Panagariya, 61, whose market-friendly, pro-growth economics has helped shape Modis outlook, told Reuters in an interview that higher spending is critical to Indias economic revival.
Modi swept to power on May 16 on a promise of reviving an economy that is undergoing the worst slowdown since the 1980s. Indian financial markets are rallying on hopes that the strong mandate would enable him deliver on his promise.
In an economy where you are trying to push up the growth rate, a fiscal deficit of 4.5% (of GDP) is fine, said Panagariya, a professor at Columbia University and a former chief economist of the Asian Development Bank.
That number is 4 basis points higher than the 4.1% budgeted by the outgoing government for the fiscal year that began in April, which Panagariya called an unrealistic target.
Modi is due to be sworn in as PM on Monday. His government has to present a budget by July for the remaining part of the fiscal that ends in March.
Panagariyas suggestion is at odds with a proposal being worked on by bureaucrats at the finance ministry who want the new government to reduce the deficit even further than the current target - to as low as 3.8% of GDP.
Panagariya asked the incoming administration not to be unduly worried about a small fiscal slippage and suggested it use the room to boost infrastructure spending.
I would say raise capital expenditure from 1.76% (of GDP) to 2%, he said.
His prescription is in line with election promises of Modis BJP to ramp up spending on infrastructure to support growth.
Arun Shourie, a contender for the post of finance minister in Modis cabinet, told CNBC television on Friday that he also thought a 4.1 percent deficit was impossible.
However, a higher deficit could increase the risk of a sovereign credit downgrade. Since April 2012, India has been facing a downgrade threat from Standard & Poors, which rates it at BBB minus with a negative outlook.
RETROSPECTIVE TAX LAW, BANKING REFORMS
Insiders close to Modi have suggested that Panagariya could be appointed the prime ministers chief economist. His mentor, Jagdish Bhagwati, told Reuters last month that Panagariya could head the team of the governments economic advisers.
Panagariya is an expert on trade, and during the interview stressed that he was not a macro-guy. He refused to comment on a possible new role but last month said he would join the government if asked.
He said tax and fiscal reforms were top priorities for the new government, adding that the next finance minister should amend the countrys retrospective tax law and commit to ending diesel subsidies in the upcoming budget.
India amended its tax code retrospectively in 2012 to reopen a tax dispute worth more than $2 billion with Vodafone after the countrys Supreme Court had ruled in favour of the British mobile operator.
Analysts see that move as an unwelcome defining moment in Indias relationship with multinationals, which gave it a reputation as a nation unfriendly to investors and slowed foreign inflows.
I would like the government to sort out the retrospective taxation issue, Panagariya said. Basically, take out the retrospective part of the legislation and simply make it prospective.
The BJP lambasted the outgoing Congress government for the retrospective tax law, promising to repeal it if voted to power.
Panagariya advised the new administration to implement a proposed direct tax code beginning April 1, 2015 and a nationwide goods and services tax (GST) from April 1, 2016.
While both the measures are expected to boost government revenues by improving tax compliance, they have been pending for years for want of a political consensus.
Panagariya said the upcoming budget needs to push banking reforms to address the issue of rising bad loans at Indian banks, which have stifled credit flows to corporates.
Stressed loans in India - those categorised as bad and restructured - total $100 billion, or about 10 percent of all loans. Fitch Ratings expects stressed assets to reach 14 percent of loans by March 2015.
The Columbia University professor said the government can tackle the issue by reducing its stake in state-run banks and merging weak banks with stronger banks.
You can recapitalise the banks, but the government currently doesnt have unlimited amount of revenues, he said. Some part of the solution has to be reducing the central governments stake in the banks.
A central bank-appointed panel earlier this month suggested the government cut its stakes in state-controlled banks to below 50 percent.