India’s much-celebrated “Goldilocks” narrative, an economy achieving robust growth alongside low inflation, appears to be unravelling into a fiscal gridlock as we approach the 2026 Budget. Headline figures paint a picture of strength, with real GDP growth estimates for FY26 hovering around 7-7.4 per cent (supported by strong quarterly performances like 8.2 per cent in Q2) and nominal growth near 8.8 per cent in the first half. Yet, beneath this veneer lies fragile underlying momentum, persistently weak tax buoyancy, and rapidly shrinking fiscal space. The government is caught in a classic policy dilemma: how to sustain growth momentum without sacrificing fiscal prudence, and how to stimulate demand without eroding hard-won credibility in global markets.
Recent policy surprises underscore this tension. The abrupt hike in basic excise duty on cigarettes, enacted through the Central Excise (Amendment) Bill, 2025, and set to take effect from February 1, 2026, marks a sharp increase, with duties on cigarettes rising dramatically. This move, following GST rationalisation, is projected to generate substantial additional revenue helping offset the impending lapse of GST compensation cess. While aimed at protecting tax incidence and supporting health initiatives, it highlights the government’s reliance on targeted, non-recurring revenue levers amid broader collection shortfalls.
Emergency-style tools
The Reserve Bank of India (RBI) has mirrored this urgency with its own interventions. In late December 2025, the RBI announced additional open market operations (OMOs) worth ₹2 trillion in government securities purchases (conducted in tranches through January 2026) and a $10 billion dollar/rupee buy-sell swap auction. These steps followed earlier liquidity infusions and came despite a monetary policy that had already signalled large-scale easing. The paradox is evident: such measures, reminiscent of crisis-era responses, include cumulative actions like 150 basis points of CRR cuts, 125 basis points of repo rate reductions, and massive liquidity support totalling around ₹8 trillion or more in recent periods. Why deploy emergency-style tools in a supposedly healthy “Goldilocks” economy boasting near-8 per cent real growth and subdued inflation?
Despite these aggressive efforts, financial conditions have tightened rather than eased. India’s 10-year government bond yields have hovered around 6.6-6.65 per cent into early 2026, reflecting persistent upward pressure amid rising fiscal deficit and supply concerns. The rupee has weakened beyond 90/dollar (touching levels near 91 in late 2025), while banking system liquidity has slipped into deficit territory. These trends raise the spectre of crowding-out, where expansive fiscal policy competes with private investment for resources, pushing up interest rates and curbing corporate capex.
Crowding-out typically emerges when government spending overheats the economy, widens the current account deficit, and burdens households with higher taxes and inflation, leading to adjustment via elevated rates and currency depreciation. However, if public investment delivers strong productivity gains and multiplier effects, it can trigger crowding-in, catalysing private sector activity, boosting incomes, and improving tax buoyancy. The current risk is that India’s public investment push, while front-loaded in areas like infrastructure, may not yet be generating the expected returns, trapping the economy in a potential vicious cycle of high debt, subdued growth, and fiscal constraints.
Restrained spending
The data reveals a sobering reality. Government spending has remained restrained, growing slower than nominal GDP over recent years. In April-November FY26, total expenditure reached approximately ₹29 trillion, up 6.8-7 per cent year-on-year, below the budgeted 7.4 per cent and nominal GDP growth of around 8.8 per cent. This moderation follows a low base, resulting in a two-year CAGR of just 5 per cent, driven largely by interest payments rather than discretionary outlays. Non-interest revenue expenditure and non-loan capital expenditure have grown at a meagre 2-3 per cent pace.
Tax collections paint an even more concerning picture. Gross tax revenue grew only 3.3 per cent year-on-year through November 2025, while net tax collections (after State devolution) declined 3.5 per cent to around ₹13.9 trillion. This performance leaves the government far short of the full-year target of 11 per cent growth (₹28.4 trillion net), requiring an improbable 30 per cent surge in the remaining months. The implied tax elasticity stands at a dismal 0.38x against a budgeted 1.1x, signalling weak private sector momentum rather than the buoyant activity claimed in headline narratives.
The fiscal deficit has widened sharply as a result. In April-November FY26, it reached ₹9.77 trillion, or 62.3 per cent of the full-year Budget Estimate of ₹15.69 trillion (targeting 4.4 per cent of GDP), about 10 percentage points higher than in the previous year. This slippage stems primarily from revenue shortfalls, not spending excesses, with non-interest revenue expenditure even contracting modestly. Even with robust non-tax revenues (bolstered by ₹2.8 trillion in RBI dividends), the overall gap is estimated at ₹2-2.3 trillion. Meeting the deficit target may require expenditure cuts of ₹2.5 trillion in the final quarter, potentially slashing capital spending by up to 40 per cent while interest costs rise (already consuming over 50 per cent of tax revenue).
Credit growth rebounds
Banking sector dynamics compound the challenge. Credit growth rebounded to 12 per cent in late 2025, outpacing deposit growth (around 10 per cent), pushing the credit-deposit ratio higher and squeezing banks’ capacity to absorb government securities. Banks have increasingly turned to costly non-deposit funding for unsecured loans, raising overall lending rates and highlighting structural rigidities that limit the effectiveness of counter-cyclical stimulus.
These trends point to mounting debt sustainability risks. Central government debt has doubled over the past seven years, approaching ₹196 trillion in FY26 estimates. With tax buoyancy faltering, rising interest burdens, and limited room for further household taxation, the government has turned to ad-hoc measures like excise hikes. If GST-driven demand revival fails to materialise, further rollbacks or adjustments loom.
In essence, India’s fiscal paradox is one of gridlock masked by headlines. Robust GDP figures conceal weak private capex, subdued household demand (hit by real income pressures and subsidy withdrawals), and a negative fiscal multiplier in some areas. Recent tax and GST easing, combined with RBI’s liquidity push, may temporarily inflate consumption in an overleveraged household sector, but rising rates could crowd out investment, and slowing tax revenues might force swift reversals.
As the 2026 Budget approaches, fiscal space has tightened dramatically. Rising State devolution, moderating corporate profits, and reliance on one-off revenues constrain options. The government must choose to maintain prudence amid softening demand (risking deeper slowdown) or expand deficits to support rural/household incomes, perhaps via accelerated asset monetisation or PSU divestments. Raising corporate taxes risks hurting earnings and valuations.
Ultimately, India’s challenge is to escape this bind, balancing fiscal discipline with meaningful growth support, without tipping into a cycle of debt fragility, weak demand, and constrained policy. The “Goldilocks” era may be giving way to a more sobering reality, where prudence and stimulus must coexist in uneasy tension.
The writer is CEO and Co-Head of Institutional Equities at Systematix Group
Published on January 13, 2026
