In India, fiscal policy cannot be confined to demand management. It finances roads, railways, power, schools, health, nutrition and transfers. That gives the Union and state budgets a developmental role. It also makes the quality of spending as important as the size of the deficit.
That choice has become harder. The Centre’s fiscal deficit was 4.8% of GDP in FY25 and the Budget for FY26 set a target of 4.4%. The 16th Finance Commission has recommended a 3% of GSDP annual fiscal deficit limit for states. Debt reduction now leaves less room for unfunded promises.
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Monetary policy has also become less forgiving. The RBI’s repo rate was 4% until May 2022, rose to 6.5% by February 2023, and stayed there until the first rate cut in February 2025. As credit deepens, investment and consumption respond more quickly to lending rates. A loose Budget can make the RBI’s job harder.
Fiscal policy and capital expenditure
Government spending is split between revenue expenditure and capital outlay. Revenue expenditure pays salaries, interest, subsidies, food, education, health and nutrition schemes. Much of it is essential. Midday meals, public health spending, school education and food support cannot be treated as dispensable merely because they sit on the revenue side.
The problem lies elsewhere. Broad cash promises, free power and gas schemes with loose eligibility add to recurring expenditure. They are easy to announce and hard to withdraw. They also crowd out capital outlay when fiscal consolidation begins.
Goyal and Sharma’s 2018 work on Indian government expenditure found that capital expenditure has a much larger long-run multiplier than revenue expenditure. Revenue spending can lift output in the first quarter, but the effect fades. Capital expenditure works through public assets, logistics, construction demand and private investment.
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RECO ratio and the post-pandemic shift
The years after Covid show why composition matters. Between FY22 and FY25, the Centre’s fiscal deficit fell from about 6.7% of GDP to 4.8%. The repo rate moved sharply higher. Yet real GDP growth averaged 7.7% and nominal GDP growth 11.9% during the period.
Part of the answer lies in the RECO ratio, revenue expenditure for every rupee of capital outlay. For the Centre, the ratio improved from 5.9 in FY22 to 4.3 by FY25, using RBI data. The fiscal deficit was also used differently. Capital outlay rose from about 17% of the Centre’s fiscal deficit in FY21 to more than half by FY25.
This shift helped growth absorb tighter fiscal and monetary conditions. A lower deficit, by itself, can weaken demand. A lower deficit with a higher capital outlay share can protect investment and reduce inflationary pressure over time.
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Finance Commission and state budgets
The case for a capital outlay bias is stronger at the state level. States carry large parts of health, school education, welfare, farm support and power subsidies. They also face the hardest political choices when revenue disappoints.
The 16th Finance Commission did not recommend revenue deficit grants to states. It also did not recommend sector-specific or state-specific grants. The Union government has taken note of that assessment. This changes the incentive structure for states that relied on grants to bridge revenue gaps.
But a 3% deficit rule can produce the wrong result if states meet it by cutting capital works first. Salaries, pensions, interest payments and subsidies are harder to compress. Roads, irrigation, local infrastructure and urban works are easier to delay.
A better fiscal configuration would track three numbers together: the fiscal deficit, the revenue deficit and the capital outlay share. A zero revenue deficit is useful only if it does not starve basic services. A lower fiscal deficit is useful if borrowings finance assets rather than current bills.
The Centre’s FY22-FY25 experience offers the practical lesson. Deficit reduction need not damage growth if the spending mix shifts towards capital outlay. The harder task now is to make that bias permanent, especially in state budgets.
Rewanth Raichooti is a research associate with the Council for Social Development, Hyderabad.