Rising State Debt and India’s Fiscal Federalism: Structural Challenges and the Way Forward
Context
Economist Jayan Jose Thomas has highlighted the growing debt burden of Indian states, arguing that it stems from a structural imbalance in India’s fiscal federalism. While states shoulder the bulk of expenditure on public services and development, their authority to raise revenues remains limited, compelling them to depend heavily on borrowings.
India’s Fiscal Federalism and State Debt Dynamics
Overview
What is the Issue?
India’s fiscal structure assigns the Union Government greater control over major tax sources, whereas State Governments are responsible for most public spending, including healthcare, education, agriculture, irrigation, and social welfare. This mismatch between revenue generation and expenditure obligations forces states to finance deficits through loans.
Major Indicators of Fiscal Stress in States
1. Limited Share in Central Tax Transfers
Although states like Kerala have strengthened their own tax collections—earning nearly 1.5 times the national average per capita revenue—their allocation from the Union’s divisible tax pool remains comparatively modest. Kerala, for example, received only 1.92% of tax devolution despite accounting for around 2.6% of India’s population in 2023–24.
2. Restricted Capital Investment
A significant portion of state finances is devoted to recurring expenditures. In Kerala, nearly 90% of the budget is consumed by routine revenue expenditure, leaving only about 10% available for capital investments such as infrastructure and productive assets.
3. Heavy Committed Expenditure
Fixed obligations continue to constrain fiscal flexibility:
- Government salaries account for roughly 20% of expenditure.
- Pension payments constitute 15.3%.
- Interest payments consume nearly 16.5% of the state budget.
4. Low Credit Utilisation of Bank Deposits
Kerala’s Credit-to-Deposit (CD) Ratio is around 66%, lower than the national average of 76%, indicating that a considerable portion of local savings remains underutilized instead of financing state-level investments.
5. Costly Market Borrowing
States raise funds through State Development Loans (SDLs) at interest rates of 6.5–7.5%, typically 0.25–0.75 percentage points higher than the borrowing cost of the Union Government.
Major Structural Challenges Before States
1. Limited Capacity for Human Capital Investment
Weak fiscal capacity restricts investments in quality universities, research institutions, innovation centres, and modern transport infrastructure, encouraging migration of skilled youth to other states and countries.
2. Constraints in Reducing Revenue Expenditure
States cannot significantly reduce expenditure on salaries, pensions, healthcare, education, and welfare schemes without affecting essential public services and social development achievements.
3. Growing Gap Between Private Prosperity and Public Finances
Private wealth may continue to rise while public finances remain constrained, limiting investment in infrastructure and increasing regional inequalities.
4. Rising Debt Servicing Burden
An increasing share of fresh borrowings is used to repay interest on previous loans rather than financing productive capital assets, creating a persistent debt cycle.
5. High Cost of Public Financing
Compared to several countries, Indian states face relatively expensive borrowing costs, reducing their capacity to invest in long-term infrastructure projects.
Comparative Perspective: China’s Local Government Financing Model
China’s rapid infrastructure development has been driven largely by provincial and local governments. They mobilize financial resources through multiple channels:
- Local Government Bonds (LGBs)
- Revenue from land sales
- Local Government Financing Vehicles (LGFVs)
Supported by abundant domestic savings and coordinated financial planning, Chinese local governments are able to access funds at much lower borrowing costs than Indian states.
Way Forward
1. Reform the Tax Devolution System
Revise the Finance Commission’s devolution formula to adequately reward states that efficiently mobilize their own tax revenues while ensuring equitable resource distribution.
2. Channel Idle Domestic Savings into State Development
Develop institutional mechanisms that enable surplus bank deposits to finance state infrastructure and development projects.
3. Reduce Borrowing Costs for States
Introduce Union-backed guarantees or coordinated borrowing frameworks to lower interest rates on State Development Loans (SDLs) and reduce debt-servicing pressure.
4. Increase Capital Expenditure
Gradually shift expenditure priorities toward productive investments such as transport infrastructure, industrial corridors, digital infrastructure, irrigation systems, and research facilities.
5. Strengthen Portable Social Security
Develop inter-state mechanisms that allow healthcare, pensions, and other welfare benefits to remain portable for migrant workers across India.
Conclusion
State borrowing should not be viewed solely as a fiscal burden. When used to finance education, healthcare, infrastructure, agriculture, and other productive investments, it strengthens long-term economic growth and human development. Reforming India’s fiscal federal framework, improving tax devolution, reducing borrowing costs, and enabling states to better utilize domestic financial resources can promote balanced regional development and enhance the country’s overall economic resilience.
Source : The Hindu