State Government Finances: Fiscal Federalism, Rising State Debt and the Need for Structural Reforms

Recent Developments:

• Kerala and Tamil Nadu have recently released White Papers highlighting rising outstanding debt, increasing committed expenditure and shrinking fiscal space for development, reviving the debate on the sustainability of State finances in India.
• Recent CAG State Finance Reports have also flagged persistent fiscal imbalances, high committed expenditure and increasing dependence on borrowings in several States.

Fiscal Federalism and the Core Fiscal Dilemma:

Structural Imbalance in Indian Fiscal Federalism:

• Fiscal deficit arises when a government's total expenditure exceeds its revenue receipts excluding borrowings.
• India's fiscal structure creates a vertical fiscal imbalance, where the Union Government possesses greater taxation powers, while States undertake a larger share of developmental expenditure.
• States bear primary responsibility for delivering essential public services despite having comparatively limited revenue-raising capacity.
• This structural mismatch compels many States to rely on market borrowings to finance developmental commitments.

Major Expenditure Responsibilities of States:

• Social sectors: Health, education, nutrition, social welfare and human development programmes.
• Economic sectors: Agriculture, irrigation, rural development, transport, power and local infrastructure.
• States also finance salaries of teachers, healthcare workers, police personnel and numerous frontline public servants.

Sources of State Finances:

Own Revenue Sources:

• State GST (SGST) constitutes the largest component of States' own tax revenue.
• Other sources include State excise duty, stamp duty, registration fees, motor vehicle tax and non-tax revenue.

Transfers from the Union Government:

• Tax devolution recommended by the Finance Commission.
• Grants-in-aid under Article 275 and other statutory provisions.
• Centrally Sponsored Scheme (CSS) assistance.
• Loans and other fiscal support from the Union Government.

Why Revenue Still Falls Short:

• Even fiscally efficient States may receive a relatively smaller share of Union tax devolution because Finance Commission transfers are based on multiple criteria such as income distance, population, forest cover, demographic performance and tax effort.
• Consequently, expenditure obligations often grow faster than available revenues, widening fiscal deficits.

Kerala as a Case Study:

Revenue Strength but Limited Fiscal Space:

• Kerala records one of the strongest own tax revenue performances among Indian States.
• Despite strong tax mobilisation, its share in Union tax devolution remains relatively modest compared to its developmental responsibilities.
• The revenue gap is therefore financed largely through State borrowings, increasing future interest obligations.

Pattern of Public Expenditure:

• A substantial share of State expenditure is committed towards:
• Salaries, pensions and interest payments, leaving limited fiscal space for new investments.
• Only a relatively small portion of the budget remains available for capital expenditure, which creates productive public assets such as roads, transport systems and educational infrastructure.

The Investment Dilemma:

• Reducing expenditure on salaries or pensions may weaken public service delivery and social sector achievements.
• Maintaining current expenditure, however, leaves insufficient resources for future-oriented investments.
• Limited capital formation constrains employment generation, industrial competitiveness and long-term economic growth.
• Fiscal stress has also contributed to migration of skilled youth seeking better employment opportunities outside the State.

Understanding State Debt:

Why State Debt Should Not Be Viewed Uniformly:

• Public debt becomes problematic primarily when borrowings finance persistent consumption without improving future productive capacity.
• Borrowing for infrastructure, education, healthcare, research and productive public investment can strengthen long-term economic growth and future revenue generation.
• Therefore, the quality and utilisation of debt are often more important than the absolute size of debt.

How States Borrow:

• States primarily raise funds through State Development Loans (SDLs) issued in the domestic bond market.
• Domestic investors such as banks, insurance companies and financial institutions purchase these securities using household savings.
• Thus, State borrowing largely mobilises domestic savings for public investment.

India and China's Subnational Financing Model:

China's Approach:

• Provincial and local governments undertake a large share of infrastructure-led development.
• Financing sources include:
• Local Government Bonds (LGBs),
• Land sale revenues,
• Local Government Financing Vehicles (LGFVs),
• Central fiscal transfers.
• Strong coordination between central planning and local investment supports long-term growth.

India's Constraints:

• Indian States borrow mainly through SDLs, generally at higher interest rates than the Union Government.
• Higher borrowing costs increase debt servicing burdens and reduce resources available for developmental expenditure.
• Borrowing ceilings imposed under fiscal responsibility frameworks further restrict investment capacity.

Challenges in State Finances:

Major Fiscal Challenges:

• High committed expenditure crowds out productive capital investment.
• Rising interest payments reduce fiscal flexibility.
• Limited taxation powers constrain independent revenue generation.
• Increasing dependence on borrowings creates long-term fiscal liabilities.
• Higher borrowing costs compared to the Union Government raise debt servicing burdens.
• Fiscal stress may weaken infrastructure creation and employment generation.

Way Forward:

Strengthening Fiscal Federalism:

• Enhance predictability and transparency in Union-State fiscal transfers.
• Rationalise borrowing limits based on the quality of public investment rather than uniform ceilings.
• Expand fiscal space for well-designed capital expenditure.
• Improve efficiency of public expenditure through outcome-based budgeting.
• Strengthen States' capacity to mobilise own tax revenue and improve tax administration.
• Encourage cooperative fiscal federalism through greater Centre-State coordination.
• Improve debt transparency, medium-term fiscal planning and independent fiscal monitoring.

Constitutional & Institutional Provisions:

Important Constitutional Articles:

• Article 268–281: Distribution of financial resources between the Union and States.
• Article 280: Establishment of the Finance Commission.
• Article 293: Borrowing powers of State Governments.
• Article 275: Grants-in-aid to States.

Important Institutions:

• Finance Commission
• Reserve Bank of India (RBI)
• Comptroller and Auditor General (CAG)
• GST Council

Value Addition for UPSC:

Important Terms:

• Fiscal Deficit: Excess of total expenditure over total receipts excluding borrowings.
• Revenue Expenditure: Expenditure incurred for day-to-day administration and service delivery without creating assets.
• Capital Expenditure: Expenditure that creates durable public assets or enhances productive capacity.
• Committed Expenditure: Mandatory expenditure on salaries, pensions and interest payments.
• State Development Loans (SDLs): Market securities issued by State Governments to raise funds.
• Vertical Fiscal Imbalance: Mismatch between taxation powers and expenditure responsibilities across different levels of government.
• Cooperative Fiscal Federalism: Collaborative financial coordination between the Union and States to ensure balanced development