What State Finances Tell Us About the Economy?

General Studies Paper-3

Context

• State finances and budgets reflect both macroeconomic resilience and local governance priorities, from infrastructure and education to healthcare and local employment initiatives.
• Tracking fiscal patterns of states is crucial for broader understanding of the economy.

Fiscal Trends of Indian States: FY2025 Review and Outlook

• The fiscal health of India remains a key pillar of macroeconomic stability. The fiscal trends for major Indian states in FY2025 using provisional actuals (PA), gives evolving fiscal landscape and expectations for FY2026.
• Major Indian states (focusing on 17 states) collectively account for ~90% of India’s GDP.
• Rising Fiscal Deficit in FY2025: The combined fiscal deficit of the 17 states widened to ₹9.5 trillion (3.2% of GSDP) in FY2025 PA from ₹7.8 trillion (2.9% of GSDP) in FY2024.
  • Capital spending contributed, rising by ₹678 billion (0.2% of GSDP).
• Revenue Trends: Revenue receipts growth slowed to 6.3% in FY2025 from 7.9% in FY2024.
  • Revenue expenditure, however, maintained a steady 9% growth, compressing fiscal space and worsening the revenue deficit.
• Centre vs States: While the Centre reduced its revenue deficit, states saw a surge, indicating sub-optimal fiscal quality.
  • A larger share of revenue deficit within total fiscal deficit implies less borrowing room for capital expenditure, which is more productive and growth-inducing.
• Capital Expenditure Patterns: FY2025 capex by the 17 states stood at ₹7.4 trillion, up ₹678 billion from FY2024, but the increase is lower than the FY2022-24 trend of ₹910–1,120 billion annually.
  • Capex undershot the Revised Estimates (RE) by ₹1.1 trillion, whereas the Centre overshot its target.
• Capex Surge: States like Uttar Pradesh, Andhra Pradesh, Madhya Pradesh, Maharashtra, Tamil Nadu, and Karnataka witnessed a 42% YoY spike, reaching ₹2.2 trillion vs ₹1.5 trillion in March 2024.
  • Over 30% of annual capex was executed in March alone — higher than FY2024 — reflecting back-ended spending, often coinciding with March borrowing spikes.
  • The Centre’s special assistance for capital expenditure loans played a pivotal role.

Key Hurdles in State Finances

• Vertical Fiscal Imbalance: The Centre collects the bulk of tax revenue while States carry the burden of core expenditure (health, education, infrastructure).
  • It creates dependency on central transfers and limits autonomy.
• Delayed Transfers and GST Compensation: States often report delays in fund allocation, especially GST compensation, affecting budget planning and execution
  • Disputes within the GST Council and evolving revenue estimates add to uncertainty.
• Borrowing Constraints: The FRBM (Fiscal Responsibility and Budget Management) Act restricts deficit spending, limiting investment in high-impact sectors.
  • States need permission to borrow beyond certain limits—even for welfare schemes or emergency relief.
• Overreliance on Loans and Off-Budget Borrowing: Several States resort to market borrowings or bypass budget scrutiny via public sector enterprises and special purpose vehicles (SPVs).
  • It can obscure debt levels and reduce transparency.
• Populist Spending vs. Productive Investment: In election cycles, revenue may be diverted to freebies and subsidies, leaving little room for capital investment.
• Weak Revenue Mobilization: Many States underperform in generating internal revenue, relying heavily on shareable taxes and grants.
  • Agricultural income – entirely under State domain – remains largely untaxed.

Government Initiatives

• Finance Commission Recommendations:
  • Vertical and Horizontal Devolution: Periodic recommendations on tax sharing and grants-in-aid to ensure equity and efficiency.
  • Performance-Based Incentives: States rewarded for improvements in sanitation, education, and fiscal management (e.g., 15th Finance Commission).
• Fiscal Responsibility and Budget Management (FRBM) Act: Many states have adopted their own FRBM laws to cap fiscal deficits and improve transparency.
  • Encourages medium-term fiscal planning and accountability.
• Atmanirbhar Bharat Borrowing Incentives: States allowed additional borrowing (up to 2% of GSDP) if they implemented reforms in:
  • One Nation One Ration Card;
  • Ease of Doing Business;
  • Power sector;
  • Urban local body revenue enhancement
• GST Compensation Mechanism: Post-GST rollout, the Centre assured compensation for revenue shortfalls.
  • Though time-bound, it helped states transition to the new tax regime.
• Digital Public Financial Management Systems: Platforms like PFMS and e-Kuber streamline fund transfers, track expenditures, and reduce leakages.
  • Enhances transparency and real-time monitoring.
• Debt Consolidation and Sinking Funds: States encouraged to set up Consolidated Sinking Funds for debt repayment.
  • RBI guidelines promote prudent debt management.

Reform Pathways for Strengthening State Finances

• Revenue Mobilization:
  • Property Tax Reforms: Digitization and rationalization to improve collections.
  • Agricultural Income Tax Debate: Some experts advocate taxing high-income farmers under state jurisdiction.
  • User Charges and Non-Tax Revenue: Better pricing of public services to recover costs.
• Expenditure Efficiency:
  • Outcome-Based Budgeting: Linking spending to measurable results.
  • Rationalization of Subsidies: Targeted delivery through DBT to reduce fiscal burden.
• Borrowing and Debt Management:
  • Market-Based Borrowing: States issue bonds with credit ratings to attract investors.
  • Off-Budget Borrowings: Need for transparency in loans taken via PSUs and SPVs.
  • Institutional Capacity Building: State Fiscal Research Units: For evidence-based policy formulation.
  • Training Programs: For local officials in budgeting, forecasting, and compliance.
• Cooperative Federalism:
  • GST Council Reforms: Greater voice for states in rate-setting and dispute resolution.
  • Flexibility in Centrally Sponsored Schemes: Allowing states to adapt schemes to local needs.