Low Inflation Creates 5 Tough Challenges for Govt Budget

Low Inflation Poses Challenges for Government Finances and Budget Targets

Inflation has dropped significantly in recent months, with retail inflation (CPI) falling to around 3-4% from double digits earlier.

• Projections indicate subdued inflation persisting due to factors like favorable monsoons, stable global commodity prices, and moderated food price pressures.
• While this eases living costs for households, it disrupts the government’s revenue and expenditure assumptions baked into the Union Budget.

Impact on Government Revenue (Tax Collections):

• Nominal GDP Growth Slows: Low inflation reduces nominal GDP growth (real growth + inflation rate). For FY26, the government targeted 10.5% nominal GDP growth; with inflation at ~4%, real growth would need to hit 6.5% to meet it—risky if growth falters.
• Lower Tax Buoyancy: Direct taxes (income, corporate) and indirect taxes (GST) are tied to nominal economic activity. Stagnant prices mean slower revenue accrual without tax rate hikes.
• Example: In FY24, nominal GDP grew 9.6%; a drop to 8% could shave off ₹1-2 lakh crore in tax collections, per rough estimates.

Strain on Expenditure and Subsidies:

• Real Value of Spending Rises: Fixed nominal budgets (e.g., for salaries, pensions) buy less in real terms when prices are low, effectively increasing the fiscal burden.
• Pressure on Welfare Schemes: Subsidies for food, fuel, and fertilizers are often inflation-indexed. Low inflation keeps nominal costs down but amplifies real spending if demand-side pressures emerge.
• Debt Servicing Costs: Low growth erodes the tax-to-GDP ratio, making it harder to service rising public debt (currently ~58% of GDP).

Challenges to Fiscal Deficit Targets:

• Budget Assumptions at Risk: The FY26 fiscal deficit goal of 4.4% of GDP relies on buoyant revenues. Low inflation could widen the gap, forcing spending cuts or borrowing spikes.
• FRBM Act Pressures: The Fiscal Responsibility and Budget Management Act mandates deficit reduction; missing targets due to low inflation could invite credibility issues and higher borrowing costs.
• Policy Dilemma: The government may need to stimulate demand (e.g., via capex push) without reigniting inflation, balancing growth with fiscal prudence.

Broader Implications and Outlook;

• Positive for RBI‘s Mandate: Low inflation aids the Reserve Bank’s 4% target, potentially enabling rate cuts to boost investment.
• Government’s Balancing Act: To mitigate risks, focus on supply-side reforms (agri, logistics) and non-inflationary revenue sources like disinvestment.

Key Takeaway: While low inflation signals economic stability, it underscores the “Goldilocks” challenge—not too hot, not too cold—for fiscal sustainability.