India may slash its food and fuel subsidy bill by about $8 billion in next week's budget, two sources said, but despite the impressive headline, the cut is not as radical as free market champions had hoped for in Prime Minister Narendra Modi's first full budget.

Most of the 20 per cent cut in the budget for subsidies results from lower global oil prices rather than structural changes, with the government's appetite for reform tempered by a heavy local election defeat in New Delhi this month.

"The total subsidy bill could come down to around 2 trillion rupees ($32 billion)," a senior government official, who has direct knowledge of the matter, told Reuters. That calculation was echoed by another source privy to budget discussions.

Fuel subsidies are expected to drop by around two-thirds to 220-230 billion rupees in the fiscal year that starts on April 1, thanks above all to a halving of international oil prices to around $60 a barrel.

The sources said Finance Minister Arun Jaitley was likely to set the total budget for subsidies at about $32 billion, down from $40 billion in the current financial year.

It will be the first full budget presented since Modi's Bharatiya Janata Party swept to power in India last May. It produced an interim budget in July that was largely designed by the outgoing Congress party government.

The numbers imply four-fifths or $6.5 billion of the total subsidy savings will come from lower fuel subsidy costs. Other subsidy costs will only be cut by around 5 percent.

That could disappoint investors, who see the February 28 budget as a test of Modi's stomach for unpopular reforms, with some critical that he has not moved faster to revive the economy.

"The direction of subsidy reduction is perfect but we need more to be done," said Deven Choksey, managing director at Mumbai brokerage KR Choksey Securities, who called for more welfare schemes, including fertilisers, to shift to direct cash payments to avoid fraud.

The sources suggested that the focus on savings would be on cutting waste rather than more radical free market efforts some policy advisers have been lobbying for.

According to calculations described by the first source, lower oil prices combined with measures to deregulate fuel prices and clamp down on fuel benefit fraud will account for four-fifths of the savings.

The launch of direct transfer of funds into bank accounts of over 100 million households earlier this year for subsidised cooking gas alone is expected to contribute over one billion dollars towards overall savings next year.

Nearly 100 billion rupees ($1.6 billion) of the savings could come from clamping down on corruption in fertiliser distribution and adjusting food subsidies, he said.

The officials said the thrust of the budget was to improve the economic environment by trying to spark consumer demand and investment without overshooting a fiscal deficit target of 3.6 per cent of GDP.

Lower subsidy costs would help the government increase funding for Modi's dream projects like railways, roads, solar power and support to exports while honouring deficit commitments closely watched by ratings agencies.

India's vast but decrepit state railways have sought to nearly double spending on new infrastructure to 500 billion rupees in the upcoming rail budget for 2015/16, a senior Railways Ministry source said.

FOOD WELFARE

Modi and his Bharatiya Janata Party ideologically support weaning voters off distorting subsidies.

But Modi needs to win state elections to implement that agenda in parliament, and a resounding defeat in the high-profile Delhi state poll this month may force him to reconsider some proposals.

"The finance minister will have to meet investors' expectations without inviting a political backlash," said the second official.

Modi is expected to quietly delay implementation of a food aid law passed by the last government that would widen distribution of ultra-cheap grains to two-thirds of the population.

Delaying the implementation of food scheme could, along with a smaller increase to government-set farm-gate prices, avert 200-300 billion rupees in extra spending on food subsidies, said the first official.

Despite calls from policy advisers to end subsidies on fertilisers, the officials said the government favoured deregulating urea prices in a phased manner, to avoid "protests inside and outside the parliament".

"It is not easy. But we can save about 50 billion rupees by plugging leakages," said the first official, referring to scams to abuse the fertiliser subsidy.

Welfare reform is highly sensitive in India, where nearly 70 per cent of the 1.25 billion population lives on $1.50 a day or less, according to the Asian Development Bank. - Reuters