Karnataka's PSU Borrowing Model: A Fiscal Template for States

Off-Budget Borrowing (OBB) refers to borrowings undertaken by state governments through public sector undertakings (PSUs), special purpose vehicles (SPVs), or government-guaranteed entities that do not appear directly on the state’s Budget. These borrowings are typically used to finance subsidies, infrastructure projects, or losses of public utilities, while keeping the official fiscal deficit within legislated limits under Fiscal Responsibility Legislations (FRLs). As a result, OBB creates hidden liabilities that are not immediately visible to legislatures, investors, or citizens.

The major concern with OBB lies in its impact on fiscal transparency and credibility. By keeping substantial liabilities outside the Budget, states mask their true debt position and understate fiscal stress. The World Bank report highlights that OBB has evolved into a quasi-permanent source of funding, effectively circumventing budgetary discipline. This undermines the purpose of FRLs, which were introduced to promote prudent fiscal management and intergenerational equity.

A further problem is the uneven and often unreliable reporting of OBB across states. Large discrepancies between state-reported figures and those audited by the Comptroller and Auditor General (CAG), as seen in Tamil Nadu and West Bengal, erode trust in fiscal data. From a UPSC interview perspective, OBB raises deeper questions about cooperative federalism, accountability in public finance, and whether headline fiscal indicators meaningfully reflect a state’s economic health. Addressing OBB is therefore central to restoring transparency, market confidence, and democratic oversight in India’s fiscal framework.

Karnataka’s 2014 amendment to its Fiscal Responsibility Legislation Act is significant because it expanded the definition of state liabilities to include borrowings of state PSUs and special purpose vehicles. This move acknowledged an important fiscal reality: although such entities borrow in their own name, the ultimate repayment burden often rests on the state, either through guarantees, subsidies, or bailouts. By recognising this explicitly, Karnataka improved the accuracy of its fiscal reporting.

This approach strengthens budgetary control and legislative oversight. When PSU and SPV borrowings are brought onto the state’s balance sheet, they are subjected to the same scrutiny as direct government debt. This reduces incentives to shift expenditure off-Budget merely to comply with deficit targets. The World Bank’s endorsement of Karnataka’s model reflects the view that transparency, even if it reveals higher debt levels, is preferable to opaque accounting that postpones fiscal correction.

For other states, the Karnataka example demonstrates that fiscal responsibility need not be incompatible with development spending. Instead, it encourages honest accounting and better debt management. In an interview context, this case illustrates how institutional reforms at the state level can complement national fiscal objectives and offers a practical pathway for aligning state finances with constitutional principles of accountability and prudence.

One key reason for states’ continued reliance on off-Budget borrowing is the tension between fiscal rules and political economy pressures. States face strong demands to provide subsidies, free utilities, and welfare schemes while adhering to deficit limits mandated by FRLs. OBB allows governments to meet immediate political and social objectives without breaching headline fiscal targets, making it an attractive short-term solution.

Another important factor is the availability of willing lenders. Public sector banks and government-owned financial institutions such as NABARD, HUDCO, REC, and Power Finance Corporation have played a major role in financing state-level OBB, often backed by state guarantees. This has reduced market discipline, as lenders assume implicit sovereign backing and therefore underestimate risk. Between 2018-19 and 2022-23, annual borrowing by states and their entities from PSBs ranged from ₹3.1 trillion to ₹4.9 trillion, underscoring the scale of this phenomenon.

Finally, weak accounting standards and oversight enable OBB to persist. Practices such as routing large expenditures through opaque budget heads like Minor Head 800 – Others obscure the true nature of transactions. Together, these factors create a system where off-Budget borrowing becomes normalised, highlighting the need for structural reforms rather than incremental adjustments.

Opaque accounting practices significantly heighten fiscal and systemic risks. Underreporting of off-Budget borrowing leads to an inaccurate assessment of a state’s debt sustainability, potentially resulting in delayed corrective action. The World Bank’s finding of large discrepancies between state-reported OBB figures and CAG estimates—such as Tamil Nadu reporting ₹594 crore against an audited estimate of ₹12,357 crore—illustrates how severe these distortions can be.

Such opacity also weakens institutional accountability. Legislatures, Finance Commissions, and citizens rely on credible fiscal data to evaluate government performance. When liabilities are hidden or misclassified, democratic oversight is compromised. The use of broad accounting heads like “Minor Head 800 – Others”, accounting for over 15 per cent of expenditure in some states, further obscures fiscal realities and reduces transparency.

From a macroeconomic perspective, these practices can affect financial stability. Banks and investors may misprice risk if state liabilities are understated, increasing vulnerability during economic downturns. A critical analysis therefore suggests that transparency is not merely a technical accounting issue but a cornerstone of fiscal federalism, market confidence, and long-term economic stability.

A consolidated Public Sector Accounting System would integrate the finances of state governments, PSUs, and SPVs into a single, coherent framework. This would ensure that all liabilities—direct or indirect—are captured comprehensively, eliminating the artificial separation between on-Budget and off-Budget activities. Such consolidation would make the true fiscal position of states more visible and comparable across the country.

By enforcing standardised reporting under the supervision of the CAG, as envisaged under Article 150 of the Constitution, this system would strengthen audit and compliance mechanisms. States would be required to disclose guarantees, grants, loans to state-owned entities, revenues kept outside the Consolidated Fund, and revenue forgone through waivers. This would reduce discretion in reporting and improve the credibility of fiscal data.

Over time, improved transparency would enhance market discipline and policy decision-making. Credit rating agencies, investors, and Finance Commissions would be able to assess risks more accurately, encouraging states to adopt sustainable borrowing practices. For UPSC interviews, this reform can be discussed as a key step towards modernising India’s public financial management in a complex federal system.

The Union government’s decision to bring nearly 93 per cent of its off-Budget liabilities, amounting to around ₹3.7 trillion, onto its balance sheet by FY2022 offers an important case study. This move improved fiscal transparency and allowed policymakers to confront the true scale of public debt, even though it temporarily worsened headline deficit and debt indicators.

For states, the key lesson is that short-term political discomfort can yield long-term fiscal credibility. Transparent accounting strengthens investor confidence and enables more effective debt management. It also facilitates informed negotiations with Finance Commissions regarding borrowing limits and transfers, based on realistic assessments rather than understated figures.

The Union’s experience also shows the importance of sequencing reforms—combining transparency with institutional safeguards and medium-term fiscal adjustment plans. States that follow this path can avoid debt traps, improve governance, and align development spending with sustainable public finance. This case study underlines that fiscal reform is as much about political will and institutional design as it is about accounting techniques.