Will new fiscal pressures cause India’s debt control to collapse?

To counter their impact on economic growth and continue with reforms, India’s government recently announced a simplification of the goods and services tax (GST) from a four-rate structure (5%, 12%, 18% and 28%) to a simplified two-rate regime of 5% and 18%.

Households looking to buy big-ticket items such as electronics and white goods may delay their purchases till these lowered rates become effective from 22 September. This can lead to a slowdown in consumption this month. But over the next few quarters, lower GST rates should combine with the earlier income-tax reduction to increase consumption on the margin.

Lower GST rates, various other monetary as well as fiscal measures that have already been announced, and additional support—we expect one more 25-basis-point rate cut by the Reserve Bank of India on 1 October while the government is likely to announce further fiscal support for small and medium enterprises, including exporters—should join forces to help sustain India’s real gross domestic product (GDP) growth at around 6.5% in 2025-26 and 2026-27, despite the threat of higher US tariffs.

Reduced GST rates are also likely to lower inflation by about 25 basis points, but given the multiplicity of factors at play, it is difficult to be sanguine about the inflation trajectory. We are forecasting 3% and 4.5% average consumer inflation for 2025-26 and 2026-27, respectively, and we don’t see the need to revise these forecasts at this stage in the wake of GST relief.

Risks to growth and consequently India’s fiscal balance have increased due to the tariff threat, lower-than-expected nominal GDP growth so far and revenue uncertainty on account of GST rate rationalization. Also, in the years ahead, the Centre will have to plan for higher expenditure on salaries in line with the 8th Pay Commission awards, which may flatten the debt-consolidation path if nominal GDP growth remains subdued, thereby pushing the fiscal deficit higher.

Finance ministry officials have assured us that GST 2.0 will be fiscally sustainable, with higher consumption expected to offset any shortfall in revenues due to the rate relief. Also, once the compensation cess ends this year and the GST rate increases from 28% to 40% on sin and luxury goods, that 12-point increase will be additional revenue for both the Centre and states and will help offset revenue losses.

Despite these offsets, 2025-26 is likely to see a revenue shortfall that is estimated in the range of ₹40,000-50,000 crore (0.13% of GDP). The Union budget had pegged this year’s total GST collection at ₹11.8 trillion, an increase of 10.9% over the previous year. Even without GST rationalization, GST and other tax collections risk falling short as nominal GDP growth is now expected to miss the 10.1% assumed in the budget.

If a part of the compensation cess intake is used to fund the likely GST shortfall (say, half of it), then the risk of fiscal slippage will reduce.

The Union budget for 2025-26 projected a compensation cess mop-up of ₹1.67 trillion, a 9.2% increase over 2024-25’s revised estimate of ₹1.53 trillion. Net proceeds in the GST compensation fund after the servicing of loans are estimated at around ₹50,000 crore. If half of this can be used to offset any shortfall in GST revenue, then the fiscal deficit slippage risk would come down to ₹20,000-25,000 crore, or just 0.1% of GDP. This would push the 2025-26 fiscal gap to 4.5% of GDP, marginally higher than the 4.4% estimated in the budget.

When we last undertook a debt sustainability exercise about a year ago, we concluded that India will likely get a credit rating upgrade soon, though our assessment was that based on its adequate debt repayment capacity as well as macro-economic improvements over the past several years, it probably deserved a two-notch upgrade. In this context, the decision last month of S&P Global Ratings to upgrade India’s sovereign debt rating to BBB from BBB- (after a gap of 18 years) hardly comes as a surprise, at least to us.

Given today’s growth and fiscal concerns, we revisited our debt sustainability exercise to ascertain if India’s debt consolidation path had changed materially from our previous findings. This assumes importance as the government’s medium-term fiscal roadmap is now aimed at achieving sustained debt consolidation by the end of this decade, but without pre-committing itself to explicit fiscal-deficit targets for each year.

Our analysis reveals that despite India’s GST rate rationalization, an increased outlay expected on government salaries and no significant fiscal consolidation from current levels (we assume that the consolidated budget deficit of the Centre and states will stay near its current level of 7.3% of GDP), it is possible for India to lower its debt-to-GDP ratio to 75.1% of GDP by 2030-31 (our previous forecast was slightly lower at 74.8% of GDP), provided nominal GDP growth averages around 10.5-11% during this period.

Barring unforeseen shocks, this assumption of nominal growth is realistic, based as it is on projections of real GDP growth averaging 6-6.5% and inflation averaging 4-4.5% (for use as the GDP deflator) over the forecast period.

The author is chief economist, India, Malaysia, and South Asia at Deutsche Bank AG.