What the Budget Is

The Union Budget is the government’s annual financial statement, presented under Article 112 of the Constitution, laying out its estimated receipts and expenditure for the coming fiscal year. It serves two functions simultaneously:

1. an accounting exercise projecting how much revenue the government expects to raise and spend, and
2. a policy instrument signalling the government’s priorities through where that money is allocated.

The Receipts-Expenditure Gap

For 2026-27, total expenditure is budgeted at ₹53.5 lakh crore, funded by non-debt receipts of ₹36.5 lakh crore, with the gap of ₹16.96 lakh crore financed through borrowings. This gap is the fiscal deficit and it exists because the government’s receipts alone are not sufficient to cover its full expenditure — a common feature of most modern economies rather than a sign of fiscal mismanagement by itself, though the size and trend of this gap matters considerably.

The Shift Toward Capital Expenditure

The most significant shift within this budget is the composition of expenditure. Capital expenditure — spending on long-term assets such as roads, railways, and infrastructure that expand the economy’s future productive capacity — is budgeted at ₹12.2 lakh crore, growing faster than revenue expenditure, which covers recurring costs such as salaries, subsidies, and interest payments.

A rupee spent on capital expenditure adds to the country’s productive base and tends to have a larger multiplier effect on future GDP growth than a rupee spent on recurring consumption-type expenditure, which is why the government has consistently prioritised raising the capital expenditure share of the budget even while working to bring down the overall fiscal deficit.

Capital expenditure averaged roughly 1.7% of GDP in the pre-pandemic period and has risen to around 3% of GDP post-pandemic, while effective capital expenditure — which additionally counts grants-in-aid to states for capital asset creation — reached 4% of GDP in FY 2024-25. This near-doubling of the capital expenditure share of the economy within half a decade is among the most significant fiscal shifts of the period. The composition is heavily concentrated: road transport and railways together account for over half of central capital expenditure, reflecting a deliberate bet on physical connectivity infrastructure as the primary channel through which public investment is expected to lower transaction costs and crowd in private investment.

The Effective Capital Expenditure to Fiscal Deficit ratio has risen, from 84.1% (FY24-25) to 90.1% (RE 2025-26) to 101.1% in BE 2026-27, meaning that on this broader measure, the government’s entire fiscal deficit for the year, is now effectively financing capital asset creation rather than consumption spending.

The Other Half of the Story: Revenue Expenditure Rationalisation

The rising capital expenditure share is only half of the composition shift; the other half is restraint on the revenue side. Revenue expenditure fell as a share of Total expenditure — which is a notable achievement given that the same period saw a substantial expansion in the reach of welfare delivery. Three mechanisms account for this:

• Subsidy rationalisation, which reduced the recurring outgo on major subsidy heads relative to the size of the economy.
• Direct Benefit Transfer (DBT) efficiency, which cut leakages in transfer delivery even as beneficiary coverage expanded. The savings came from plugging leakage rather than from withdrawing benefits.
• Just-in-Time (JIT) fund releases, which replaced bulk advance transfers to implementing agencies with disbursement timed to actual expenditure need, reducing idle float in the system and lowering the government’s effective borrowing requirement for a given level of programme spending.

Taken together, these are efficiency gains rather than austerity — the same or greater delivery achieved with a smaller recurring fiscal footprint, which is precisely what created room for the capital expenditure expansion described above without a proportionate widening of the deficit.

Reading the Receipts Side

On the receipts side, tax revenue continues to dominate, with net tax revenue to the Centre budgeted at ₹28.67 lakh crore, forming the overwhelming majority of total receipts.

This composition breakdown makes two points.

1. On the receipts side, borrowings account for 24% of every rupee the government spends — the largest single source, ahead of income tax (21%) and corporation tax (18%) — underscoring just how central the fiscal deficit is to financing current spending.
2. On the expenditure side, states’ share of taxes (22%) and interest payments (20%) together account for 42% of every rupee spent, before a single rupee reaches any new central scheme or capital project — an illustration of how much of the budget is effectively pre-committed.

Deficit Indicators: Where India Stands

The Four Deficit Measures

A government’s budget can be analysed through several distinct deficit measures, each capturing a different dimension of its fiscal position.

• The fiscal deficit measures the government’s total borrowing requirement — the gap between total expenditure and total receipts excluding borrowings.
• The revenue deficit isolates the gap on the recurring side alone — the excess of revenue expenditure over revenue receipts — and signals whether the government is borrowing merely to fund day-to-day consumption rather than asset creation.
• The primary deficit strips out interest payments on past borrowing from the fiscal deficit, showing the government’s current-year borrowing need independent of the burden of servicing old debt.
• The effective revenue deficit refines the revenue deficit further, by subtracting grants given to states for the creation of capital assets — since these grants, though recorded as revenue expenditure, ultimately fund asset creation rather than consumption, and excluding them gives a more accurate picture of how much revenue spending is genuinely unproductive.

India’s Current Position

For 2026-27, the fiscal deficit is budgeted at 4.3% of GDP, an improvement from the revised estimate of 4.4% for 2025-26 and 4.8% in the FY 2024-25 Actuals.

Placed in a longer perspective, this represents the continuation of a sustained consolidation effort rather than a recent trend. Measured from the true COVID peak, the fiscal deficit has fallen from 9.2% of GDP in FY 2020-21 to 4.8% in FY 2024-25, 4.4% in RE 2025-26, and a budgeted 4.3% in 2026-27 — a reduction of nearly five percentage points of GDP. The government attributes this to sustained efforts to keep revenue receipts on their budgeted path alongside rationalisation of expenditure, without pulling back from growth-supporting spending.

This was also a stated commitment met on schedule. In FY 2021-22, the government announced a medium-term goal of bringing the fiscal deficit below 4.5% of GDP by FY 2025-26. The approach taken was a glide path rather than rigid annual deficit targets.

External Validation: The 2025 Rating Upgrades

This consolidation record has drawn external recognition. During 2025, three global rating agencies — Morningstar DBRS, S&P, and R&I (Japan) — upgraded India’s sovereign credit rating. The cited reasoning is worth noting because it maps directly onto the three threads running through this chapter: India reduced its deficit, improved revenue collection, and shifted the composition of spending toward infrastructure and away from subsidies — and did all three simultaneously. That combination is rare, since deficit reduction is usually achieved by cutting capital spending rather than alongside expanding it.

The global backdrop sharpens the point considerably. Most major economies currently run fiscal deficits higher than their pre-pandemic levels. India and Brazil are the only major economies whose deficits have fallen below pre-pandemic levels. India’s consolidation is therefore not merely an improvement against its own past — it is a divergence from the prevailing global direction.

Reading This Against the FRBM Target

Set against the FRBM Act’s original target of a 3% fiscal deficit, and the 16th Finance Commission’s revised glide path recommending 3.5% of GDP by 2030-31, the current 4.3% figure represents continued, gradual consolidation rather than an abrupt correction. This measured pace reflects a broader trade-off: fiscal consolidation matters for long-term macroeconomic stability, but compressing the deficit too quickly risks cutting into the very capital expenditure growth that is meant to expand the economy’s productive capacity, so the government has consistently chosen to bring the deficit down in calibrated steps rather than through a sharp one-time reduction.

The Deeper Debate: Deficit Rule or Debt Anchor?

Since the FRBM Act was passed in 2003, the 3% fiscal deficit target has been met exactly once.

India has now adopted a debt anchor rather than a deficit rule: a target of bringing central government debt to 50% (±1%) of GDP by FY 2030-31. This has two claimed advantages.

1. It is concrete and verifiable, so it can build credibility in a way the deficit rule failed to.
2. And it is flexible in the short run — the government can allow the deficit to widen in a downturn or narrow in a boom without breaching the target, provided the debt path stays on track, which a rigid annual deficit ceiling does not permit.

Financing the Deficit and Public Debt

How the Deficit Gets Financed

The fiscal deficit represents the government’s borrowing requirement for a single year, but that borrowing accumulates over time into the government’s total outstanding debt. The government primarily finances its deficit through market borrowings — the sale of government securities such as dated bonds and treasury bills — supplemented by smaller sources such as small savings collections and external borrowings. Each year’s fiscal deficit, once financed, adds to this accumulated stock, which is why a country’s debt-to-GDP ratio reflects not just current-year fiscal discipline but the cumulative effect of every past year’s deficit relative to the size of the economy at the time.

India’s Current Debt Position

The Centre’s outstanding liabilities are budgeted at 55.6% of GDP for 2026-27, continuing a gradual decline from a peak of 61.4% of GDP in 2020-21, when COVID-related spending pushed borrowing sharply higher. The government has set a long-term target of bringing this down to around 50% (±1%) of GDP by March 2031, working toward the FRBM Act’s original target of 40% of GDP for the Central Government alone and 60% of GDP for General Government (Centre plus states combined) — the 16th Finance Commission has similarly recommended bringing the combined debt-to-GDP ratio down to 73.1% by 2030-31.

India's debt is less risky than the headline debt-to-GDP ratio suggests because it is mostly rupee-denominated and domestically held, with external debt only about 2.6% of GDP and largely concessional. This limits exchange-rate risks. The weighted average borrowing cost has also fallen from 7.11% (FY25) to 6.65% (FY26), reducing future interest expenses. Since nominal GDP growth (10%) exceeds the average interest rate (6.65%), the debt-to-GDP ratio can decline over time even with a modest primary deficit. However, the debt burden remains significant, with interest payments consuming 26% of total government expenditure in 2026–27, limiting fiscal space for development spending. Reducing the debt stock therefore remains important.

Beyond the Budget: Cross-Subsidies as Hidden Fiscal Distortion

Not every fiscal burden appears in the budget documents. A significant category of distortion operates through cross-subsidy — where one class of user is charged above cost so that another can be charged below it, entirely within a public utility’s own pricing structure. Because no money passes through the budget, these transfers show up in neither the expenditure heads nor the subsidy bill, yet they impose real economic costs.

Two cases dominate:

• Railways. Freight tariffs are set well above cost in order to subsidise passenger fares, which are held below cost. The consequence is that Indian rail freight is priced uncompetitively against road transport, pushing cargo onto highways — which is more expensive per tonne-kilometre, more carbon-intensive, and a direct contributor to India’s high logistics costs as a share of GDP. The subsidy to passengers is thus paid for twice: once by freight users, and again by the whole economy through elevated logistics costs.
• Power. Industrial and commercial consumers are charged tariffs above cost to subsidise agricultural and domestic consumers. This raises the input cost of manufacturing precisely in the sector the country is attempting to expand, and it weakens distribution company finances, which in turn become a recurring claim on state budgets.

The Electricity (Amendment) Bill, 2025 addresses this directly, mandating the elimination of cross-subsidies for manufacturing and railways within five years and a transition toward cost-reflective tariffs. The reform logic is that if a subsidy to a particular group is a genuine policy objective, it should be delivered transparently through the budget as a direct transfer — where it is visible, measurable, and subject to periodic review — rather than concealed inside a tariff structure where it distorts prices across the entire economy and escapes scrutiny altogether.

Tax Revenue: Direct vs. Indirect, and the Tax-GDP Ratio

India’s Current Tax-GDP Ratio

India’s gross tax-to-GDP ratio stands at around 11.2% for 2026-27. This remains well below the level most economists consider healthy for a country of India’s size — commonly cited around 15% — and far below the OECD average of roughly 34% and even the emerging-market average of roughly 21%. A low tax-to-GDP ratio directly constrains the fiscal space available for deficit reduction and social sector spending priorities, since it limits how much revenue the government can raise without resorting to additional borrowing.

A Structural Shift Within the Tax Mix

Within this overall ratio, a significant structural shift has taken place: direct taxes now contribute close to 6.9% of GDP, having overtaken indirect taxes, and now account for 61.2% of gross tax revenue — the highest share in two decades. Indirect taxes, by contrast, contribute a smaller 4.9% of GDP.

This shift matters for equity: since direct taxes are progressive and indirect taxes are regressive, a rising direct tax share means a growing proportion of government revenue is being raised in a manner that places more of the burden on those with a greater ability to pay, rather than uniformly across all consumers regardless of income.

What Drove the Shift: Buoyancy and the Widening Filer Base

The rising direct tax share reflects faster growth in direct tax collections.

Tax buoyancy measures how fast tax revenue grows relative to the economy: a buoyancy of 1 means tax revenue grows exactly in line with nominal GDP, above 1 means it outpaces the economy, and below 1 means it lags.

• Personal (non-corporate) income tax is the standout performer. Collections rose from 2.4% of GDP to 3.3% of GDP in the post-pandemic period, with a buoyancy of approximately 1.8 — meaning personal income tax has been growing nearly twice as fast as the economy itself.
• Corporate tax grew broadly in line with GDP, with a buoyancy of roughly 1. The 2019 corporate tax rate cut lowered the headline rate but broadened the base.

The mechanism behind personal income tax buoyancy is visible in the filer data: the number of income tax returns filed rose from 6.9 crore in FY 2021-22 to 9.2 crore in FY 2024-25. This reflects three overlapping forces —

1. rising incomes pushing more people above the exemption threshold,
2. improved compliance, and
3. the continuing formalisation of employment that brings previously untracked income into the tax net.

The NUDGE Initiative: Compliance Through Behavioural Economics

A distinctive feature of recent tax administration is a shift in enforcement philosophy. The NUDGE approach — Non-intrusive Usage of Data to Guide and Enable — replaces the traditional model of raids, scrutiny, and litigation with data-driven prompts sent directly to taxpayers.

The mechanism is straightforward: the department cross-references third-party data it already holds (bank transactions, securities trades, property registrations, high-value purchases) against what a taxpayer has declared, and where there is a discrepancy, it sends an alert inviting voluntary correction rather than opening an adversarial proceeding.

The rationale draws on behavioural economics. Most non-compliance is not determined evasion but omission, error, or uncertainty about obligation — and for that majority, a well-timed prompt is both cheaper and more effective than enforcement. Enforcement capacity is finite and expensive; reserving it for genuine evasion while handling routine discrepancies through nudges raises overall compliance at lower administrative cost, and avoids the deadweight loss of prolonged litigation. This represents a genuinely modern approach to tax administration.

Reading the Indirect Tax Decline

The falling indirect tax-to-GDP ratio fell for deliberate policy reasons, not because of evasion or poor collection.

• Excise duty fell because fuel duty was cut in 2021-22, so the government absorbed part of the oil price shock instead of passing it on to consumers and fueling inflation.
• Customs duty fell because import duties on raw materials and inputs were deliberately lowered, cutting production costs for Indian manufacturers and making them more globally competitive.
• GST collections grew more slowly per transaction because of GST 2.0 (September 2025), which simplified four slabs (5%, 12%, 18%, 28%) into two main ones (5%, 18%), plus a 40% rate for luxury/sin goods. Shifting items into lower slabs meant less tax per sale — but total collections stayed healthy anyway, since a much larger base of registered businesses made up the difference.

Where India Still Lags

India’s tax-to-GDP ratio of ~11.2% remains well below the level of developed economies, and the underlying reasons are structural. A large informal sector where transactions escape the income tax net, a constitutionally exempt agricultural income base, and a low per capita income base that keeps only a small share of the population above the income tax threshold. Closing this gap would require — formalisation of the workforce, rising per capita income, and reduced disguised unemployment in agriculture.

GST 2.0: The Current Structure

What Changed Under GST 2.0

GST 2.0, introduced at the 56th meeting of the GST Council and effective from September 2025, marked a major rationalisation of India’s indirect tax structure. The earlier system operated with four principal slabs — 5%, 12%, 18%, and 28% — which created frequent classification disputes. Under GST 2.0, this was simplified to two principal rates, with a third reserved for a narrow category:

• 5% — Merit Rate, covering essentials, agricultural inputs, medicines, and food items
• 18% — Standard Rate, covering most goods and services
• 40% — De-merit / Sin Rate, reserved for luxury and harmful goods such as tobacco, aerated drinks, and high-end vehicles

Most items from the erstwhile 12% and 28% slabs were redistributed between the 5% and 18% rates.

Revenue Performance Since the Transition

GST collections have remained resilient through this transition. The fact that collections are still growing at a healthy pace despite this rate cut suggests the widening and deepening of the tax base, and continued gains in compliance and formalisation, are outweighing the effect of lower per-transaction rates.

The formalisation evidence is direct: the number of registered GST taxpayers rose from about 60 lakh at the time of GST’s introduction in 2017 to over 1.5 crore today — a two-and-a-half-fold expansion of the registered base. Since GST registration brings a business into a documented transaction trail that also feeds income tax data, this expansion has consequences well beyond indirect tax collection; it is part of the same formalisation process driving the personal income tax filer growth.

The expected effects of the rate rationalisation run through two channels.

1. Lower rates should raise consumption volumes, partially offsetting the lower rate per transaction. And
2. a simpler two-rate structure should improve compliance, both by reducing the classification disputes that the four-slab system generated and by lowering the incentive to misclassify goods into an adjacent lower slab.

The Tax Reform Tripod

GST 2.0 is best understood as the third leg of a sequenced programme of tax reform rather than an isolated measure:

• Corporate tax cuts (2019) — reduced the headline rate and broadened the base on business income
• Personal income tax relief (April 2025) — eased the burden on individual income
• GST 2.0 (September 2025) — rationalised indirect taxation on consumption

Each leg targets a different tax base — corporate income, personal income, and consumption — and the common design principle across all three is lower rates applied to a wider base, with the revenue effect cushioned by improved compliance and formalisation rather than by offsetting rate increases elsewhere.

Fiscal Federalism: Centre-State Financial Relations

The Constitutional Mechanism

Article 280 of the Constitution establishes the Finance Commission as a periodic expert body, constituted every five years, to recommend how the Union’s tax revenues and grants should be shared with the states. This mechanism exists because states carry substantial expenditure responsibilities — particularly in health, education, and law and order — but do not independently raise revenue proportional to those responsibilities, especially after GST subsumed most of their independent indirect tax powers.

The Finance Commission’s recommendations operate through two distinct components:

• vertical devolution, which determines what share of the Centre’s divisible pool of taxes goes to states as a whole, and
• horizontal devolution, which determines how that pooled amount is then split among individual states.

Vertical Devolution: A Point of Continued Contention

The 16th Finance Commission, covering the award period 2026-27 to 2030-31, retained the states’ share in the divisible pool at 41%, unchanged from the 15th Finance Commission. The Commission’s reasoning for holding the share at 41% rested on three grounds:

• the Centre’s own rising expenditure needs in defence and infrastructure,
• the fact that much of the Centre’s spending under Centrally Sponsored Schemes is ultimately routed to states anyway, and
• an assessment that current transfers, taken together, already give states adequate resources.

States argue that the Centre’s growing use of cesses and surcharges — which sit outside the divisible pool entirely — has steadily shrunk their effective share of central tax revenue, even as the headline 41% figure has stayed constant.

Horizontal Devolution: A Shift Toward Rewarding Output

Within the fixed 41% pool, the 16th Finance Commission’s full devolution formula (Table 6b) rests on six criteria.

Newly introduced Contribution to GDP criterion, reflects a policy tilt toward rewarding economically productive states, even though income distance remains the single largest weighted criterion in the formula.

Uttar Pradesh, with by far the largest population, receives the largest share of the divisible pool (17.6%), followed by Bihar (9.9%) — both large, lower-income states that benefit disproportionately from the income-distance and population criteria — while smaller and wealthier states such as Goa (0.37%) and Sikkim (0.34%) receive the smallest shares.

What This Means for State Finances

Alongside this, the 16th Finance Commission has tightened fiscal discipline requirements on states themselves, capping state fiscal deficits at 3% of GSDP and recommending an end to off-budget borrowing — a practice several states had used to route spending outside their formal deficit accounting.

This points to a tightening fiscal environment for states: their independent tax powers remain constrained post-GST, their share of the Centre’s divisible pool remains capped at 41% despite demands for more, and their own borrowing flexibility is now more tightly bound by the 16th Finance Commission’s fiscal deficit ceiling.

State Expenditure Quality: The Other Half of Fiscal Federalism

Devolution determines how much states receive. Equally important is what they do with it. Two developments define the current picture, pulling in opposite directions.

SASCI: The States’ Capital Expenditure Lifeline

The Special Assistance to States for Capital Investment (SASCI) scheme provides 50-year interest-free loans to states, usable exclusively for capital spending.

States are increasingly reliant on the Centre’s push to sustain investment levels. Poorer states draw on SASCI more heavily than richer ones, which makes it function as a convergence instrument, channeling investment capacity toward states least able to finance it themselves.

The Unconditional Cash Transfer Problem

Working directly against this is the rapid spread of unconditional cash transfer (UCT) schemes at the state level, typically targeted at women — Maharashtra’s Ladki Bahin and Karnataka’s Gruha Lakshmi etc. The number of states operating such schemes increased five-fold between FY 2022-23 and FY 2025-26.

The fiscal concern is one of crowding out. Committed expenditure — salaries, pensions, interest payments, and subsidies — already absorbs roughly 62% of states’ revenue receipts. Committed expenditure is, by definition, not readily compressible. Layering open-ended cash transfer commitments on top of it leaves capital expenditure as the residual claimant: it is the only major head that can be cut at short notice without breaching a contractual or statutory obligation. This is precisely why states’ own capex declined even as SASCI propped up the headline figure.

The effectiveness concern is separate and equally important. Global evidence indicates that unconditional cash transfers improve short-term household consumption, but do not consistently deliver improvements in child nutrition, educational attainment, or sustained exit from poverty. They relieve immediate distress without necessarily building the human capital that would make the relief unnecessary.

The International Comparison. The contrast frequently drawn is with two Latin American programmes widely regarded as successful:

• Mexico’s Progresa (later Oportunidades/Prospera)
• Brazil’s Bolsa Família

Both are conditional cash transfers: payment is contingent on verifiable behaviour — school attendance for children, routine health check-ups and immunisation. Both were also time-bound and subject to periodic review. The conditionality is what converts a consumption transfer into a human capital investment, and the review requirement is what prevents the scheme becoming a permanent, unreviewable claim on the budget.

Indian state schemes largely lack both features — there are typically no conditionalities attached and no sunset clauses. The policy position that follows is clear: cash transfers should carry conditionalities, be periodically reviewed, and should not be permitted to crowd out capital investment.

For India’s Viksit Bharat @2047 ambitions: the government needs to fund two things simultaneously —

• the capital expenditure required to sustain growth (Investment-rate target of 40% of GDP), and
• the social sector spending required to convert that growth into human development — while also bringing the fiscal deficit down along a credible consolidation path.

The Forward-Looking Question

Meeting Viksit Bharat @2047’s more ambitious social commitments — zero poverty, universal quality education, and comprehensive healthcare — while sustaining a 40%-of-GDP investment rate and holding to the consolidation path, will require:

• A faster rise in the tax-to-GDP ratio. At around 11.2%, India’s ratio is far below the ~15% level generally considered adequate, and further below the emerging-market average of roughly 21%.
• Expenditure reprioritisation. Shifting spending away from untargeted and unconditional transfers toward capital formation and human capital investment.
• Improved expenditure efficiency. The DBT and Just-in-Time reforms demonstrate that better delivery mechanics can expand effective coverage without proportionate increases in outlay.
• Eliminating hidden distortions. Removing cross-subsidies in power and railways, and replacing them with transparent budgeted transfers where a subsidy is genuinely warranted, would lower economy-wide costs and bring concealed fiscal burdens into the open where they can be assessed against alternatives.