5%-8.0% of gross domestic product, down from an expected 9% this year.
Strong economic growth and the rise in spending as a result of inflation "will boost the government's tax revenue and help narrow the deficit," said Dushyanth Wijayasingha, economist at Asia Capital.
Deputy finance minister Ranjith Siyambalapitiya told Dow Jones Newswires this week the government expects the deficit to narrow to 5% in 2007 due to higher tax collections and increased borrowings.
He said the economy is likely to expand 8% in the 2007 calendar year, up from the near 7% growth expected this year.
The budget is due to be presented in parliament on Nov.
16 by President Mahinda Rajapakse, who also holds the finance minister portfolio.
This is Rajapakse's first budget after he won the presidential election in November 2005 with his pro-poor policies attracting a large portion of the rural vote.
Populist measures like relief to low-income groups and incentives to small and medium-scale businesses are likely, say experts.
"But we don't expect any new corporate taxes or changes to the corporate tax structure," as this will fuel inflation, said Vajira Premawardhana, head of research at Lanka Orix Securities.
Instead, the government may raise the duty on imported goods and hike the value-added tax, stamp duty, excise duty and the port and aviation levy, said analysts.
They expect government revenue to rise around 18% on-year in 2007.
In a bill presented last month in parliament, the government put the defense ministry's expenditure next year at LKR139.
6 billion ($1.3 billion), twice the LKR69.5 billion budgeted for this year.
The higher defense budget comes amid increased violence between government troops and Tamil Tiger rebels in the north and the east, which have hurt efforts to revive the country's peace process.
Siyambalapitiya said recurring costs are estimated to total LKR586 billion next year compared with a LKR503.
1 billion target for this year and pegged capital expenditure at LKR733 billion, up from an estimated LKR217.9 billion in 2006.
He said a large portion of the capital expenditure will be used to fund several big construction and development projects and rural development programs.
The planned investments for 2007 include a coal-fired power plant estimated to cost 0 million, development of the existing Colombo Port, building a second international airport in the south, and a key highway connecting the south to the east.
In order to bridge the budget gap next year, the government has set a total gross borrowing limit of LKR690 billion, up from an estimated LKR518 billion this year, Siyambalapitiya said.
Analysts expect overseas borrowings to rise next year as the government struggles with inflation and higher interest rates.
Rising fuel prices and a resumption in fighting have pushed inflation to a near five-year high, prompting the central bank to tighten monetary policy this year.
"The government will try to keep local borrowing down due to the recent rise in interest rates and may borrow more internationally to finance the deficit," said HNB Stock Brokers' analyst, Geeth Balasuriya.
As part of the borrowing plan, the government may look at reviving a $500 million-$1 billion international bond, which was shelved earlier this year due to the volatile security situation.