Even as the Centre pursues fiscal consolidation, the financial health of India’s States is emerging as a growing macroeconomic concern. Budget estimates for FY26 suggest that a significant number of States are stretching their fiscal limits, raising questions about debt sustainability, quality of spending, and the long-term credibility of India’s federal fiscal framework.
Why State deficits are widening
As many as 13 States have budgeted fiscal deficits above 3.5 per cent of their Gross State Domestic Product (GSDP) for FY26. Larger States such as , , and are projecting deficit ratios exceeding 4 per cent. Given the well-documented tendency of States to overestimate revenue receipts, actual deficits could turn out significantly higher.
Compounding this stress is the outlook for central tax revenues. Slower growth in the Centre’s direct and indirect tax collections in FY26 would translate into lower tax devolution, further squeezing State finances that are already under pressure.
The capex push: a rare positive signal
One notable improvement in State finances has been the rise in capital expenditure. This has been largely supported by the Centre’s 50-year interest-free loans, encouraging States to invest in irrigation, water supply, transport, and urban infrastructure. Such spending has strong multiplier effects and supports medium-term growth, making it a desirable component of fiscal expansion.
Revenue expenditure and the RBI’s warning
The concern, however, lies on the revenue side of State budgets. A recent study by the has flagged the growing use of populist doles in FY26 budgets. These include farm loan waivers, free electricity, subsidised public transport, unemployment allowances, and direct cash transfers to women.
While some welfare spending is defensible on equity grounds, a proliferation of such schemes during a period of revenue uncertainty risks crowding out productive expenditure and deepening fiscal stress. The pressure is set to intensify further with payouts related to the Eighth Pay Commission expected to raise revenue expenditure from FY28 onwards.
Rising debt and off-budget risks
State borrowing requirements are projected to exceed the ₹12.45 lakh crore budgeted for FY26. At the aggregate level, outstanding State debt has risen to around 29.2 per cent of GDP—well above the 20 per cent benchmark recommended by the FRBM Review Committee. Debt ratios vary widely across States, ranging from under 20 per cent to over 45 per cent of GSDP, with several States already breaching the 30 per cent mark.
Adding to the opacity are off-budget borrowings. Outstanding guarantees extended by States to public sector undertakings stood at nearly 3.9 per cent of GDP by March 2024 and are likely to have increased further, masking the true fiscal burden.
Transparency and the case for new fiscal metrics
To address these risks, greater transparency is essential. The adoption of a uniform accounting framework by 2027–28, as mandated by the , would improve comparability and credibility of State finances. There is also a growing argument for shifting the focus from annual fiscal deficit targets to debt-to-GSDP ratios, which better capture long-term sustainability and may allow limited flexibility in productive spending.
How States can stabilise their finances
Ultimately, durable fiscal correction must come from within the States. Augmenting own tax revenues through improved compliance, deeper digitisation, and rationalisation of exemptions is critical. Non-tax measures such as land and asset monetisation, time-bound amnesty schemes, and market-linked pricing for certain public utilities can provide additional fiscal space. Above all, expenditure decisions driven primarily by electoral considerations need to be restrained to preserve fiscal credibility.
What to note for Prelims?
- Fiscal deficit and debt-to-GSDP ratios of States
- Role of RBI in monitoring State finances
- Off-budget borrowings and State guarantees
- FRBM Review Committee recommendations
What to note for Mains?
- Centre–State fiscal coordination and debt sustainability
- Trade-off between welfare spending and fiscal discipline
- Capital expenditure versus revenue expenditure quality
- Need for transparency and accounting reforms in State finances