India's success in trimming its fiscal deficit has surprised even itself but progress in the next two years will be harder as dizzying growth slows and pressure for populist spending rises before elections.

The not so good news in the deficit numbers is that the government relies on a higher tax collection rather than spending reforms to narrow the shortfall.

So far it is higher revenues that have helped the government. They haven't shown any effort to compress spending, said A. Prasanna, an analyst with Mumbai-based ICICI Securities.

Right now, you are at the peak of the cycle and when the measures taken by the central bank cool the economy, then there will be pressure on the deficit.

Hitting a legislated federal deficit target of 3.0 percent and wiping out the revenue deficit by 2009 will depend how the government copes with higher interest rates and pressure to spend ahead of elections in two years.

Missing the target would raise the risk of higher bond supply and borrowing costs. And a government unable to straighten out its finances will spook investors whose expectations are already running high.

Hefty capital inflows have pushed the rupee to 9-year highs, making it Asia's best performing currency this year. The booming stock market, which has hit successive all-time highs this month, is also vulnerable to a sell-off, analysts say.

A high fiscal and revenue deficit means government money can end up funding debt and non-productive spending rather than development, which will help keep the economic engines greased.

There's little risk of blow-out, but there are risks in the composition of spending, says rating agency Moody's Investors Service, which rates India's foreign currency debt as investment grade but domestic currency debt as speculative.

If current expenditure is ramped up at the cost of capital expenditure, it could prove to be inflationary, Moody's senior analyst Aninda Mitra wrote in an emailed response to Reuters.

Or if several expenditure initiatives are carried out on an off-budget basis, then that would hurt the overall debt burden.

HIGHER TAXES

India has come a long way: Once burdened with a deficit of nearly 10 percent of gross domestic product (GDP), the communist-backed coalition has been in a virtuous cycle of deficit reduction thanks to unexpectedly fast economic expansion.

The combined states' and federal deficit has fallen to 6.3 percent of GDP, although analysts say it could be higher due to off-budget subsidies and it is still one of the widest in Asia, including China at just 0.7 percent last year.

Tax revenue rose to 10.8 percent of GDP in 2006/07 from 8.2 percent in 2001/02, helped by 9.4 percent economic growth last year -- the fastest pace in 18 years and second only to China among major economies.

The central bank expects 8.5 percent growth this fiscal year and the government forecasts the federal fiscal deficit to fall to 3.3 percent. Legislation requires it to cut the deficit every year until it reaches 3.0 percent and wipe out its revenue deficit, the shortfall between taxes raised and non-investment spending, by 2009.

If the revenue deficit is not eliminated that would make it difficult to bring down interest rates because the market will be swamped with government borrowing, said D.H. Pai Panandikar, president of private economic think-tank RPG Foundation.

Growth could be impacted because a deficit means reduction in savings and in turn investments.

Tax revenues may not deliver an automatic bonus this year, with corporate earnings likely dented by higher borrowing costs and a surging rupee hitting exports. Economists are not ruling out one more tightening to control price and credit growth.

It is unlikely that the government will be able to spring another positive surprise on the outcome for the fiscal deficit in the current year, Rajeev Malik, analyst with JP Morgan, said in a research note.

Overall economic growth is poised to be slower this year and corporate taxes will be impacted by both slower top-line growth and increased pressure on margins.

POPULIST SPENDING

On top of this, the Congress party-led government, elected on the promise of reforms with a human face, is under fire for failing to spread prosperity beyond the cities and deliver on promises of rural employment, healthcare and education.

Stung by the party's poor showing in state polls, Prime Minister Manmohan Singh has committed $6 billion over four years to revive farming.

Non-development spending has more or less remained at 70 percent of overall spending -- the bulk of it due to higher interest costs, subsidies and pensions.

Analysts say state elections ahead of the 2009 federal polls will put more pressure on the coalition to open its purse.

From now on there will be increased demands for popular schemes and pressure from all quarters to increase spending, political analyst Mahesh Rangarajan said.

Furthermore, before the 2009 vote, hundreds of thousands of civil servants are likely to get a large pay rise.

A similar round of pay hikes in 1997 blew out the combined state and central deficits to nearly 10 percent of GDP, damaging economic growth and taking years to repair.

China India Inflation