Next steps in fiscal management: Road map needed for debt, deficit targets

The Union Budget for 2025-26 will be presented in a few weeks. While various stakeholders have their own expectations, this column will focus primarily on the management of government finances, extending beyond just the upcoming Budget. Reports suggest that the Union government would aim to contain the fiscal deficit at 4.4 per cent of gross domestic product (GDP) in 2025-26. This means it will achieve the medium-term target set after the pandemic, which will be a significant achievement and must be appreciated. However, the debate is what happens next. In the July Budget, Finance Minister Nirmala Sitharaman had announced that from 2026-27, the government would keep the fiscal deficit each year such that the central government debt remains on a declining path as a percentage of GDP.

 

More clarity will be needed in this context. Given that debt stock is at a higher level and needs to be reduced as quickly as possible, the government will be well-advised to give more details about what the medium-term trajectory and the end goal will be. Just keeping the debt level on a declining path directionally may not be enough. Financial markets and other stakeholders will need a clear road map for debt reduction and the desired level of fiscal deficit to attain the target. The Central government debt is projected to decline from 58.1 per cent of GDP in 2023-24 to 56.8 per cent in 2024-25, and will remain nearly 17 percentage points above the level recommended by the Fiscal Responsibility and Budget Management (FRBM) Review Committee in 2017. This writer had argued before the July 2024 Budget that the post-pandemic fiscal position be studied carefully, preferably by an expert group, to develop an appropriate fiscal strategy. Overall fiscal management may require a significant shift owing to fundamental changes in the economy—both global and Indian—after the pandemic. Besides, there are other points worth considering.

 

First, the Union government is supporting the Indian economy through higher capital spending, which increased from 1.67 per cent of GDP in 2019-20 to 3.4 per cent of GDP in the current year. While this increase has helped the economy recover from the pandemic shock, the government will at some point soon need to align its borrowing requirements with the financing capacity of the economy. The net household financial savings declined to 5.3 per cent of GDP in 2022-23. Although financial savings may recover to the longer-term average, they would largely be cornered by public sector borrowing requirements. At present, the economy is not facing financing problems because the private corporate sector is not investing enough. This is not a desirable condition. Thus, the government needs to create room for the private sector to invest without substantially increasing external financing requirements.

 

Second, it will also be important for markets to know if states will be expected to follow the same framework. The total debt stock of states stood at 28.5 per cent of GDP in 2023-24, over 8 percentage points higher than the level suggested by the FRBM Review Committee. India’s general government debt and budget deficit remain a significant source of vulnerability. Thus, having a clear road map will help increase confidence in financial markets.

 

Aside from the need to develop a broader fiscal strategy, some specific interventions will be expected in the coming months. The government is reviewing the Customs duty structure and the Income Tax Act. It would be interesting to see if these reviews will immediately translate into policy action. Going beyond the next Union Budget, the other major policy intervention to watch will be the impending changes in goods and services tax (GST). While the changes will have to be approved by the GST Council, the Union government can play an important role.

 

Since a large number of states are also governed by the National Democratic Alliance, it should be relatively easy for the Union government to push for an overhaul of the indirect tax system. Different groups of ministers (GoMs) are looking at aspects of rate rationalisation and compensation cess. Notably, the compensation cess is being collected to repay the debt incurred to compensate states for revenue shortfall during the pandemic. Once the purpose is fulfilled, which is expected to happen by the end of this year, the collection will have to be discontinued unless relevant legal changes are made.

 

Since the GST system also needs rate and slab rationalisation, and is being studied by a GoM, it will be important that changes are made in the least disruptive way to make it simple and take the average rate to the revenue-neutral level. According to a recent government response in Parliament, the average GST rate in 2023-24 was 11.6 per cent, significantly lower than the revenue-neutral rate of 15-15.5 per cent suggested by an expert committee in 2015, led by then chief economic advisor Arvind Subramanian. Premature rate reductions are partly responsible for the underperformance of GST. In this regard, the Union government suffered more than the states because it was not compensated for the revenue loss. Dr Subramanian and others have estimated the losses to be between 0.6 and 1 per cent of GDP annually. The total collection, including the compensation cess in 2023-24 as a percentage of GDP, was roughly the same as the collection in the pre-GST period from the taxes subsumed into the system.

 

The necessary course correction in GST, to some extent, will also enhance the government’s ability to address the debt and deficit challenges. Besides, the Union government should revisit and revive the disinvestment programme. It will help make the fiscal adjustment process smoother without compromising on capital expenditure.