The Union Budget 2025-26 quietly signalled a significant shift in India’s fiscal philosophy. Buried in the Statement on the FRBM Framework was an acknowledgement that fiscal management will increasingly be anchored to the debt-to-GDP ratio rather than the annual fiscal deficit target. This change matters because it challenges a long-held but poorly grounded rule and opens space for a more growth-aligned fiscal strategy.
What the Budget Statement Indicates
The Ministry of Finance noted that using debt-to-GDP as the fiscal anchor aligns with global thinking. Unlike rigid annual deficit ceilings, a debt-based anchor captures the cumulative impact of past and present fiscal decisions and allows greater operational flexibility. The intent, as stated, is to rebuild fiscal buffers while retaining space for growth-enhancing expenditure.
This is not a cosmetic rephrasing. It reflects an explicit recognition that the FRBM-mandated 3 per cent fiscal deficit limit has failed to meaningfully guide India’s fiscal trajectory.
The Problem with the 3 Per Cent Deficit Rule
Since the FRBM Act came into force in 2003, India has never met the 3 per cent fiscal deficit target. Even before Covid-19, the target was frequently deferred. After the pandemic shock, deficits understandably rose to 9.5 per cent, 6.8 per cent, 6.4 per cent, 4.8 per cent, and are budgeted at 4.5 per cent in 2025-26.
The deeper issue is conceptual. The 3 per cent figure has no strong empirical foundation. It was borrowed from European fiscal conventions and transplanted into an emerging economy context without rigorous justification. There is no clear economic rationale for why 3 per cent is “safe” while 3.5 or 4 per cent is not, especially for a country with large developmental and infrastructure needs.
Why Rigid Deficit Targets Fail Counter-Cyclical Policy
Annual fiscal deficit ceilings tend to work against counter-cyclical macroeconomic management. During economic slowdowns, governments need the flexibility to expand spending to stabilise demand. Hard deficit caps often force premature austerity, compressing public investment and weakening growth prospects.
Debt sustainability, in contrast, depends less on a single year’s deficit and more on the interaction between growth, interest rates, and the composition of spending. A debt-to-GDP anchor implicitly recognises that higher growth can stabilise or even reduce debt ratios despite temporarily higher deficits.
Crowding Out: Theory versus Indian Evidence
A common objection to higher government borrowing is the risk of crowding out private investment. Indian data does not strongly support this concern. Banks continue to invest far above the statutory liquidity ratio of 18 per cent; as of October 2025, over a quarter of deposits were parked in government securities.
This persistent demand for government bonds suggests that public borrowing has not constrained private credit. Private sector lending has expanded alongside elevated government borrowing, undermining the claim that fiscal flexibility necessarily harms private investment.
Public Investment as the Growth Engine
Fiscal flexibility has enabled a sharp rise in Union government capital expenditure. Infrastructure allocations increased from ₹5.4 lakh crore in 2022-23 to ₹11.11 lakh crore in 2025-26, about 3.4 per cent of GDP — the highest in independent India.
These investments in roads, railways, ports, airports, urban transit, energy, and water systems are foundational public goods. International experience, including China’s post-reform growth, shows that sustained public infrastructure creation can crowd in private investment by lowering logistics costs and improving productivity. India’s PM Gati Shakti programme reflects this infrastructure-led competitiveness strategy.
What Really Matters for Fiscal Sustainability
The relevant questions for fiscal policy are not whether the deficit is exactly 3 per cent, but whether:
- the debt-to-GDP ratio remains on a sustainable path,
- economic growth exceeds the cost of government borrowing, and
- public expenditure is directed towards productivity-enhancing uses.
On these parameters, India’s position remains relatively comfortable, particularly if high growth is sustained.
Why the Shift Signals Pragmatism
Moving towards a debt-based fiscal anchor reflects learning from two decades of experience. Despite persistent deviations from the 3 per cent target, India has recorded strong growth, especially when public investment played a leading role. The new approach accepts economic reality while retaining a medium-term commitment to sustainability.
What to Note for Prelims?
- FRBM Act, 2003: original focus on fiscal deficit targets.
- Difference between fiscal deficit and debt-to-GDP ratio.
- Statutory Liquidity Ratio (SLR) and its relevance.
- PM Gati Shakti and infrastructure-led growth strategy.
What to Note for Mains?
- Critically examine the rationale of fixed fiscal deficit targets in emerging economies.
- Discuss debt-to-GDP ratio as a more flexible fiscal anchor.
- Analyse the role of public investment in crowding in private investment.
- Link fiscal policy design with counter-cyclical macroeconomic management and long-term growth.
