Govt changes stance on fiscal consolidation, prioritises debt reduction

Finance Secretary said the figure of 3% for fiscal deficit does not take into account the specific dynamics of a fast growing economy like India

The Modi government 3.0 committed itself to bringing down the fiscal deficit, which is an excess of expenditure over revenues, to below 4.5 per cent of gross domestic product (GDP) next financial year, but did not specify the target after that year.

On the other hand, Finance Minister Nirmala Sitharaman stated in her latest Budget speech: “From 2026-27 onwards, our endeavour will be to keep the fiscal deficit each year such that the Central government debt will be on a declining path as percentage of GDP.”
 

Till then, the Centre has been announcing fiscal deficit targets along with those for revenue deficit, which is an excess of expenditure such as salaries and pension for current needs over revenues from current streams such as taxes and non-tax receipts, and the debt to GDP ratio. 
 

As such, the government is changing its stance on fiscal consolidation to primarily target the debt to GDP ratio. The resultant reduction of fiscal deficit and revenue deficit will hinge on that goal.
 

“Yes, it is a new approach that the government has spoken about. And so each year’s calibration will be based on what will be a percentage which will keep our debt on a reducing path now that will, of course, be set out closer to the year when it comes into effect,” Finance Secretary T V Somanathan elucidated at a post-Budget press conference on Tuesday.

 

 He further explained that it is not the intention of the government to focus on a deficit number but rather to look at what will keep reducing the government debt-GDP ratio in normal years.

 

Changed stance
 

Ranen Banerjee, partner at PwC India, says from 2026-27 the fiscal deficit will be kept at a level that will lead to a declining debt to GDP ratio. This means the deficit, which will be financed through borrowing, has to be less than the GDP growth rate so that the debt stock grows at a slower pace than economic expansion. “This will lead to lowering of the debt to GDP ratio,” he explains.  
 

Somanathan attributed this change in stance to a fixed figure for the fiscal deficit at 3 per cent, which the Fiscal Responsibility and Budget Management (FRBM) Act mandated the Centre to ultimately achieve. In fact, the NK Singh Committee on fiscal consolidation recommended using debt as the primary target for fiscal policy. It recommended that the Centre's debt to GDP ratio be brought down to 38.7 per cent by 2022-23.
 

To achieve the targeted debt to GDP ratio, it proposed yearly targets to progressively reduce the fiscal and revenue deficits till 2022-23. It wanted the Centre to bring down the fiscal deficit from 3.5 per cent during 2017-18 to 2.5 per cent by 2022-23.

Consequently, the FRBM Act, 2003 was amended to mandate the Centre to take appropriate measures to limit the fiscal deficit to 3 per cent of GDP by March 31, 2021. It also required the Union government to ensure that its debt does not exceed 40 per cent of GDP by the end of 2024-25.

The Act also required the Union government to endeavour that these targets are not exceeded after the stipulated dates.

 

Post-pandemic reality
 

The statement of fiscal policy that Finance Minister Sitharaman presented along with the Budget papers under the FRBM Act on Tuesday in Parliament explained the reasons behind deviating from these targets. It said the path to achieve the targeted level of fiscal deficit and debt to GDP ratio was being followed during the pre-Covid era.
 

However, the Covid-19 pandemic, including the global geopolitical tensions, triggered an unprecedented economic and fiscal crisis across the globe. “India, too, was adversely affected. The pandemic caused the Central government to raise the level of fiscal deficit to 9.2 per cent of GDP in FY 2020-21 as against 3.5 per cent of GDP estimated in the BE (Budget Estimates),” the paper said.
 

On the Budget for 2024-25, it said with continued global uncertainty and potential new avenues of conflict still open, prudence demands that the government retain fiscal flexibility to be able to effectively respond to the potential unforeseen challenges.

The Budget is being presented at a time when the Indian economy is exhibiting unmistakable resilience in a relatively uncertain global economy, the paper said.
 

“While being one of the fastest growing economies in the world gives the nation a lot to cheer about, the optimism has to be tempered with caution,” it explained.
 

The Budget expedited fiscal consolidation, projecting it at 4.9 per cent of GDP for 2024-25, down from the Interim Budget estimate of 5.1 per cent. This was despite an increased spending on employment generation schemes, financial 

packages for Bihar and Andhra Pradesh, and relief under the new personal income tax regime.
 

The finance minister was able to project a lower fiscal deficit for FY25, compared to the Interim Budget, because of a record surplus transfer from the Reserve Bank of India (RBI) of Rs 2.1 trillion and dividends from public sector banks, such as State Bank of India, Canara Bank, Indian Bank, Bank of India, and EXIM Bank, totalling Rs 13,440 crore. In total, the Budget projected the RBI transfer and public sector banks dividend to offer it Rs 2.3 trillion, higher by Rs 1.3 trillion over interim Budget’s estimates of Rs 1 trillion.  
 

This helped the government project a non-tax revenue (NTR) kitty higher by Rs 1.5 trillion for FY25 than what was pegged by the Interim Budget.
 

This will make up for the Rs 20,000 crore revenue shortfall the FM projected, post devolution to the states, for this financial year compared to the pre-election general Budget.
 

Rising NTR also helped the government raise its revenue expenditures by Rs 60,000 crore for FY25 against Interim Budget estimates by launching various employment-linked schemes and financial assistance to Bihar, Andhra Pradesh, and a few other states.
 

It should be noted that the original FRBM Act of 2023 wanted the Centre to reduce the fiscal deficit to 3 per cent of GDP and eliminate the revenue deficit by 2007-08. However, these targets were later extended by a year.

The global financial crisis and resultant stimulus package by the then United Progressive Alliance government changed things drastically. Fiscal deficit hit 6 per cent of GDP and revenue deficit 4.5 per cent during 2008-09.
 

Somanathan said the figure of 3 per cent for fiscal deficit does not take into account the specific dynamics of a fast growing economy like India. Some people attribute this figure to the Maastricht Treaty in Europe. However, the growth rates of those countries are very low, he said, seeking to distinguish the Indian economy from those economies.

The Maastricht Treaty established the European Union, paved the way for the Euro and created EU citizenship.
 

India is currently the fastest growing large economy in the world, the finance secretary said, adding the deficit which the country’s economy can support in a particular year without expanding the debt is not necessarily 3 per cent of GDP.

“It is much more than 3 per cent. It is probably less than 4.5 per cent,” he pointed out.

But is it the right approach to target debt, rather than fiscal deficit?
 

Bank of Baroda Chief Economist Madan Sabnavis says the fiscal deficit reduction is a way to lower the debt to GDP ratio. “Hence, targeting the latter, rather than the former, is logical. But optics matter, and how we manage the deficit ratios and their path will still be important,” he points out.
 

Rating agencies assessment of the economy does lend credence to Sabnavis observations. For instance, Standard & Poor’s had said in May that it may raise the ratings if India's fiscal deficits narrow meaningfully.
 

The rating agencies focus on combined fiscal deficits of the Centre and the states. S&P wanted India to narrow its fiscal deficit so that the net change in general government deficit falls below seven per cent of GDP on a structural basis.