Despite the external origin of the financial crisis, the potential impact on India’s corporate sector could be large, as India has become increasingly integrated with the global economy in the past decade. The Selected Issues paper discusses India’s economic development and policies. The impact on the corporate sector will in turn feed into India’s overall economic growth. The significant volatility in the exchange equity prices, and interest rates triggered by the global crisis, together with the decline in global economic activity and capital flows, will weight on India’s firms.


Despite the external origin of the financial crisis, the potential impact on India’s corporate sector could be large, as India has become increasingly integrated with the global economy in the past decade. The Selected Issues paper discusses India’s economic development and policies. The impact on the corporate sector will in turn feed into India’s overall economic growth. The significant volatility in the exchange equity prices, and interest rates triggered by the global crisis, together with the decline in global economic activity and capital flows, will weight on India’s firms.

IV. India's Experience with Fiscal Rules: an Evaluation and The Way Forward1

1. India is currently reviewing its fiscal rules framework with a view to inform the design of a successor arrangement. After a decade of large and intractable fiscal deficits, India adopted a rules-based fiscal framework, the Fiscal Responsibility and Budget Management Act (FRBMA), in 2003. The FRBMA's stated objective is to ensure inter-generational equity in fiscal management and the fiscal sustainability necessary for long-term macro-economic stability. India's states were given incentives by the Twelfth Finance Commission (TFC) to implement their own fiscal responsibility laws (FRLs) in the form of conditional debt restructuring and interest rate relief.2 With the FRBMA and FRLs only setting out targets until March 2009, policy makers are currently evaluating the strengths and weaknesses of the existing framework to learn lessons that could help inform a possible successor fiscal rule framework. This paper aims to contribute to the current debate by discussing India's experience with fiscal rules, assessing strengths and weaknesses of the current fiscal rules framework, and proposing options for strengthening fiscal discipline in India, which encompass both design options for a successor FRBMA and other complementary reforms.

A. India's Experience with Fiscal Rules

2. The FRBMA and supporting regulations establish procedural rules and set out fiscal targets in a multiyear context. The FRBMA requires the government to commit up-front to a monitorable fiscal policy strategy over a multiyear period, and to report and publish fiscal outcomes and strategy changes on a routine basis. FRBMA numerical rules include a single medium-term target of current balance of the central government to be achieved by March 2008. The associated regulations, meant to guide the execution of the provisions of the Act, set out the following numerical rules: (i) reduction of the current deficit by at least 0.5 per cent of GDP in each financial year beginning with 2004/05; (ii) reduction of the overall deficit by at least 0.3 percent of GDP in each financial year; (iii) limit of 0.5 percent of GDP on the incremental amount of guarantees given by the central government; (iv) initial annual limit on debt accumulation of 9 percent of GDP, to be progressively reduced by at least one percentage point of GDP each year.

3. At the subnational level, nearly all of India's 28 states have enacted FRLs.3 The TFC suggested that the FRL of each state should provide for the elimination of the current deficit by 2008/09, the reduction of the overall fiscal deficit to 3 percent of gross state domestic product (GSDP), along with annual targets for revenue and reduction of fiscal deficits, measures to enhance transparency in budgetary operations, and a medium-term fiscal policy framework. While there is some variation in design of the FRLs across states, an important number of features of the FRBMA have been adopted in the states' FRLs.

4. So far, India's experience with fiscal rules has been mixed. At the central level, the FRBMA contributed by strengthening the procedural rules underpinning the fiscal framework. However, it is less clear whether the FRBMA led to better fiscal performance. While a substantial fiscal consolidation occurred following the adoption of the FRBMA (and until 2007/08), it is difficult to establish causality since robust economic growth and tax administration reforms led to significant revenue gains. Moreover, despite the apparent consolidation, off-budget activities increased, deadlines to comply with fiscal targets were extended, and the fiscal adjustment was not underpinned by expenditure reform. Significant slippages with respect to the 2008/09 deficit targets were expected even before the evolving global crisis precipitated calls for fiscal stimulus, raising questions about the effectiveness of the FRBMA (Figure 1).

Figure 1:
Figure 1:

Central Government Fiscal Performance under FRBMA

Citation: IMF Staff Country Reports 2009, 186; 10.5089/9781451818659.002.A004

5. The experience with FRLs at the subnational level also shows mixed results. While significant improvements were observed in the states' overall balances, a more detailed look at the nature of the fiscal consolidation reveals the large role that increased central government transfers (linked to buoyant central government tax revenues) and lower interest payments have played in this consolidation. This raises questions about the vulnerability of states' fiscal positions to a slowdown in economic growth. Econometric analysis also does not reveal a statistically significant association between the adoption of fiscal rules and the degree of fiscal consolidation when revenue sharing transfers and interest payments are excluded from the current deficit measure.

Table 1.

Adjustment in State Government Finances, 2002/03–2008/09

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According to central government accounts.

According to the RBI Study of State Budgets which uses state accounts' estimates of central government transfers.

6. However, states that had either debt targets and/or expenditure rules showed more fiscal adjustment than the ones that did not. The variation in the design of fiscal laws across India's states permits an examination of whether certain design features of the fiscal rules are correlated with better fiscal performance. In a dynamic panel data framework, a regression of the current deficit excluding central government transfers and interest payments as a share of GSDP4 on interaction variables of an FRL indicator and the dummy for a debt target or expenditure target and relevant controls5 yield negative and statistically significant coefficients for the former, suggesting that fiscal consolidation was larger after the enactment of the FRL in states whose laws also included these design features.

Table 2:

State Fiscal Adjustment and Fiscal Rule Design

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B. Strengths and Weaknesses of the Current Fiscal Rules Framework

7. India's current FRBMA is in line with FRLs in other countries in highlighting the importance of sound procedural rules. The strengths of the FRBMA lie predominantly in the adoption of several important procedural rules including, medium-term targets and enhanced transparency for budget processes. These rules have similarities with the frameworks of advanced countries, such as New Zealand, the EU and Canada, and have contributed to improving fiscal management in India.

8. However, on several dimensions, the FRBMA could be strengthened. The main weaknesses are:

  • (1) Absence of clear accounting definitions for target fiscal indicators. This has allowed creative accounting as reflected by the issuance of off-budget bonds to finance subsidies, which have thus been excluded from the definition of the FRBMA-relevant deficit variable.

  • (2) Insufficient transparency in budget preparation. Numerical targets have not been supported by comprehensive expenditure reform plans. In addition, the assumptions underpinning the budget do not always include annual forecasts for key macroeconomic variables, and the discussion of fiscal risks6 is limited.

  • (3) Focus on a current balance target. This allows weaknesses in budget classification to be exploited, by misclassifying current expenditures as capital expenditures. Targeting the current balance may also bias spending against education and health, which have a large current expenditure component.7 In addition, international experience illustrates that deficit type targets such as the current balance are more likely to reduce incentives for fiscal savings in good times, and to force adjustment in bad times (i.e. procyclicality).8

  • (4) Lack of explicit debt and expenditure targets. Despite rapid economic growth and buoyant revenues, India's inability to contain expenditure growth (Figure 1) led to modest declines in the general government debt. Since the enactment of the FRBMA, general government debt fell by only 7-8 percentage points of GDP and, at 80 percent of GDP, is high by emerging markets standards.

  • (5) Absence of well-defined sanctions for noncompliance. There are no explicit automatic penalties for missing fiscal targets and/or not following budget procedures. International experience shows that institutional sanctions (e.g., withholding of transfers, borrowing restrictions, and fines) and/or personal sanctions (e.g., fines, dismissal, and penal prosecution) are likely to be needed especially in countries with a history of weak fiscal discipline.

  • (6) No independent assessment of compliance with the FRBMA. Historically, budget projections have been subject to systematic forecast errors. Expenditures have consistently being underestimated in recent years even more particularly so if off-budget bonds are included.

9. Subnational FRLs are likely to share the strengths and weakness of the FRBMA. While there is some variation in the characteristics of subnational FRLs and some states have debt and/or expenditure targets, most of the FRLs have been inspired by the FRBMA and the recommendations of the Twelfth Finance Commission. An additional weakness at the subnational level is the inability to obtain reliable information on state finances on a timely basis. While the lags have been reduced in recent years, they remain sizeable.

10. The approach for setting numerical targets for subnational governments may need to be revisited given the significant disparity across India's states. Most states target a current balance of 0 percent of GSDP and an overall deficit of 3 percent of GSDP. However, as illustrated by Flanagan and Purfield (2006) and Rajaraman (2007), states face widely different initial fiscal conditions and growth prospects. Thus, some states require more fiscal adjustment than others to achieve a sustainable debt position.

C. The Way Forward

11. Based on international experience as well as the experience with fiscal rules in India, the following options may be considered when designing a successor to the FRBMA:

  • In terms of target variables: (i) include an explicit national medium-term debt target and define a path to achieve it; (ii) discuss with states the setting of state debt targets consistent with such path, for example, based on net revenue as in Brazil; (iii) on the basis of the desired debt path and a revenue projection based on a prudent trend growth assumption, derive annual nominal primary expenditure growth rules on the basis of the government's flow budget constraint; and (iv) consider including specific rules to protect capital spending if there is a concern that it may be cut excessively during adjustment. These changes will put the medium-term focus of fiscal policy squarely on debt sustainability, tackle the deficit bias at its very core (expenditure overruns), and reduce the tendency to procyclical responses of fiscal balance targets by allowing automatic stabilizers to operate.

  • In terms of coverage: (i) bring all subsidy-related expenditures on budget; (ii) gradually expand the coverage of the fiscal accounts to include public enterprises that pose fiscal risks; and (iii) the accounts of special purpose vehicles created for funding government spending such as PPPs both at central and subnational levels. This coverage expansion will address existing loopholes and reduce possibilities of circumvention.

  • In terms of procedure and transparency: (i) explicitly provide a plan of measures and reforms that support the achievement of targets (e.g., subsidy reform); (ii) systematically discuss the macroeconomic assumptions underlying the targets (including GDP growth, inflation, imports, exports and the exchange rate); (iii) provide exact definitions of the concepts underpinning the target variables; and (iv) include a statement of fiscal risks, including from PPPs. Additional disclosure along these lines will allow improved market monitoring and pricing of risk. In addition, (v) strengthen public financial management by reforming the budget classification and the accounting framework, and (vi) ensure timely and reliable reporting of subnational fiscal operations since these are important preconditions for the successful implementation of a fiscal rule.

  • In terms of escape clauses: tighten the definition of escape clauses so that they only apply to exceptional circumstances and require objective analysis and scrutiny in their application by an independent fiscal council to strengthen credibility.

  • In terms of correction of deviations and enforcement: (i) reduce the size of deviations that trigger corrective actions; (ii) introduce automatic and time bound mechanisms to correct deviations from targets that prioritize areas of spending that would be cut if there were a need; (iii) introduce explicit penalties that are applied automatically when fiscal targets are missed and/or budget procedures are not followed; and (iv) institute independent fiscal councils to assess compliance with statistical and accounting standards and fiscal rules ex ante (i.e., budget forecasts, assessment of the impact of measures and targets) and ex post (execution, invocation of escape clauses, assessment of compliance with medium-term fiscal strategy). Consideration should be given as to whether existing bodies (such as the Controller Accountant General, Controller Auditor General, and Estimates Committee of the parliament) could carry out some or all of these functions before creating new institutions. Timely corrective actions and sanctions for non compliance coupled with independent oversight will reduce the likelihood of deviations and increase the cost of deviations to key players, thus strengthening the credibility of the rules.

12. A range of additional reforms could help strengthen fiscal discipline. In particular, continuing to strengthen financial market control mechanisms as well as cooperative arrangements across government levels and pursuing reforms to the intergovernmental fiscal relations system. Strengthening financial market control mechanisms involves gradually eliminating the availability of significant non market based and captive sources of financing (such as the statutory liquidity requirement for banks to hold state issued paper, compulsory investment by the National Small Savings fund in state debt and borrowings from public accounts). Cooperative arrangements could be reinforced by transforming existing cooperation frameworks (such as the bi-annual conference of State Finance Secretaries) into forums where both the center and the states could discuss subnational FRL reforms and borrowing ceilings consistent with national objectives. Finally, persevering with intergovernmental fiscal reforms in particular to reduce states' dependence on central transfers, simplify the transfer system, and review the design of the transfer system on the basis of needs and fiscal capacity of the different states.


  • Anderson, B. and J. Minarik, 2006. “Design Choices for Fiscal Policy Rules,” OECD Journal of Budgeting, 5(4).

  • Buiter, Willem and Urjit Patel, 2006. “Excessive Budget Deficits, a Government-Abused Financial System, and Fiscal Rules,” India Policy Forum.

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  • International Monetary Fund, 2004. “Public Investment and Fiscal Policy” (Washington). Available via the Internet:

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  • International Monetary Fund, 2005. “Fiscal Responsibility Laws” (unpublished, Washington).

  • International Monetary Fund, 2005. “Promoting Fiscal Discipline Over the Business Cycle” (unpublished, Washington).

  • International Monetary Fund, 2005. “Promoting Fiscal Discipline: Is There a Role for Independent Fiscal Agencies” (unpublished, Washington).

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  • International Monetary Fund, 2008. “Fiscal Risks—Sources, Disclosure, and Management.” (Washington). Available via the Internet:

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  • Purfield, Catriona and Mark Flanagan, 2006. “Reining in State Deficits,” in India Goes Global: Its Expanding Role in the World Economy, eds Catriona Purfield and Jerald Schiff (Washington: International Monetary Fund).

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  • Rajaraman, Indira, 2007. “The Political Economy of the Indian Fiscal Federation.” India Policy Forum.


Prepared by Alejandro Sergio Simone and Petia Topalova. This paper summarizes the main findings and reform options discussed in a forthcoming working paper.


The Finance Commission is a constitutional body established under article 280 of the Indian Constitution every five years with the primary purpose of determining the sharing of centrally collected tax proceeds between the central and state governments and the distribution of grants-in-aid of revenues across states. The terms of reference of the Finance Commissions can be expanded by order of parliament.


West Bengal and Sikkim are the only two states that have not yet enacted a fiscal responsibility law.


The current balance is used as an indicator of fiscal performance because all the states' FRLs include a target for the current deficit.


Controls include fixed-effects to control for economy-wide changes (such as economic growth, higher revenue at the central level, implementation of the TFC recommendations), state fixed-effects to control for time-invariant heterogeneity in the fiscal stance across India's states, the (log of) GSDP, the lag of the debt to GSPD ratio, and an indicator for the adoption of VAT at the state level.


Fiscal risks, defined as the possibility of deviations in fiscal variables from what is expected, are generated from different sources such as unexpected fluctuations in traditional macroeconomic variables including real growth, exchange rates, interest rates, commodity prices as well as unexpected contingent liabilities stemming from banking crises, natural disasters, state owned enterprises, subnational government bailouts, legal claims, government guarantees and public-private partnerships (see IMF (2008) for an in-depth discussion).


See IMF (2004) for additional discussion.


See Anderson (2006) for a discussion of the European experience, and Buiter and Patel (2006) for a discussion of this feature of India's FRBMA.

India: Selected Issues
Author: International Monetary Fund