Challenges lie ahead on the path of fiscal consolidation

The fiscal deficit of the central and state governments may remain more than 7 percent of GDP for several years.

Government of India’s (GoI’s) 2025-26 budget has shown a continued and welcome commitment to fiscal consolidation. It shows an improved performance in 2024-25 (RE) by keeping the fiscal deficit to GDP ratio at 4.8 percent instead of the budgeted level of 4.9 percent.

In 2025-26, the budget has provided for a fiscal deficit of 4.4 percent of GDP, lower than the 2024-25 (RE) by 0.4 percentage points. This entire reduction, however, has been at the cost of reducing the size of GoI’s total expenditure relative to GDP also by a similar margin from 14.6 percent in 2024-25 (RE) to 14.2 percent of GDP in 2025-26 (BE). This reduction by itself could be contractionary in nature. However, the budget has tried to neutralize this by improving the quality of expenditure and the quality of fiscal deficit.

Enhancing quality of expenditure and deficit

While the level of capital expenditure relative to GDP has remained stagnant at 3.1 percent in 2025-26 (BE), the ratio of capital expenditure to total expenditure has been budgeted to increase from 21.6 percent in 2024-25 (RE) to 22.1 percent in 2025-26 (BE). Since capital expenditure is associated with a higher multiplier, this should have a positive impact on growth.

Stimulus has also been introduced through the consumption route by enhancing disposable incomes in the hands of the middle-income group by a margin of about Rs 1 lakh crore by way of rate rationalization and reductions in the personal income tax schedule. This may have a positive multiplier effect. Another route through which the budget has sought to stimulate the economy is to continue providing 50-year interest free loans to state governments for building infrastructure. GoI’s own capital expenditure growth is limited to that of the nominal GDP growth at 10.1 percent in 2025-26 (BE). However, this growth is higher than the growth of revenue expenditure at 6.7 percent. The budget shows a revenue deficit of 1.5 percent of GDP and a much lower effective revenue deficit of 0.3 percent for 2025-26. This implies that some of the budgeted revenue expenditures are being given to the state governments as grants-in-aid meant for capital asset creation. Thus, together, there is an improvement in the quality of expenditures favouring capital asset creation which may neutralize the contractionary effect of the lowering of the GoI’s total expenditure relative to GDP.

On the whole, however, the 2025-26 real GDP growth may be closer to the lower end of the Economic Survey’s projected range of 6.3-6.8 percent of GDP.

New fiscal consolidation paradigm

The Budget 2025-26 has confirmed the announcement that was made in the July budget of 2024-25 that the GoI would now move to an incremental reduction in the debt-to-GDP ratio. In the Annexure entitled ‘Statements of Fiscal Policy as required under the Fiscal Responsibility and Budget Management Act, 2003’ alternative paths of the debt GDP ratio with nominal GDP growth assumptions of 10.0 percent, 10.5 percent and 11.0 percent are given along with mild, moderate and high degrees of fiscal consolidation.

In these alternative scenarios, the debt-GDP ratio falls to levels ranging from 47.5 percent to 52.0 percent in 2030-31. If we consider, the moderate scenario along with a 10.0 percent nominal GDP growth, we can derive the path of fiscal deficit to GDP ratio as falling from 4.4 percent in 2025-26 (BE) to about 3.5 percent in 2030-31 in incremental steps. The debt GDP ratio would remain significantly above the FRBMA norm of 40 percent and the fiscal deficit norm of 3 percent of GDP.

In fact, there would be additional pressure in 2026-27 on government finances, pertaining to both central and state governments, on account of pay and salary revisions. This is likely to derail the fiscal consolidation process further. In all likelihood, it would not be possible to achieve the debt-GDP target of 40 percent even by early 2040s. But maintaining a higher debt-GDP ratio for an extended period of time would imply progressively higher interest payments relative to GoI’s revenue receipts which has been the trend in recent years. Further the effective interest rate for the GoI is also increasing as they borrow on behalf of the states and pass it on to states at zero interest rate.

There is a need to re-examine the balance between available investible resources and demand for it from the government and non-government sectors. The fiscal deficit of the central and state governments may remain more than 7 percent of GDP for several years. The households’ surplus savings kept in financial form, have fallen to a level of 5.0 percent and 5.3 percent of GDP respectively in 2022-23 and 2023-24. Adding to this about 1.5 percent to 2 percent of GDP as net-inflow of capital, the total investible surplus of about 7 to 7.5 percent of GDP would be nearly fully exhausted by governments’ demand on it because of their borrowing requirements. This would amount to crowding out private corporate sector and non-government public sector from accessing the available investible surplus. They will have to rely largely on net-inflow of capital, taking it much above sustainable levels.