The Union Budget is just a few days away and expectations are high owing to the difficult macroeconomic backdrop. Growth slumped to 4.5% in the first half of the fiscal while inflation has surged, crossing the upper band of the RBI’s target range in December.

The weak backdrop is compounded by policy constraints. Monetary policy has reached its limits for now at least owing to the surge in inflation. This shifts the onus to the fiscal policy to counter the demand slowdown.

The fiscal situation is however already quite stretched with the FY20 deficit expected at 3.8% of GDP, 50bps higher than the target. This too has been contained with the help of large one-off gains in the form of the RBI’s special dividend and higher than budgeted regular dividends and savings on PM-KISAN and lower than budgeted interest payments. These factors are likely to be absent next year, constraining fiscal space to manoeuvre.

The government could budget for a higher deficit in FY21 to support growth, while committing to a stringent fiscal consolidation roadmap in the medium term. However, the real fiscal deficit is already significantly higher than the reported numbers; estimates put it at over 6% of GDP including off-budget capex and subsidy arears.

Adding the deficit of the state governments, this number moves up to ~9% of GDP. Contending for higher deficits from these levels would only be quixotic; if anything, the fiscal deficit needs to decline hereon.

Even if the government chooses to provide a limited stimulus, it would have some tough choices. Should it raise the disposable incomes of ~32million individuals through a targeted tax cut for the low-income earners to boost urban demand? Or should PM-KISAN pay-outs be increased to support the incomes of the ~74mn farmers benefitting from the scheme? Or could it resort to higher rural infrastructure related spending and increased NREGA outlay to boost income and job opportunities for rural wage labourers? All segments are under duress.

The budget will have to strike the right balance between these choices while navigating policy constraints amidst a tough macro-environment.