The government on Tuesday slashed factory gate duties and service tax to boost slowing growth as Standard & Poor's cut its outlook on the country's long-term sovereign credit rating to negative from stable.
Warning of tough times ahead, the government, which is heading toward a general election by mid May, cut the rate of central excise duty by 2 percentage points to 8 percent and trimmed the tax rate on services to 10 percent from 12 percent.
"I have tried to make certain changes to provide further stimulus to the economy," said acting Finance Minister Pranab Mukherjee, replying to a debate on an interim budget for 2009/10 that was later approved by the lower house of parliament.
Asia's third largest economy, which was initially thought to have escaped the worst of the global slowdown, is now reeling under its impact and growth is estimated to slow to 7.1 percent in 2008/09, from 9 percent in the previous year.
"Even though the signals are encouraging, the full impact of recession in other parts of the world, particularly Asia and Europe, is yet to unfold," he said.
"Due to strong export linkages with these economies it is likely that the Indian economy may feel further impact in coming months."
S&P cited worsening government finances for its outlook downgrade, which could raise overseas borrowing costs for Indian companies and weaken the rupee.
Analysts said the duty cuts may put further pressure on government finances. "In the short term the duty cuts may not work much but in the medium term it will stimulate demand. The deficit will remain high," N.R. Bhanumurthy, economist at the Institute of Economic Growth, said.
Economic Affairs Secretary Ashok Chawla said the duty and service tax cuts would result in a revenue loss of 300 billion rupees ($6 billion) in the next fiscal year.
Measures to boost growth along with spending on pay hikes for civil servants and a massive programme to write off the debt of small farmers has helped swell the federal fiscal deficit to 6 percent of gross domestic product in 2008/09.
S&P said it expects the general government deficit, including off-budget items such as oil and fertiliser bonds, to increase to 11.4 percent in the fiscal year ending in March, up from 5.7 percent in the previous fiscal year.
"It is not unexpected. You have the global meltdown and it has its consequences," Mukherjee said when asked about S&P's action. He did not elaborate.
India has sought over recent years to consolidate its public finances, reducing the federal fiscal deficit to 2.7 percent of gross domestic product in 2007/08.
But the deficit is now set to spiral into one of the largest in the world and the combined deficit for federal and state governments is set to breach the 10 percent of GDP seen in the late 1990s.
The S&P outlook cut "is clearly a response to fiscal slippages and a possibility of a worsening scenario in 2009/10 due to additional fiscal stimulus concerns," said Abheek Barua, chief economist at HDFC Bank. "It is likely to affect short and long-term credit rates in addition to equity markets."
The rupee closed at 49.87/88 per dollar, 0.3 percent weaker than its previous close, following losses in other Asian currencies and the outlook downgrade.
It has lost 2.3 percent this year after falling 19.1 percent in 2008.