target of 50% by 2030-31.
State fiscal rules: States must maintain deficit below 3% of GSDP; extra borrowing tied to power sector reforms, capital expenditure, etc.
15th FC: Allowed states 4% of GSDP fiscal deficit in 2021-22, reducing to 3% by 2023-26.
Detailed Explanation
1 The FRBM Act, 2003: Origins and Objectives
The FRBM Act was enacted to institutionalise fiscal discipline following years of high fiscal deficits in the 1990s, which had crowded out private investment and contributed to balance of payments vulnerability. The Act set a target to eliminate revenue deficit and reduce fiscal deficit to 3% of GDP by 2008-09 (later revised).
Key definitions: Fiscal Deficit = Total expenditure minus total receipts excluding borrowings. Revenue Deficit = Revenue expenditure minus revenue receipts. Effective Revenue Deficit = Revenue deficit minus grants for capital asset creation. Primary Deficit = Fiscal deficit minus interest payments.
Mandatory statements: Budget must be accompanied by the Medium-Term Fiscal Policy Statement, Fiscal Policy Strategy Statement, and the Macroeconomic Framework Statement.
2 N.K. Singh Committee (2017)
The N.K. Singh Committee, constituted to review the FRBM framework, submitted its report in January 2017. Key recommendations: (i) Shift from fiscal deficit to debt as the primary fiscal anchor — Centre and states combined debt should be 60% of GDP by 2023 (40% Centre + 20% states); (ii) Fiscal deficit as operational target — 2.5% of GDP for Centre by 2022-23; (iii) Escape clause — allows 0.5% deviation in case of national calamity, national security, collapse of agriculture, decline in real output growth, structural reforms with fiscal costs; (iv) Fiscal Council — independent body to advise on fiscal policy; (v) Revenue deficit elimination by 2023.
Several of these recommendations were partially accepted. The escape clause was operationalised; the independent Fiscal Council was not set up.
3 Fiscal Federalism: Centre-State Fiscal Relations
Revenue sharing: The 15th Finance Commission (FC) recommended that 41% of the divisible pool of central taxes be devolved to states. This is the primary mechanism of vertical fiscal transfers.
Grants-in-aid: Article 275 (grants to states in need) and Article 282 (discretionary grants). The FC provides sector-specific grants for health, education, urban, rural, and disaster management.
State borrowings: States borrow primarily through State Development Loans (SDLs) in the market. The Centre sets annual borrowing ceilings — 3% of GSDP as a rule, with conditional allowances up to 4-4.5% linked to capital expenditure and reforms (power sector, ease of doing business, etc.).
Asymmetry: States bear significant expenditure responsibilities (education, health, agriculture, police) but depend on the Centre for a large share of revenue. This vertical fiscal imbalance requires large transfers, but also creates moral hazard if states over-borrow knowing Centre may bail them out.
4 Post-COVID Revision
COVID-19 fiscal stress: The pandemic caused both revenue collapse and emergency expenditure surge. Union fiscal deficit rose from 3.5% (Budget Estimate 2020-21) to 9.2% (Revised Estimate), a near-tripling. States' combined deficit also widened significantly.
Union Budget 2021-22 framework: Finance Minister Sitharaman announced a revised glide path: fiscal deficit to be reduced from 9.2% (2020-21) to below 4.5% of GDP by 2025-26, with a path of gradual consolidation. The government prioritised capital expenditure (capex) over revenue compression, aiming to use capex as a multiplier for growth.
Budget 2025-26 medium-term framework: The Union Budget 2025-26 targeted fiscal deficit of 4.4% and introduced a new five-year consolidation framework (2026-27 to 2030-31) to reduce debt-to-GDP to 50% (±1%) by 2030-31. This signals a shift towards debt sustainability as the anchor, consistent with N.K. Singh Committee recommendations.
Important Concepts
Revenue deficit vs. fiscal deficit: Revenue deficit means current expenses exceed current revenues — implies government is borrowing to fund consumption, which is fiscally unsound. Fiscal deficit includes capital borrowings.
Crowding out: High government borrowing pushes up interest rates, displacing private investment.
SDL market: State governments raise market loans; spread over central government securities indicates fiscal health perception.
Fiscal multiplier: In a downturn, fiscal stimulus can have a multiplier effect on GDP — capex has higher multiplier than revenue expenditure.
Committed expenditure: Salaries, pensions, interest payments — inflexible portion of revenue expenditure that limits fiscal space.
Current Relevance
Revised FRBM framework: The 15th Finance Commission recommended a High-Level Inter-Governmental Group to review and revise the FRBM framework for both Centre and states. This is pending.
State debt concerns: Several states (Punjab, Rajasthan, West Bengal) have high debt-to-GSDP ratios, raising concerns about debt sustainability. CAG and RBI have flagged risks from state guarantees and off-budget borrowings.
Capital expenditure push: Since 2021-22, the Union government has significantly increased capex outlay and also provided interest-free 50-year loans to states for capex — a new instrument of Centre-State fiscal cooperation.
💭 Conclusion
The FRBM framework reflects India's effort to institutionalise fiscal discipline while retaining the flexibility needed in a developing economy. The post-COVID recalibration — shifting from a rigid 3% deficit rule to a medium-term debt sustainability anchor — represents a more nuanced and context-sensitive approach. Effective fiscal federalism requires not just revenue sharing, but strong fiscal institutions at all levels of government to prevent fiscal profligacy that undermines macroeconomic stability.