India's combined fiscal deficit — comprising the Centre and states — is expected to decline to 7% of GDP in FY26, reflecting a continued effort towards fiscal consolidation, capital investment prioritisation, and tax buoyancy improvements, according to a research note by Morgan Stanley released on Wednesday (June 19, 2025).

This outlook aligns with the broader economic narrative that a stable fiscal position not only boosts investor confidence, but also acts as a pillar for medium-term economic growth and inflation control.

Breakdown of Fiscal Projections

Morgan Stanley's economists estimate:

• Central government fiscal deficit will ease from 5.1% in FY25 to 4.4% in FY26

• State government deficits will reduce to 2.6% of GDP in FY26

Together, this brings the aggregate fiscal deficit to 7%, marking a significant decline from the peak pandemic-era shortfalls.

“The fiscal glide path reinstates the government’s commitment to fiscal discipline, with a focus on improving tax buoyancy and reorienting spending towards capital investments,” the research note said.

This also indicates a return to the pre-pandemic fiscal roadmap, which aims to lower fiscal vulnerability while maintaining growth momentum.

Focus on Tax Buoyancy

One of the core highlights of the report is India's improving tax buoyancy — a measure of how tax revenues grow with respect to GDP.

• In FY25, tax buoyancy stood at 0.98

• This compares to a pre-pandemic average of 0.9

• Post-pandemic, the average has improved to 1.2

This trend reflects stronger tax collection efficiency and formalisation of the economy, likely aided by:

• Widened GST base

• Increased compliance through digitisation

• Direct tax reforms and widening taxpayer base

An uptick in buoyancy is essential to generate non-inflationary resources for funding capital expenditure without expanding deficits.

Capital Expenditure Push

India has made significant strides in capital expenditure (capex) since the pandemic:

• Capex as a share of total government expenditure rose to 22.6% in FY25

  • Pre-pandemic, this was only 12.5%

• Capex as a share of GDP doubled from 1.6% before the pandemic to 3.2% in FY25

  • The highest in 19 years

This sharp rise in capital spending is in line with:

• The Union Government's push for infrastructure-led growth

• PM Gati Shakti, National Infrastructure Pipeline (NIP), and urban transit modernisation

• Front-loading of funds to sectors like railways, roads, defence, and green energy

Morgan Stanley noted that such sustained capital investments have long-term multiplier effects, supporting job creation and productivity without stoking inflation.

Centre vs States: Fiscal Trends

While the Centre has made efforts to reduce revenue deficits and improve capex, the states’ performance has also started to improve, albeit gradually.

• The states’ deficit narrowing to 2.6% in FY26 is attributed to:

  • Higher transfers from the Centre

  • Own tax revenue recovery (like VAT on fuels, state GST)

  • Containment of revenue expenditure on populist schemes

However, some analysts caution that states may still face challenges due to:

• Debt service burdens

• Election-linked expenditures in populous states

• High subsidies in electricity and agriculture

Yet, the medium-term fiscal outlook appears constructive with ongoing FRBM Act commitments and Centre-state fiscal coordination.

Structural Reforms Aiding Fiscal Management

India’s post-pandemic fiscal strategy has revolved around:

• Reducing revenue deficit

• Boosting quality of expenditure

• Rationalising subsidies and leakages through DBT (Direct Benefit Transfer)

• Incentivising capex via interest-free loans to states

With the introduction of the ‘Scheme for Special Assistance to States for Capital Investment’, the Centre allocated ₹1.3 lakh crore to incentivise states for productive spending.

Medium-Term Outlook: Growth and Stability

Morgan Stanley analysts stressed that the fiscal roadmap supports:

• 5.8%–6.2% GDP growth average over FY26–FY28

• Moderation in inflation towards RBI’s 4% target band

• Stable currency and attractive bond yields for investors

A 7% fiscal deficit, though still above pre-pandemic norms, is considered manageable in the current macroeconomic context, provided growth remains resilient.

“It also helps anchor inflation expectations by reducing excess demand in the system,” the note added.

India’s Debt Position in Context

India’s public debt to GDP ratio is currently around 83%, significantly higher than the FRBM Act’s recommended 60% threshold. Fiscal consolidation remains critical to maintain debt sustainability.

The narrowing fiscal deficit path helps ensure:

• Better sovereign credit ratings

• Lower risk premium on Indian bonds

• Higher FDI and FPI inflows, especially in the debt market

Risks to the Outlook

While the fiscal outlook is encouraging, there are several potential headwinds:

1. Global oil price volatility impacting fuel subsidies and trade balance

2. Slower-than-expected growth affecting tax collections

3. Weather shocks such as monsoon shortfalls causing agri-linked spending

4. Rising political populism in an election-heavy year with state polls due

Any of these could prompt a policy recalibration and impact fiscal metrics temporarily.

Conclusion

India’s commitment to fiscal consolidation, as reflected in Morgan Stanley’s projections, signals a return to fiscal prudence after years of pandemic-related spending.

With strong tax buoyancy, a rising share of capital expenditure, and coordinated state-centre policies, the government appears focused on building a resilient macroeconomic foundation.

While a 7% combined fiscal deficit is not insignificant, it is on a declining trajectory, and the quality of expenditure — prioritising growth-enabling investments — will be crucial in defining India’s economic story over the next decade.

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