Stick to fiscal deficit as the norm for fiscal prudence Premium

With the current lower levels of household financial savings, it is better for the central government to stick to 3% of GDP as a limit to fiscal deficit with a road map being drawn up

Government expenditures exceeding revenue by a high margin can lead to a difficult situation. In the 1980s, rising fiscal deficit accompanied by rising government debt led to a difficult balance of payments situation and a high ratio of interest payment to revenue receipts. This forced the government to borrow progressively more to meet developmental expenditures.

In the final 2024-25 Union Budget, the Finance Minister said, “From 2026-27 onwards, our endeavour will be to keep the fiscal deficit each year such that the Central government debt will be on a declining path as percentage of GDP.” The Budget speech also says that the Centre’s fiscal deficit would be reduced to 4.5% of GDP in 2025-26 from its budgeted level of 4.9% in 2024-25.

With these levels of fiscal deficit in two consecutive years, the Centre’s debt-GDP ratio is estimated at 54% in 2025-26, assuming a nominal GDP growth of 10.5% in these two years. After this, the central government aims to have only a reducing path of debt-GDP ratio without stating a debt-GDP target and specifying a path to reach that. This implies effective abandoning of the Centre’s Fiscal Responsibility and Budget Management (FRBM) 2018 debt-GDP target of 40% for the central government and 60% for the combined government for an indefinite period. It can be shown that with a nominal GDP growth in the range of 10%-11%, a falling path of the debt-GDP ratio can be ensured year after year while maintaining a fiscal deficit-GDP ratio for the Centre at 4.5%. In fact, at this level of fiscal deficit, the debt-GDP ratio would reach a level of 48% by 2048-49 while showing a falling debt-GDP ratio all along. State governments, in their respective Fiscal Responsibility Legislations (FRLs), have adopted a fiscal deficit-Gross State Domestic Product (GSDP) target of 3%. They may also be tempted to abandon their targets and only show a falling path of their respective debt-GSDP ratios. If the two levels of government maintain, on average, fiscal deficit to GDP ratios of 4.5% and 3% net of intergovernmental lending, the average combined fiscal deficit would amount to 7.5% of GDP for several years.

Such a profile of debt and fiscal deficit, while consistent with a falling debt-GDP/GSDP profiles, would leave little space for the private sector to access available investible surplus unless current account deficit is increased beyond sustainable levels.

The Twelfth Finance Commission had argued that the investible surplus for the private corporate sector and the non-government public sector can be derived as the excess of household financial savings and net inflow of foreign capital over the draft of this surplus by the central and State governments through their borrowing. In this context, the Twelfth Finance Commission had observed (paragraph 4.41 of their report), “The transferable savings of the household sector of 10 per cent of GDP combined with an acceptable level of current account deficit of 1.5 per cent would be adequate to provide for a government fiscal deficit of 6 per cent, an absorption by the private corporate sector of 4 per cent, and by non-departmental public enterprises of 1.5 per cent of GDP.”

The recent tendency is for household financial savings to come down. In 2022-23, it was 5.3% of GDP as against 7.6% in the previous four years excluding the COVID-19 year of 2020-21. With 5.3% of household savings and about 2% of net inflow of foreign capital, available investible surplus of 7.3% will be fully pre-empted by the fiscal deficits of the central and State governments at about 7.5% of GDP. We can look at a higher level of fiscal deficit only if household financial savings rise.

There is a simple arithmetic relationship between fiscal deficit and debt-GDP ratio. To reduce the debt-GDP ratio, one has to act on fiscal deficit-GDP ratio, which essentially means change in the debt-GDP ratio between two consecutive years. The fiscal responsibility framework, which has been built in India after 2003, with States coming on board with their respective FRLs, has considered suitable combinations of debt-GDP/GSDP levels along with fiscal deficit-GDP/GSDP levels.