On counter-cyclical fiscal policy

The Interim Budget surprised many with a sharp fiscal deficit cut, boosting capex and social spending. While critics remained cautious, experts saw a well-balanced counter-cyclical approach.

In the interim Budget of an election year, the commitment to slash the fiscal deficit by almost 80-90 basis points of GDP has caught several observers by positive surprise. Some may see the move as a tacit acceptance of a high fiscal burden that needed to be urgently pruned. Others may regard it as a mere movement on the pre-determined fiscal glide path. And some sceptics may see it as a commitment that is likely to be reversed in the event of the incumbent government returning to power. In truth, it is a strong signal of a counter-cyclical fiscal policy that treads the fine balance between growth-enhancing and growth-distributing Budget.

India’s economic growth has been strong over the last ten years at 7.1%, barring the pandemic year of FY21. The post-pandemic average growth is close to 8%. Clearly, it is time to build fiscal buffers to safeguard against an unanticipated global shock. The Interim Budget has recognised this need by reducing the fiscal deficit from 5.9% of GDP in FY24 to 5.1% in FY25. It has also reiterated the government’s commitment to continue with fiscal consolidation in FY26 by aiming for a fiscal deficit of 4.5%. With high growth anticipated in the next two years as well, this fiscal glide path is an indication that a counter-cyclical fiscal policy is well and truly underway.

The risk with fiscal consolidation is that it may dampen growth. However, if fiscal consolidation can accommodate a growing capex budget, high growth is secured, as capex entails large growth multipliers of the order of 4 and above. The last four Union Budgets have been able to do that. They have demonstrated fiscal consolidation by keeping the fiscal deficit relative to GDP within Budget targets and yet accommodated a rapidly growing allocation for capex. The effective capex of the government has increased from 2.6% of GDP in FY20 to 4.6% in FY25.  A counter-cyclical fiscal policy implemented by the interim Budget is not likely to dampen growth as it has maintained the trajectory of rising capex allocations which, to reiterate, underpins high growth and also employment generation.

The rising government capex also crowds in private capex to make the counter-cyclical fiscal policy even more successful. The crowding in of private capex happens because public investment focuses on connectivity infrastructure, which reduces logistics costs while speeding up the movement of goods in the economy. The large allocation of the capex budget for shipping (Sagarmala), bridge and tunnel work, road works for roadway infrastructure, and the implementation of three economic railway corridor projects for multi-modal connectivity and the aviation sector are major steps towards improving logistics efficiency. Private capex will further increase when it builds capacity to increase production and benefit from Production Linked Incentives (PLI), whose allocation has also been enhanced in the budget.

Perhaps the most important takeaway from the Interim Budget is higher allocation on critical social expenditures in combination with fiscal consolidation and enhanced capex. To this end, the Interim Budget has carefully ensured adequate public spending in areas of education, health, and basic public services. Schemes such as MGNREGA, Pradhan Mantri Garib Kalyan Anna Yojana (PMGKAY), Direct Benefit Transfer-LPG, and Pradhan Mantri Awas Yojna (PMAY), among others, have also been provided with a higher allocation. These competing demands on the Union Budget have been accommodated by a robust growth expected in gross tax revenues at 11.7% in FY25. This is attributed to taxation reforms including doubling the tax base of GST, reduction in the corporate tax rates, tax exemptions for sovereign wealth funds and pension funds, and the simplification of tax filing procedures.

Maneuvering the Budget ship through global uncertainties and domestic constraints warrants a stable policy mix. Globally, counter-cyclical fiscal policy has, in some instances, displayed an asymmetric tendency, easing in downturns but not tightening enough in upturns, resulting in a rising debt path with a build-up of inflationary pressures, which may hurt the long-run growth. Therefore, a calibrated implementation of a counter-cyclical fiscal policy is more desirable, as India’s experience during the pandemic has shown. Because of this calibration, the central government’s outstanding debt has been declining since FY21 without hurting economic dynamism and growth. The recipe for a sustainable growth trajectory, therefore, entails productive expenditure with prudent fiscal management.

Rajiv Mishra, coauthored with Megha Arora and Esha Swaroop, Indian Economic Service Officers, Ministry of Finance, this piece for Financial Express.

Views are personal and do not represent the stand of this publication.