Not just an external threat: India faces strong fiscal headwinds within

More attention needs to be paid to fiscal implications of the West Asian conflict for the Union and state governments

With Prime Minister Narendra Modi outlining a series of austerity steps that Indians should take in the wake of the ongoing West Asian conflict, the Union and state governments must now plan strategies to manage the fiscal costs that higher crude oil prices will impose on their finances. India faces not just an external account problem, but an equally grave fiscal challenge.

 

Austerity measures, in whatever form, should conserve the country's foreign exchange resources and help the government manage its external account. A widening current account deficit, along with capital outflows, will require concerted efforts by the Union government to bridge the balance of payments gap, which is certain to increase. The fiscal challenge, however, differs from a potential external account crisis, though the two are interrelated.

 

In the last few days, the Union government has initiated steps such as allowing two rounds of increases in the retail prices of petrol, diesel and compressed natural gas (CNG). It has also sent directives to central ministries and public-sector enterprises, including state-controlled banks, on how to conserve foreign exchange. These measures should help oil companies recover some of the losses incurred since the sharp increase in crude oil import costs.

 

State governments have also announced austerity measures, but a couple of them have reduced taxes on aviation turbine fuel, which will impact their revenue. Most of them, however, are yet to take steps towards managing their expenditure or revenues. Clearly, states have not done enough to convince anyone that they fully recognise the magnitude of the crisis ahead. But before assessing the scale of the challenges for the states, it would be useful to first get a sense of the likely increase in the Union government’s fiscal burden.

 

The Union Budget for 2026-27, presented on February 1, set a fiscal deficit target of 4.3 per cent of gross domestic product (GDP). The exercise to set this target, compared to a fiscal deficit of 4.4 per cent of GDP in 2025-26, could not have accounted for the likely impact of the West Asian conflict, which will surely affect both revenue and expenditure.

 

Take the revenue impact first. On March 26, the Union government cut the special additional excise duty on petrol and diesel by ₹10 per litre, which will result in an annual revenue loss of over ₹1 trillion in 2026-27. The states were spared this fiscal burden because the entire duty reduction came from a change in the special additional excise duty, whose proceeds are not part of the divisible pool.

 

On the expenditure side, the Union government faces a fertiliser subsidy burden, which the Budget for 2026-27 had estimated at ₹1.7 trillion. This subsidy bill is now set to rise to ₹2.4 trillion. This means an additional fiscal burden of ₹70,000 crore.

 

There are a few other steps that will increase the fiscal pressure on the government's finances. Within days of the West Asian conflict erupting on February 28, the finance ministry announced it had allocated ₹1 trillion to the Economic Stabilisation Fund as a precautionary measure. This aimed to create an emergency cushion for responding to global headwinds, supply-chain disruptions, sudden stress in specific sectors, or any event with significant fiscal implications.

 

The department of economic affairs had created a provision for an Economic Stabilisation Fund in its revised estimates for 2025-26, allocating ₹50,000 crore under this head. Till the end of February 2026, hardly any amount from this fund had been used. It appears the ₹1 trillion allocation for the Economic Stabilisation Fund will be managed by the department of economic affairs as needed. Necessary provisions will be made through supplementary demands for grants to be approved by Parliament. It is a sign of prudent fiscal management, but it nevertheless increases the pressure on government finances.

 

There is also a credit guarantee scheme for micro, small and medium enterprises (MSMEs) and airlines that will provide financial support by guaranteeing loans worth ₹2.55 trillion to units affected by the West Asian conflict. The scheme’s fiscal cost for the government is estimated at about ₹18,000 crore.

 

Even after accounting for some revenue from the export tax levy on petroleum products (aimed at conserving them for domestic use), the burden of additional expenditure and revenue loss will be around ₹2.9 trillion. Assuming India’s nominal economy size will be around ₹393 trillion, as projected in the Budget, this could widen the fiscal deficit by 0.73 percentage points from the estimated 4.3 per cent. The Union government could, therefore, face a fiscal deficit of well over 5 per cent of GDP in the current financial year. This could be even higher, as it is likely that non-tax revenues may take a hit. In addition, there will be second-order effects on direct and indirect tax revenues, expenditure slippages won’t be reined in, and economic growth will be adversely affected.

 

Given this scenario, the states’ fiscal situation becomes more problematic. For 2025-26, 23 states accounting for about 85 per cent of the total size of all the state budgets have released their provisional estimates. The combined fiscal deficit of these 23 states is over 3.3 per cent of their gross state domestic product (GSDP), but many states have already exceeded the 3.5 per cent deficit level (Andhra Pradesh at 4.6 per cent, Bihar at 6.9 per cent, Himachal Pradesh at 6 per cent, Madhya Pradesh at 4.6 per cent, Rajasthan at 3.8 per cent, and Telangana at 4.36 per cent).

 

More worryingly, the dependence of most of these states on devolution of taxes from the Union government is substantial — a little more than half of what they collect by way of own tax revenues. If their own tax revenues amounted to 6.5 per cent of GSDP in 2025-26, their reliance on the share in Union taxes was 3.45 per cent. If the Union tax collections suffer during 2026-27 due to the external economic turmoil, the states’ revenue situation will also take a hit and their fiscal balance will be the first casualty.

 

Many of these 23 states may squeeze their capital expenditure (which saw a marginal dip to 2.3 per cent of GSDP in 2025-26, compared to 2.4 per cent the previous year) to adhere to the promised fiscal deficit target. But that solution will have other adverse growth ramifications, a path the Union government should also avoid when the private sector’s investment rates have yet to rise sustainably.