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Policymaking is all about trade-offs. The upcoming budget faces an acute policy trade-off between nurturing the fading growth and diminishing fiscal space with challenging debt dynamics. At the same time, renewed uncertainties around global markets and ensuing tighter financial conditions would also weigh on the fiscal reaction function. The role of fiscal policy becomes more crucial in the current cyclical slowdown, as part of the growth hit has been attributed to tighter fiscal and monetary stance in general, while private economic agents (consumption and investment) have also stayed less robust or missing.
The policy aim thus is to ensure keeping the overall expenditure-to-GDP ratio healthy, with high revenue expenditure (revex) and healthy capital expenditure (capex) spending. Even as additional support to some segments of the economy is warranted, a delicate balance needs to be maintained, ensuring the fiscal impulse is maximized to boost potential growth. However, all of this would still have to be achieved while adhering to the medium-term fiscal sustainability.
This further puts pressure on front-loaded investment-focused stimulus to stay an important source of growth, especially given its larger multiplier effect on growth and employment. To be sure, this clearly has been the Centre’s strategy post covid, with FY25 central capex budgeted to be rising by almost 1.7 percentage points of GDP since FY20 at 3.4%. However, FY25 so far seems to have seen much slower capex than budgeted (a phenomenon seen in election years). While most key sectors will likely catch up to the budgeted targets, sectors like defence, new schemes under economic affairs, and telecommunication (BSNL recap) seem to be lagging, implying capex to GDP will likely undershoot to 3.1%—the lowest since FY23. This will also help the Centre consolidate more than needed and the fiscal deficit could end up being much lower at 4.7%.
Public capex hitting a peak?
Will FY26 be a catch-up year for Centre’s capex? We think the broader private investment cycle may push out for some more time amid weak private consumption demand (led by a purchasing power squeeze amid slower income growth), in conjunction with heightened global uncertainty and excess Chinese capacity. Thus the role of public capex will be even more important to keep the overall investment share in GDP steady.
However the question, increasingly, is of fiscal space. We argue that public capex has probably peaked and the ability of the Centre as well as states to materially contribute to capital asset creation in the economy will likely stay stagnant. The Centre’s revenue stream will likely be lower next year amid (1) tax buoyancy falling to 0.9-1.0x from 1.1x/1.4x in FY25E/FY24 as the economy enters a late-cycle trajectory, (2) higher FX volatility impacting dividend payouts by the RBI (however offset by high gross FX sales), (3) weaker non-debt capital receipts led by sluggish disinvestment and privatization strategy. This, in conjunction with further consolidation in the deficit target, implies that the spending headroom may be limited, with total expenditure/GDP ratio likely sliding sub-14% in FY26 from 14.7% in FY25BE.
Assuming the Centre’s capex-to-revex ratio remains the same as FY25BE at 0.3x, the Centre’s capex is unlikely to cross 3.2% of GDP in FY26. State capex may not be able to offset much. States have generally treated capex as a residual spending as their committed revex (interest payments +pensions + salaries + freebies) continues to bite them. For the 19 key states that we track, the FY25BE committed expenditure/GSDP has risen to 7.6%—the highest since Covid and much higher than the pre-Covid period. And with limited revenue mobilization levers, their capex targets will be missed, especially on projects not funded by the Centre’s capex loan programme— not to mention slower execution and absorptive capacity constraints of states in general. Assuming all states consolidate their fiscal deficit to sub-3% of GSDP in coming years, the capex share in their spending will have limited space to increase amid their bias towards welfarism.
We expect the combined Centre + States capex/GDP ratio to barely cross 5% in FY25 vs 5.4% in FY24, and we think this could become a binding ratio ahead, with the combined capex hovering to a new-normal of 5.0-5.1% range. Thus, mobilizing revenues and better targeting of subsidies will become a bigger imperative going ahead. India’s tax/GDP—which has been broadly flat over more than 1.5 decades—has seen some improvement in the last two years, but will need to rise further. This will entail focussing more on reforming the progressive system of direct taxes, while indirect tax reforms should be focused on simplifying GST slabs, improving its efficiency, breadth and compliance—instead of trying to raise more indirect taxes, which are regressive in nature. However, boosting asset sales (via functional infrastructure monetization, disinvestment, and strategic sales) and better resource allocation are the least growth-impinging instruments of deficit consolidation. Hence, the act of maximizing fiscal impulse and creating fiscal space will require appropriate policy considerations and innovative ways to boost the revenue stream without compromising on quality public expenditure on infrastructure, health and education.
Madhavi Arora is a chief economist at Emkay Global Financial Services.
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