Potential targets for the Union Budget

It is expected that the government will better its FY25 fiscal deficit target of 4.9% of Gross Domestic Product (GDP). While this is a positive setup for the promised consolidation to 4.5% of the GDP by FY26, there is some argument over whether the government should skip the compression for a year to support growth. We think that even if the government opts for the fiscal consolidation path in FY26, a judicious frontloading of the available fiscal space in FY25 itself could provide the near-term impetus to growth. Union government capex growth could be higher than 30% year-on-year in the last quarter of FY25, given that it has been sluggish in the earlier part of the year. This spending, in turn, could have a positive impact on consumption as the cash flows through the economy. Given the understanding that GDP growth has started improving modestly from the December quarter, at this point, a “fiscal nudge” of this kind might be good enough to bring the economy back on track rather than a big “fiscal boost” in the FY26 Budget.

There could be multiple motivations to reach the 4.5% GDP target in FY26 despite some growth headwinds. This will be the normalisation of the fiscal boost that was given during Covid when the deficit went up to 9.2% of the GDP. To improve the quality of the fisc, the government had also brought substantial off-budget spending into the budget. Adjusting for these accounting changes, 4.5% would be broadly consistent with pre-Covid fiscal deficit levels, reflecting a return to normalcy. A deficit at 4.5% levels would put public debt-to-GDP ratio on a comfortably downward trajectory, which is the stated government fiscal objective. Meeting the promised fiscal deficit target, even under somewhat challenging conditions, would improve the credibility of the fiscal process for investors and rating agencies. A Centre deficit of at least 4.5% is also needed to take the overall general government deficit to 7% of GDP, a criterion for rating upgrade mentioned by rating agencies. In theory, a lower government deficit could create borrowing space for the private sector to accelerate the private investment cycle. On the other hand, relatively conservative fiscal policy should open up the space for some monetary easing in three steps — liquidity, lower rates, and relaxation of macro-prudential measures.

There could be various paths to achieving the desired fiscal consolidation, but a compression through a fall in the revenue-expenditure-to-GDP ratio is likely to improve the quality of the fisc further. In fact, the government has opted for this path consistently in the post-Covid fiscal consolidation and maintained its focus on increasing public capex. Despite the possibility that the Union government might fall short of its budgeted capex spending in FY25, the FY26 capex spending growth target could still be pegged at close to 15%. On the other hand, the increase in revenue spending on items such as defence, subsidies, salaries, and home affairs does not always need to match the nominal GDP growth, leading to a decline in the revenue-expenditure-to-GDP ratio. That way, there is no need for explicit expenditure cuts on any particular item to achieve consolidation.

On the revenue collection side, the budget is likely to assume that the nominal GDP growth will be pushed back above 10%, after two years of below 10% nominal growth. With elevated tax revenue buoyancy, an above 10% nominal GDP growth can sustain the tax-to-GDP ratio at close to an all-time high. However, there is some uncertainty around non-tax revenues such as the Reserve Bank of India (RBI) dividend to the government. Urban consumption slowdown has increased market chatter around a disposable income boost for the consuming class through income tax concessions. It is likely that there has been some increased personal income tax liability, despite tax rates remaining broadly stable. Nonetheless, given the fiscal constraints and intent to move towards the simplified new income tax regime, the fiscal cost of any income tax relief will likely be limited to below 0.1% of GDP.

Even if the space for an explicit fiscal stimulus is not available, the budget is likely to continue with the policy focus on human capital development. Manufacturing and infrastructure have been the other two areas of emphasis. To that end, more measures in improving the ease of doing business through simplification of direct taxation, re-calibration of the import duty structure, pushing forward with the next generation reforms to improve factor (labour, land) productivity and increased attention to research and development (R&D) spends could be considered to grab the manufacturing opportunity arising from the global supply-chain diversification. On the infrastructure front, the government might look to diversify capex by increasing allocation for sectors like urban development, water, housing, and clean energy, and by improving the execution capabilities and directional thrust in traditional capex-intensive sectors such as roads and railways.

The cornerstones of the FY26 Budget could be spending the allocated FY25 capex in the near term, preserving the quality of the fisc, delivering on the consolidation roadmap, and emphasising next-generation reforms to boost structural growth.

Samiran Chakraborty is managing director and chief economist,India, Citigroup.The views expressed are personal