State Finances and Fiscal Sustainability

Context

Recent White Papers released by the Governments of Kerala and Tamil Nadu have highlighted rising debt levels, reviving the debate on the fiscal sustainability of States. The reports suggest that growing debt often reflects structural imbalances in India’s fiscal federal framework rather than fiscal mismanagement.

Core Issue

States shoulder a major share of developmental expenditure despite having comparatively limited revenue-raising powers. This structural imbalance creates persistent fiscal pressures and increases reliance on borrowings.

Fiscal Challenge

A fundamental challenge in India’s fiscal federal system is the mismatch between revenue-raising powers and expenditure responsibilities.

While the Union Government mobilises a larger share of tax revenue, States bear primary responsibility for delivering public services and implementing development programmes, including:

1. Health
2. Education
3. Agriculture
4. Irrigation
5. Rural and urban development

As expenditure commitments often exceed available resources, States depend on borrowing to finance fiscal deficits.

Structural Causes of Fiscal Stress

State finances remain under pressure because developmental responsibilities have expanded faster than revenue-generating capacity. This structural imbalance results in persistent fiscal deficits, increasing dependence on borrowings to sustain public expenditure and development programmes.

Sources of Revenue

States finance their budgets through two principal sources.

Own Revenue

1. State Goods and Services Tax (SGST)
2. State excise duties and sales tax
3. Stamp duty and registration fees
4. Non-tax revenue

Transfers from the Union Government

1. Share in Central taxes (tax devolution)
2. Grants-in-aid
3. Loans and other transfers

Despite these sources, revenue growth often remains insufficient to meet rising expenditure commitments.

Role of Borrowing in State Finances

States primarily borrow to:

1. Finance fiscal deficits.
2. Fund infrastructure and other capital projects.
3. Bridge temporary revenue shortfalls.
4. Support welfare and development programmes.

Borrowing is a normal instrument of public finance and should be assessed by its purpose, quality, and long-term sustainability rather than by the size of debt alone.

Kerala’s Fiscal Position

Kerala illustrates the fiscal pressures faced even by financially stronger States.

1. The State’s own tax revenue is nearly 1.5 times the national per capita average.
2. However, its share in Union tax devolution was only 1.92% during 2023–24, despite accounting for 2.6% of India’s population.

The resulting fiscal gap is bridged through market borrowings, increasing debt servicing obligations.

Expenditure Pattern

A significant share of State expenditure is committed to recurring liabilities, leaving limited fiscal space for productive investment.

In Kerala:

1. Around 20% of expenditure is allocated to salaries.
2. 15.3% is spent on pensions.
3. 16.5% is used for interest payments.

Consequently, only about 10% of the budget is available for capital expenditure, limiting infrastructure creation and long-term asset formation.

Investment Dilemma

States face a difficult policy trade-off.

Reducing expenditure on salaries, pensions, or welfare may create fiscal space for investment but could weaken social development gains. Conversely, inadequate investment in infrastructure, higher education, research, innovation, and public transport constrains productivity, employment generation, and long-term economic growth.

In Kerala, this challenge is reflected in the migration of skilled youth seeking better employment opportunities. At the same time, visible private prosperity alongside constrained public finances points to widening economic disparities.

Comparison with China’s Fiscal Model

China follows a more decentralised model in which provincial and local governments play a leading role in financing development.

Its model is characterised by:

1. Local Government Bonds (LGBs)
2. Local Government Financing Vehicles (LGFVs)
3. Land-based revenue mobilisation
4. Coordinated fiscal planning with the central government

Chinese local governments borrow at around 2%, whereas Indian States raise funds through State Development Loans (SDLs) at approximately 6.5–7.5%. The higher borrowing cost increases debt servicing obligations and reduces fiscal space for development-oriented expenditure.

Reassessing State Debt

State debt should not be viewed solely as an indicator of fiscal weakness. Borrowing that finances infrastructure, human capital, and other productive assets can strengthen long-term economic growth.

Since government borrowing is largely financed through domestic savings mobilised by banks and financial institutions, prudent debt can support development without undermining fiscal stability.

The emphasis should therefore be on ensuring that borrowings finance productive assets and remain fiscally sustainable, rather than focusing solely on the size of debt.

Way Forward

1. Strengthen fiscal federalism through a more equitable sharing of financial resources.
2. Ensure predictable and adequate tax devolution and grants from the Union Government.
3. Improve expenditure efficiency while containing non-essential revenue expenditure.
4. Prioritise capital investment in infrastructure, innovation, research, and human capital.
5. Facilitate access to affordable long-term finance for productive investments.
6. Strengthen cooperative Centre–State coordination in fiscal planning.
7. Maintain fiscal discipline while providing States adequate flexibility for development-oriented borrowing.

Conclusion

Sustainable State finances are essential for strengthening India’s cooperative federal framework and supporting inclusive development. A fiscal architecture that combines prudent debt management, greater fiscal autonomy, predictable resource transfers, and affordable access to long-term finance will enable States to invest in productive assets while sustaining welfare commitments. Such an approach will strengthen public service delivery, promote balanced regional development, and support India’s long-term economic growth.