The Budget’s tightrope challenge – The Hindu BusinessLine

The Budget’s tightrope challenge – The Hindu BusinessLine


The Union Budget 2025-26, to be presented on February 1, is expected to prioritise fiscal consolidation while addressing the complexities of India’s post-pandemic recovery. Fiscal consolidation refers to reducing the fiscal deficit to enhance macroeconomic stability and promote sustainable growth.

Following a pandemic-induced spike to 9.16 per cent of GDP, the fiscal deficit has gradually declined, with projections placing it at 4.94 per cent for 2024-25. The government aims to reduce it further below 4.5 per cent by 2026-27, directed by the Fiscal Regulation and Budget Management (FRBM) Act.

The first advance estimates of GDP for 2024-25, have estimated a growth rate of 6.4 per cent, down from 8.2 per cent in the previous year. As the country has experienced slower growth during the first half of the year, owing to lower government spending and slowing investment, fiscal consolidation might not be a popular policy choice.

However, higher deficits lead to greater interest rates, suppressing investment and business activity. While consolidation will lead to slower immediate growth, it will also entail higher productivity and growth in the long run. The government must navigate the delicate balance between instant gratification and the Viksit Bharat dream.

Approaching consolidation

Fiscal consolidation can be achieved by either reducing government expenditure or increasing revenue. Both approaches, however, entail short-term contractionary effects. A reduction in expenditure lowers domestic demand and risks crowding out private investment, potentially contracting output. On the other hand, increasing revenue through higher taxes can suppress private spending and corporate activity, slowing economic output.

Despite these challenges, fiscal consolidation yields long-term benefits, such as enhanced macroeconomic stability, reduced borrowing costs, and increased business confidence. It also fosters fiscal sustainability, which reassures investors about policy continuity and encourages long-term investments. The success of this approach hinges on a structured and balanced plan that promotes employment, savings, and sustainability while minimising social and economic risks.

The government’s strategy for fiscal consolidation should emphasise reducing the revenue deficit, which would create fiscal space for capital expenditure (capex) without further increasing the fiscal deficit. This is essentially what the government has done in the post-pandemic period (Chart 2).

Over the recovery years, the revenue deficit has steadily declined, from 4.37 per cent of GDP in 2020-21 to an estimated 1.78 per cent in 2024-25. This has enabled the government to allocate more resources to capex, which serves as a key driver of demand and infrastructure development.

Capital expenditure has a strong multiplier effect of 2.45, meaning it generates significant economic activity with relatively lower inputs and also facilitates private investment. Additionally, returns from infrastructure investments, such as monetization of highways, can enhance revenue generation in the medium to long term. By focusing on capex while rationalizing revenue expenditure, the government can achieve fiscal consolidation without undermining growth prospects.

The government can optimise revenue by focusing on expenditure rationalization rather than tax increases. Revenue receipts, primarily comprising taxes, contribute significantly to the government’s income.

However, higher taxes on corporations or individuals may dampen business growth and consumption, thereby weakening economic capacity. Instead, rationalizing revenue expenditure, such as grants-in-aid to States, can reduce fiscal pressure. Encouraging States to adopt better fiscal management practices would promote cooperative federalism while alleviating the burden on Central finances. This approach aligns with the broader goal of maintaining fiscal prudence without compromising essential services or investments.

Inflation factor

Fiscal consolidation also plays a crucial role in addressing inflationary pressures. According to the rational expectations theory, announcing fiscal consolidation can lower inflation expectations, especially during periods of high inflation. In 2024, India experienced rising inflation, largely driven by skyrocketing vegetable prices. Structural inefficiencies in agricultural markets, such as inadequate storage facilities and weak value chain linkages, exacerbated price volatility.

Addressing these issues through targeted agricultural reforms would ensure long-term price stability. Programmes like the Rashtriya Krishi Vikas Yojana (RKVY), Pradhan Mantri Krishi Sinchai Yojana (PMKSY), and Krishonnati Yojana have demonstrated success in enhancing agricultural productivity and infrastructure. Increased allocations to these initiatives would not only stabilise prices but also support rural incomes and economic growth.

The applicability of the Ricardian Equivalence theorem in India adds another layer of complexity to fiscal consolidation. This theory posits that deficits financed through debt, rather than taxes, do not impact real economic variables.

However, this does not wholly apply to India, implying that while fiscal consolidation will cause output contraction, it can also effectively lower inflation by shaping expectations and spending behaviour. With inflationary pressures likely to persist into 2025-26, a well-articulated fiscal consolidation plan could alleviate household concerns and encourage stable consumption patterns. This, in turn, would help offset the contractionary effects of lower spending.

Striking the balance

Achieving fiscal consolidation requires a comprehensive and balanced approach that prioritizes long-term sustainability over short-term gains. While expenditure cuts and revenue enhancements are necessary, the focus should remain on strategic investments in infrastructure and agriculture, which yield high returns.

Cooperative federalism can play a critical role in this process by encouraging States to improve their fiscal practices. Addressing inflationary pressures through targeted reforms would further support the government’s efforts to maintain economic stability. The 2025-26 Budget presents an opportunity to lay the foundation for a resilient and inclusive economy, ensuring that the benefits of recovery are shared equitably across sectors and regions.

The writer is Research Assistant at Observer Research Foundation





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