A slowdown in tax revenues notwithstanding, the government is on track to meet its fiscal deficit target of 4.4% of GDP for FY26 and is expected to guide for a further reduction in the FY27 budget (estimated at 4.3%). However, the drivers of this consolidation are changing. The high tax buoyancy seen in the post-COVID era is fading due to slowing formalisation, weak hiring, and muted corporate earnings.
Consequently, the Centre is pivoting toward a reliance on non-tax revenues—specifically dividends from the RBI and PSUs. At the same time Centre can compress expenditure, especially revenue expenditure, to achieve its fiscal deficit targets.
Revenue Dynamics: The End of High Tax Growth
The period of high tax growth (FY22-24), driven by formalisation, is effectively behind us. Revenue momentum has weakened sharply, with gross tax growth recording only 4%YoY in the first eight months of the current fiscal year (FY26), marking the weakest performance since FY21. It is consistent with what has been observed historically- as nominal GDP growth falls below the critical 10% threshold (FY26 is expected to grow by just ~8%YoY as per the first advanced estimates)—tax buoyancy goes through a significant compression.
The current deceleration is driven by a slowdown in the formal sector, evidenced by sluggish hiring in key sectors like IT and BFSI, and uneven consumption patterns, which have put a lid on tax buoyancy. Specifically, corporate tax collections have not kept pace with economic growth, and GST collections have been dampened by low core inflation (demand slack) and rate cuts.
Looking ahead to FY27, tax growth should see recovery prima facie, owing to a favourable base, albeit a structural economic pickup would be contingent on deeper reforms and recovery in household balance sheets. To offset the shortfall in tax collections, the government is increasingly relying on non-tax revenues, particularly “bumper dividends” from the RBI and increased payouts from PSUs, to sustain its fiscal consolidation path.
Expenditure Strategy: Capex Normalisation and Off-Budget Reliance
With fiscal space constrained by slowing revenues, the Centre’s capex is entering a phase of normalisation. The aggressive budgetary capex growth of previous years (26% CAGR between FY20-25) is moderating, and the government is shifting its strategy toward “effective capex “spending routed through off-budget channels and grants. While on-budget capex growth slows, off-budget capex by Public Sector Undertakings (PSUs) has surged, growing at a strong 15% growth on CAGR basis from FY22-25, driven largely by the power, renewables and oil & gas sectors.
The government is increasingly channelling capex to states through loans, leveraging their stronger on‑ground implementation capacities and execution rates. In terms of sectoral allocation for the upcoming FY27 budget, roads are likely to retain elevated allocations, while defence is anticipated to see renewed focus and increased spending following the shifts in the geopolitical and security landscape, with “Operation Sindoor” marking an important trigger.
State Finances: The Quiet Centre-State Fiscal Deal
A significant structural shift is observed in Centre-State fiscal relations. There seems to be an implicit fiscal understanding wherein the Centre focuses on supporting the formal economy through tax cuts (foregoing ~Rs 1.5trn via income tax and GST cuts), while states shoulder the burden of populist welfare measures for the informal sector. States are aggressively spending on targeted groups through cash transfers, which is estimated to cost them ~Rs 2.6trn in FY26.
While politically effective, this division of spending burdens has come at a financial cost. State borrowings have surged at a ~17.5% CAGR between FY22-25 to fund these cash transfers and maintain capital spending. This surge in state borrowings has created a supply overhang in the bond market, keeping yields elevated despite the Centre’s own fiscal discipline. Although states are likely to demand a higher share of central revenues from the upcoming 16th Finance Commission, meaningful near-term relief seems unlikely, keeping state fiscal pressures elevated.
New Fiscal Framework: Debt Anchoring
Starting with the FY27 Budget, the government is expected to pivot from a rigid annual fiscal deficit target to a flexible debt-to-GDP anchor, aiming for a debt level of approximately 50% by FY31 from ~56.6% in FY25. This structural shift significantly expands fiscal capacity compared to the previous glide path, which mandated reducing the fiscal deficit to 3% (as per the FRBM Act). By anchoring policy to debt sustainability rather than strict annual deficit limits, the government unlocks an estimated Rs14trn in additional borrowing space over the next five years (FY27–31), allowing it to manage higher market borrowings without alarming the bond markets.
(The author is Head of Ambit Institutional Equities, Ambit)
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