The fiscal health and spending capacity of Indian states have been under intense scrutiny, with two recurring questions dominating economic discourse: how did several states manage fiscal deficits exceeding 3% of their Gross State Domestic Product (GSDP), and did expansive welfare schemes come at the cost of crucial capital investment? A detailed analysis of recent fiscal trends provides clear answers and highlights the pivotal role of central government policies in shaping state budgets.
The Mechanics of Enhanced Borrowing Limits
The primary reason for states breaching the traditional 3% fiscal deficit ceiling lies in the additional borrowing permissions granted by the Union government and the 15th Finance Commission (FC) during the FY2021-FY2025 period. States were allowed extra borrowings over their base limit of 3-4% of GSDP, estimated at an additional 0.5% to 1.1%.
This critical fiscal space was created through two major channels:
- Central Loans to States: The Centre disbursed GST compensation loans worth Rs 2.6 trillion in FY2021-FY2022. Furthermore, it transferred a massive Rs 3.7 trillion between FY2021 and FY2025 under the scheme for 50-year interest-free capital expenditure loans.
- Reforms-Linked Borrowings: States that implemented specific reforms, particularly in the power sector as recommended by the 15th FC, availed additional funds. States like Andhra Pradesh, Himachal Pradesh, Kerala, Odisha, Rajasthan, Tamil Nadu, Uttar Pradesh, and West Bengal completed these reforms and accessed a total of Rs 1.3 trillion from FY2022 to FY2025.
Additionally, a carry-forward provision for unutilised borrowing allowed states to soften annual fiscal constraints, a flexibility introduced to support growth amid the pandemic's economic fragility.
Welfare vs. Capital Spending: Striking a Balance
The second question addresses a potential trade-off between social welfare and infrastructure investment. In recent years, many states significantly ramped up direct benefit transfers, including cash transfers to women. Combined spending on such schemes across 11 major states ballooned to approximately Rs 1.5 trillion (0.8% of GSDP) in FY2026, up sharply from just Rs 120 billion (0.1% of GSDP) in FY2023.
Despite this surge, the aggregate revenue deficit of states widened only marginally. Analysis suggests that to finance these new welfare commitments, several states opted to curtail spending under other revenue heads or trim outlays in older schemes. This indicates a re-prioritization within revenue budgets rather than a wholesale sacrifice of capital expenditure.
A Remarkable Surge in State-Led Capital Investment
The most encouraging trend from this period is the substantial rise in state-led capital investment. Bolstered by the central government's capex loans, which expanded from Rs 0.1 trillion in FY2021 to around Rs 1.5 trillion in FY2025, states dramatically increased their infrastructure spending.
The combined capital expenditure and loans & advances of 28 states recorded a healthy compound annual growth rate (CAGR) of 18.5% between FY2021 and FY2025. This growth propelled the total outlay to Rs 8.4 trillion, effectively doubling over the five-year period.
All Eyes on the 16th Finance Commission
The future trajectory of state finances now hinges significantly on the upcoming recommendations of the 16th Finance Commission. Its award will determine key parameters for the coming years, including:
- The formula for sharing central resources with states.
- The base borrowing limits for state governments.
- Provisions for additional borrowing limits or incentives.
- The potential continuation of carry-forward facilities.
These decisions will fundamentally define the fiscal space available to states, influencing their ability to continue driving national economic growth through capital expenditure while managing their social welfare obligations. The delicate balance achieved in recent years offers a valuable template, but the 16th FC's mandate will set the new rules of the game.
