When the Union Collects and the States Borrow
Why fiscal federalism, not fiscal discipline is the real debate.
Every few months, a familiar alarm is sounded: Indian states are drowning in debt. Reports are cited, charts are shared, and the phrase “fiscal risk” does the rounds on social media. The most recent trigger is a CAG analysis pointing out that state borrowing has more than tripled over a decade from ₹17.6 lakh crore in 2013–14 to ₹59.6 lakh crore by 2022–23. That is a large number, and it deserves attention.
But large numbers, by themselves, don’t explain much. The real question is not whether state debt has risen it clearly has but why it has risen, and whether the structure of India’s federal system quietly pushes states in this direction. Once you look at the plumbing of public finance, the story begins to look less like fiscal recklessness and more like a design problem.
The Missing Half of the Debt Story
Start with a simple imbalance. Indian states are responsible for about 60% of public spending. They run schools and hospitals, build roads, provide electricity subsidies, fund welfare schemes, and manage day-to-day public services that citizens actually experience. But when it comes to raising money, states collect only around 40% of public revenues.
This gap is not accidental. Over time, taxation powers have steadily moved upward. The introduction of GST, for example, simplified the tax system and reduced inter-state barriers, but it also left states with very limited control over tax rates. Their own revenue sources are narrow, politically sensitive, and often slow-growing.
What GST and tax devolution have done, as several surveys note, is to stabilise state revenues not expand them. Meanwhile, spending responsibilities have only increased. The result is predictable: borrowing fills the gap. Seen in this light, rising state debt is not just a fiscal outcome; it is a structural feature of how India’s federal finances are organised.
This is why the right question is not “Why are states borrowing so much?” but “Why are states required to borrow to do what they are constitutionally expected to do?”
How Big Is State Debt and How Fast Has It Grown?
The scale of the increase is undeniable. According to CAG data, total state debt rose from about ₹17.6 lakh crore in FY2014 to ₹59.6 lakh crore in FY2023, a more than threefold jump in under a decade. By FY2024, outstanding state debt had climbed further to around ₹67.9 lakh crore, roughly 23.4% of GDP.
Looking ahead, estimates suggest that in FY2025, states’ combined liabilities will reach about 27.5% of GDP. For comparison, the Centre’s debt stands at roughly 56% of GDP. Put together, general government debt—Centre plus states—adds up to around 82% of GDP.
This also means that nearly one-third of India’s public debt now sits with state governments. That is a large share by international standards and well above the 20% of GDP ceiling recommended by the FRBM framework for states.
A Federation Where States Spend Big and Borrow Big
India’s fiscal structure is unusual among federations. States account for around 60% of total public expenditure, yet they carry roughly 30% of total public debt. This is not because states are especially profligate; it is because they are the primary delivery arm of the state.
Health, education, irrigation, urban infrastructure, social welfare—these are not optional line items. They are politically visible, socially essential, and often counter-cyclical. When growth slows or crises hit, spending pressures rise precisely at the state level, while revenue flexibility remains limited.
The PRS Legislative Research numbers make this clear. By FY2025, state debt at 27.5% of GDP combined with Centre debt at 56% takes India’s general government debt to about 82% of GDP. In other words, state finances are not a side issue they are central to the country’s overall fiscal health.
Not All States Are in the Same Boat
Aggregate numbers hide sharp differences across states. Some states are deeply stretched; others remain fiscally conservative.
In FY2023, Punjab’s debt-to-GSDP ratio was around 40%, and some estimates place it closer to 50%. Nagaland stood at about 37%, West Bengal at 34%, and Tamil Nadu was also well above 30%. Kerala and Rajasthan fall into the same high-debt bracket.
At the other end of the spectrum, Odisha stands out with a debt ratio of just 8.5%. Maharashtra (14.6%), Gujarat (16.4%), and a few others remain below the 20% mark.
What is striking is that only a handful of large states Gujarat, Odisha, West Bengal, and Maharashtra have managed to reduce their debt ratios over the past decade. For most others, debt relative to state GDP has risen steadily, often by double-digit percentage points.
This divergence matters. It tells us that while the system nudges all states toward borrowing, policy choices still matter. But it also tells us that expecting all states to converge to a single debt norm may be unrealistic.
When Rules Are Broken by Design
The FRBM framework sets a clear benchmark: state debt should not exceed 20% of GDP. Today, that benchmark is more aspirational than real. As of FY2025, only 3 of 28 states meet this target. Eight states are above 30%, and projections suggest Punjab could cross 50% in the coming years.
This is often framed as a failure of discipline. But it is worth asking whether the rule itself fits the environment. When states are responsible for the bulk of social and capital spending but lack commensurate revenue powers, breaching the ceiling becomes almost inevitable.
In absolute terms, state debt at about 22% of national GDP in 2023 is now comparable to the Centre’s share. Together, they account for nearly all public borrowing in India. Any serious discussion of fiscal consolidation must therefore include fiscal federalism, not just deficit targets.
Is the Debt at Least Sustainable?
Here, the Reserve Bank of India offers a more measured view. Despite elevated debt levels, the RBI argues that state debt remains broadly sustainable at the aggregate level.
The intuition is simple. As long as the economy grows faster than the cost of borrowing, debt becomes easier to manage over time. When incomes rise, tax bases expand, and yesterday’s loans shrink relative to the size of the economy.
This logic helps explain why consolidated state liabilities fell from 31% of GDP in March 2021 to 28.1% by March 2024. Strong nominal GDP growth and post-pandemic fiscal tightening both played a role.
However, this is not a permanent comfort. The RBI also notes that state debt is budgeted to rise again to about 29.2% of GDP by March 2026. That is why it calls for a clear, transparent, and time-bound glide path not sudden austerity, but credible long-term planning.
2. Why Are States Borrowing More?
Looking Beyond the Headline Debt Numbers
If rising state debt were simply the result of reckless spending, the diagnosis—and the cure—would be straightforward. Tighten budgets, cut waste, and move on. But India’s state finances do not work that way. The surge in borrowing reflects deeper institutional constraints that shape how states raise money, how they spend it, and what options they realistically have when revenues fall short.
To understand why borrowing has become routine rather than exceptional, one must look at how India’s federal system allocates power, responsibility, and risk.
The Built-In Revenue–Expenditure Mismatch
At the heart of the issue lies a structural imbalance that is often acknowledged but rarely confronted head-on. Indian states are responsible for about 60–61% of total public expenditure, yet they directly control only around 38–40% of total revenue collection. This gap is not the result of mismanagement; it is built into the design of India’s fiscal federalism.
Most broad-based and fast-growing taxes—income tax, corporate tax, customs duties, and now GST are collected by the Centre. States rely on a combination of tax devolution, grants, and borrowing to finance their responsibilities. Under the GST regime, many state-level taxes such as VAT and excise were subsumed into a national pool. While this improved efficiency and reduced fragmentation, it also meant that states lost independent rate-setting power. They cannot raise GST rates on their own, even when local spending pressures rise.
The Loss of Revenue Autonomy After GST
The Goods and Services Tax, introduced in 2017, was a landmark reform. It unified markets and simplified taxation. But it also fundamentally altered state finances.
Before GST, states could adjust VAT rates to manage revenue shortfalls. Under GST, that power was transferred to the GST Council. States now depend on a consumption-based tax whose rates they cannot change unilaterally.
The numbers tell the story. State GST (SGST) collections have averaged about 2.6% of GDP during the GST years, compared to 2.8% of GDP in the four years before GST. The difference may look small, but at scale it matters enormously.
The problem worsened after GST compensation ended in June 2022. For states like Puducherry, Punjab, and Delhi, compensation had made up 10–20% of total tax receipts. Once it vanished, so did a large chunk of fiscal space. These states were forced to borrow simply to sustain existing welfare commitments.
When Devolution Shrinks in Practice
Formally, the 15th Finance Commission recommended that 41% of the Centre’s divisible tax pool be shared with states. In practice, states receive far less.
The reason lies in the Centre’s growing reliance on cesses and surcharges, which are not shareable. Over time, these have expanded sharply:
Cesses and surcharges were about 10% of gross tax revenue during the 11th Finance Commission period.
Around 15% during the 14th.
Nearly 28% during the current 15th Finance Commission period.
As a result, effective devolution has fallen to around 31–32%, well below the headline 41%. This quietly reduces untied funds available to states, even as their constitutional responsibilities in health, education, agriculture, and welfare remain unchanged.
States end up borrowing to finance functions they are legally required to perform but fiscally underpowered to fund.
Who Gets Back What?
The horizontal sharing formula further complicates matters. Transfers are based on criteria such as income distance, population, area, forest cover, and tax effort. The intent is equity but the outcomes are uneven.
For every ₹100 collected by the Centre:
Bihar receives about ₹70 back.
Uttar Pradesh receives ₹46.
Kerala receives ₹21.
Industrial states like Tamil Nadu, Karnataka, and Maharashtra receive significantly less than one rupee per rupee contributed.
This progressive model aims to support poorer states, but it also weakens the fiscal capacity of higher-performing states. Over time, this creates divergence: richer states invest more and grow faster, while high-debt states remain trapped in dependency.
As the 15th Finance Commission itself noted, the system risks creating virtuous cycles for some states and vicious cycles for others.
3. When Most Spending Is Already Spoken For
Even within their existing budgets, states have very little room to adjust. A growing share of state expenditure is committed by default, leaving little flexibility when revenues fluctuate.
By FY2023–24, states were spending about 53% of their total revenue receipts on just three items: salaries, pensions, and interest payments. When subsidies are included, the figure rises to around 62%. These are not discretionary line items. Salaries and pensions are legally and politically hard to cut. Interest payments are non-negotiable. Subsidies, once introduced, are difficult to withdraw.
The stress becomes clearer when we look at individual states. In Punjab, salaries account for roughly 39% of revenue receipts, pensions 15%, interest payments 22%, and subsidies about 31%. Together, these exceed 100% of the state’s revenue receipts. This means Punjab must borrow not just to invest or expand services, but simply to pay wages and service past debt.
States like Kerala, with high social spending, also face heavy fixed costs: pensions alone take up about 19% of revenue receipts, and total “sticky” expenditure reaches roughly 75%. Once these obligations are met, very little remains for new initiatives or capital investment.
The consequence is predictable. When revenue growth slows as it did in FY2024 states cannot compress spending quickly. Borrowing becomes the default adjustment mechanism.
Borrowing to Build and to Clean Up the Past
Not all state borrowing goes toward consumption. A significant share has been used to finance public investment, though often through centrally designed channels.
A major example is the Special Assistance to States for Capital Investment (SASCI) scheme. Between 2020 and 2026, the Centre provided ₹4.01 lakh crore to states as 50-year, interest-free loans for infrastructure. These loans boosted capital spending, but they also sit on state balance sheets as long-term liabilities. During this period, states’ own capital spending remained largely flat; almost all growth in capex came via this scheme.
Similarly, legacy reform programs have left lasting debt footprints. Under the UDAY scheme (2015), states absorbed about ₹1.9 lakh crore of electricity distribution company debt in a single year. This was intended to clean up the power sector, but it permanently raised state debt levels.
Borrowing to Run, Not Just to Grow
One final indicator underscores the depth of the problem: the primary deficit, which measures whether a state’s revenues cover its non-interest expenses. Over the past three decades, states classified as having a “high increase in debt” ran an average primary deficit of 1.8% of GSDP, compared to just 0.6% for states with smaller debt increases.
This tells us something important. For many states, even after accounting for central transfers, revenues are insufficient to fund basic operations. Borrowing is not just financing growth; it is financing the everyday functioning of government.
When interest payments exceed 15% of revenue receipts, capital spending is often squeezed to below 2% of GSDP, far lower than the all-India average of 2.7%. Debt servicing crowds out investment, weakening growth prospects and, over time, the ability to service future debt.
The Hidden Risk: Off-Budget Liabilities
Beyond visible borrowing lies another layer of risk. States routinely guarantee loans taken by state-owned enterprises, especially in the power sector. These contingent liabilities consistently exceed those of the Centre, with DISCOMs accounting for about 44% of all state guarantees.
States such as Telangana, Andhra Pradesh, Uttar Pradesh, and Rajasthan are particularly exposed. When these guarantees are called as they often are during sectoral bailouts they suddenly convert into direct state debt. What appears manageable on paper can deteriorate quickly.
4. When Borrowing Becomes Necessary
The Fiscal Reality States Cannot Escape
In theory, government borrowing is meant for building assets—roads, irrigation systems, schools, power plants things that raise future growth. In practice, Indian states often borrow for a simpler reason: to keep the government running.
This is not because states casually ignore fiscal rules. It is because the structure of their finances leaves very little margin for error. When revenues fall or expenditures spike, borrowing is often the only remaining option.
Crisis Shocks and Forced Borrowing
The clearest illustration came during the COVID-19 shock. As economic activity collapsed, state revenues fell sharply, even as spending needs rose. Health outlays surged, welfare programs expanded, and basic administration had to continue.
The result was an immediate jump in debt. State debt-to-GSDP rose from about 21% in FY2020 to 25% in FY2021. Much of this borrowing did not come from new state taxes it came via the Centre, through GST compensation loans, special borrowing windows, and capital support packages. States borrowed because there was no alternative source of cash.
What matters is what happened next. Even after the worst of the pandemic passed, deficits did not automatically disappear. By FY2024, the CAG reported that 13 states had breached the 20% debt ceiling, and 18 states recorded fiscal deficits above 3% of GSDP. In plain terms, most states were still spending more than they earned.
This means borrowing was not just a crisis response it became a bridge between recurring obligations and insufficient receipts.
Borrowing to Cover the Basics
One uncomfortable reality is that states increasingly borrow to finance routine operating expenses, not just investment.
The CAG’s 2023 audit found that 11 states, including Andhra Pradesh, Punjab, West Bengal, Kerala, Bihar, and Tamil Nadu, used part of their fresh borrowing to meet revenue expenditure. This technically violates India’s fiscal norms, which discourage borrowing for salaries, pensions, or subsidies. But norms do not pay wages cash does.
Tamil Nadu’s latest budget offers a stark example. Only about 26% of net borrowings were directed toward capital expenditure. The rest went to meeting day-to-day obligations such as salaries, pensions, and welfare schemes. Faced with a choice between borrowing and defaulting on payments, state governments choose borrowing every time.
This is not moral hazard; it is arithmetic.
Living with Cash Stress
Even short-term mismatches can force states into debt. In FY2024, 16 states had to tap the RBI’s Ways and Means Advances a short-term borrowing facility meant to handle liquidity crunches.
Three states Telangana, Andhra Pradesh, and Rajasthan accounted for about 62% of total overdrafts, pointing to persistent cash-flow stress rather than one-off events. When receipts are delayed or expenditures cluster early in the year, borrowing becomes a cash-management tool.
This reveals a deeper truth: many states operate close to the edge. Any shock economic slowdown, delayed transfers, unexpected spending pushes them into borrowing territory.
Why State Deficits Matter for the Whole Economy
There is also a macroeconomic implication that is often missed. Even if the Centre tightens its fiscal stance, high state deficits can keep overall government borrowing elevated.
As one analysis puts it, elevated state deficits can keep the aggregate fiscal stance accommodative. Markets increasingly look at general government borrowing, not just the Union budget. Every time combined receipts fall short of combined obligations especially during downturns states are pushed into debt markets to balance their books.
In that sense, state borrowing functions like a fiscal balance-of-payments problem: inflows (revenues and transfers) are structurally weaker than outflows (committed spending). Debt fills the gap.
Recognising this, analysts increasingly argue that India’s fiscal debate must move beyond the Union budget and focus on the general government, Centre plus states.
The Economic Survey 2025 explicitly notes that markets now judge India’s risk based on the combined fiscal deficit, currently around 7–8% of GDP, rather than the Centre’s deficit alone. You cannot fix India’s debt dynamics by tightening one part of the system while ignoring the other.
5. Why the Obsession with Debt Numbers Can Mislead
At this stage, it is tempting to reduce the entire debate to a single ratio: state debt as a percentage of GSDP. Once that number crosses 20%, alarm bells ring. But this fixation risks missing what actually matters in public finance. Debt, by itself, tells us very little unless we ask deeper questions about how it is used, what it costs, and what it crowds out.
Not All Debt Is Created Equal
Two states can carry the same debt-to-GSDP ratio and yet face completely different futures.
One may borrow to build roads, ports, schools, and health systems—investments that raise productivity and attract private capital. The other may borrow to fund subsidies, salaries, and interest payments, generating little long-term return. As former RBI Governor D. Subbarao has pointed out, borrowing that crowds in private investment strengthens growth, while borrowing for consumption simply piles up liabilities and crowds out future activity.
Headline debt figures flatten these differences. A chart showing “state debt at X% of GSDP” does not reveal whether that debt built hospitals or merely postponed hard choices. The quality of spending matters far more than the quantity of debt but it rarely makes the headlines.
The Real Pressure Point: Interest Payments
What strains state finances most is not the stock of debt, but the flow of interest payments.
States’ total interest outgo is now around 150% of their annual own-revenue, and it is growing faster than revenues themselves. Between 2016–17 and 2024–25, interest payments grew at about 10% per year, while revenues grew at 9.2%. This gap compounds quietly over time.
Every additional rupee borrowed today locks in a future claim on state budgets. More money goes to servicing old debt, leaving less for schools, roads, or health care. This is why the debate should focus as much on interest trajectories as on headline debt ratios.
Hidden Liabilities and the Illusion of Clean Balance Sheets
Even official debt numbers may understate the true fiscal burden. States often carry large contingent liabilities, especially guarantees to public enterprises—most notably in the power sector. Losses at electricity distribution companies do not always appear on state balance sheets immediately. When they finally surface, they do so suddenly and expensively.
Past experience shows that these liabilities are often absorbed either by the states themselves or, eventually, by the Centre as seen in schemes like UDAY. This creates an odd paradox: focusing narrowly on reported state debt may exaggerate immediate risk while understating long-term obligations.
At the same time, outright default is rare. Constitutionally and politically, the Centre steps in when necessary. The real concern, therefore, is not solvency in the dramatic sense, but shrinking fiscal room to manoeuvre.
Why the 20% Rule May Be Too Crude
The FRBM framework’s 20% debt-to-GSDP limit for states is often treated as sacrosanct. But research suggests this threshold may be too blunt an instrument.
A study by the National Institute of Public Finance and Policy (NIPFP) finds that the optimal debt level for major Indian states is closer to 25% of GSDP. At lower levels of debt—up to about 25%—borrowing can actually improve fiscal outcomes by boosting growth and strengthening future revenues. Interestingly, public debt was found to contribute positively to real growth only after crossing around 22% of GSDP.
The effects also differ across states. Higher debt ceilings could meaningfully raise growth in states with high social spending (such as Kerala) or low baseline growth rates, without making debt unsustainable. A rigid focus on the 20% limit risks suppressing precisely the investment needed to revive lagging regions and stabilise their finances over time.
Transparency Has a Cost Too
The Centre’s 2022 decision to bring off-budget borrowings (OBBs) within states’ net borrowing ceilings was an important transparency reform but it came with trade-offs.
Consider Telangana. In 2021–22, its off-budget borrowings accounted for over 50% of all such borrowings across states. Once these were included, its true debt was revealed to be 38% of GSDP, far higher than the reported 28%.
Following the policy change, off-budget borrowings fell by over 70% in 2022–23. Transparency improved but states also lost a key channel for financing infrastructure and utilities. Without alternative revenue sources or higher transfers, many capital projects stalled. Cleaner balance sheets came at the cost of slower development.
Productive vs. Unproductive Debt: The Real Test
Ultimately, the sustainability of debt depends on how it is used.
States like Odisha have managed debt prudently by keeping primary deficits low and directing borrowing toward productive assets. In contrast, states such as Kerala, Punjab, and West Bengal increasingly borrow to service interest and fund operational expenses a cycle that neither boosts growth nor improves welfare in the long run.
Economic stability, therefore, cannot be judged by static ratios alone. It depends on the evolving relationship between growth, inflation, borrowing costs, and spending quality. Focusing solely on “mountains of debt” risks drawing the wrong conclusions.
6. What This Reveals About India’s Fiscal Federalism
Seen in totality, the rise in state debt is not a narrow fiscal failure it is a signal about how Indian federalism actually works.
India is, in effect, a two-layer fiscal union. Managing one layer while ignoring the other is no longer viable.
Think General Government, Not Just the Union Budget
Macroeconomic stability now depends on the combined fiscal position of the Centre and states. With the Centre running deficits of 4–5% of GDP and states at 3–3.5%, the relevant number is the aggregate deficit of 8–9%.
Markets have already made this shift. As the Economic Survey 2025 notes, investors increasingly judge India’s fiscal risk based on general government borrowing, not just the Union Budget. Fiscal responsibility, therefore, must be coordinated across levels of government.
Incentives Matter and They Need Fixing
Current transfer rules may unintentionally reward fiscal stress. Research by Eichengreen and Gupta (NCAER) notes that Finance Commissions are mandated to allocate more resources to states with larger revenue deficits, creating a form of moral hazard.
One proposal is to explicitly factor fiscal responsibility into transfer formulas. Another is conditional debt relief for highly indebted states, paired with stricter oversight. The goal is not punishment, but alignment so that prudence is rewarded, not penalised.
More Power, But With Accountability
If states are to meet their devolved responsibilities, they need more reliable revenue tools whether through higher untied transfers, a share in broader taxes, or limited new levies. But greater autonomy must come with stronger accountability.
Ideas on the table include independent state fiscal councils, tighter transparency norms, and firmer enforcement of FRBM rules. Any new fiscal space should be used to invest productively not simply to expand politically attractive but fiscally costly giveaways.
The Constitutional Fault Line
This debate has now reached the courts. The case of State of Kerala v. Union of India centres on Article 293, which governs state borrowing.
Since all states are indebted to the Union, the Centre has used its consent powers to impose Net Borrowing Ceilings and policy conditions. Kerala argues this turns the Union from a facilitator into a controller, undermining the federal balance set out in the Constitution.
This is no longer just an economic argument. It is a constitutional one.
The Path Forward: Devolution, Not Debt
If India wants to resolve its state debt problem, the solution lies upstream.
Economists suggest three reforms:
Broadening the divisible pool by including part of cesses and surcharges.
Capping cesses at a fixed share of gross tax revenue.
Modernising devolution criteria using composite indices that reward both need and performance.
Until revenues and responsibilities are better aligned, borrowing will remain the glue holding India’s fiscal federalism together. And no amount of scolding states for rising debt will change that reality.
Conclusion: A Debt Problem or a Design Problem?
It is easy to look at rising state debt and reach for moral language: profligacy, populism, fiscal irresponsibility. It is also deeply misleading.
What this story really reveals is not a failure of discipline, but a failure of design. Indian states are asked to do the bulk of the governing to educate, heal, subsidise, insure, and stabilise without being given commensurate control over the purse. When revenues disappoint or obligations rise, borrowing is not a policy choice so much as an accounting identity
The uncomfortable truth is that state borrowing has become the pressure valve of India’s federal system. It absorbs shocks, smooths political promises, finances public investment, and papers over institutional mismatches. In doing so, it keeps the system functioning but at the cost of rising interest burdens and shrinking fiscal space.
The real choice, then, is not between austerity and indulgence. It is between continuing with a model where debt does the heavy lifting, or rethinking the way India shares revenues, risks, and responsibilities. More devolution, fewer cesses, clearer incentives, and greater accountability would reduce the need for borrowing far more effectively than tighter ceilings ever could.
Until that happens, state debt will keep rising not because states are reckless, but because they are rational actors in an imperfect system. And treating a structural imbalance as a moral failure will only ensure that the imbalance persists.
Thank You So Much For Reading!!
Researched By- Naresh and Ayush.
Sources- Moneycontrol, BasisPointInsight, IndianExpress, LiveMint, psrindia, NitiAyog, TOI, ANI News, India Spend, epw, India Today, ctl.nasar.ac.in & nipfp.
There has to be a ceiling on the debt.