1. Context: Changing Nature of State Finances in India’s Federal System
The Union Budget has traditionally been a critical instrument for States to assess the stability and adequacy of Central tax devolution. This devolution was expected to act as a shock absorber, enabling States to meet routine expenditure and respond to economic fluctuations.
However, recent trends indicate that tax devolution is no longer playing this stabilising role. Instead, States are increasingly turning to market borrowings to finance even their day-to-day revenue expenditure.
This shift signals a structural change in India’s fiscal federalism, with implications for macroeconomic stability, intergovernmental trust, and long-term development planning.
If this evolving context is ignored, fiscal stress at the State level may translate into broader systemic risks for the national economy.
Stable intergovernmental transfers are foundational to cooperative federalism and fiscal sustainability.
2. Rising Dependence on State Development Loans (SDLs)
State Development Loans (SDLs) have emerged as a key financing instrument for States, replacing predictable revenue inflows with debt-based financing. What was once an exceptional recourse has become routine.
The scale of dependence is unprecedented. In 2024–25 (Revised Estimates), SDLs accounted for about 35% of Tamil Nadu’s total revenue receipts and nearly 26% of Maharashtra’s, levels that would have been fiscally alarming a decade ago.
This trend accelerated after 2020–21, when the COVID-19 shock exposed the inadequacy of Central devolution in cushioning State finances. Crucially, the dependence on borrowing has not reversed since.
If unchecked, routine expenditure funded through debt risks normalising fiscal fragility.
Statistics: SDLs as share of revenue receipts (2024–25 RE): - Tamil Nadu: ~35% - Maharashtra: ~26%
Debt substituting for assured revenue undermines fiscal resilience.
3. Post-Pandemic Fiscal Stress and Borrowing for Revenue Expenditure
The pandemic marked a turning point in Centre–State fiscal relations. As revenues collapsed, States resorted to borrowing not merely for capital investment but also for routine spending.
Borrowings by profit-making State PSUs and Special Purpose Vehicles (SPVs) are increasingly used to finance salaries, pensions, and welfare schemes. This blurs the line between productive and consumptive debt.
Such practices weaken fiscal transparency and defer the burden to future budgets without creating corresponding growth-enhancing assets.
If this pattern persists, States risk entering a debt trap where servicing past borrowings crowds out developmental expenditure.
Revenue expenditure financed through debt erodes intergenerational fiscal equity.
4. Erosion of Effective Tax Devolution Despite Constitutional Guarantees
The 15th Finance Commission fixed States’ share at 41% of the divisible pool, reinforcing the principle of fiscal autonomy. However, the effective flow of resources has been diluted.
The growing reliance on cesses and surcharges, which lie outside the divisible pool, has reduced the share of taxes actually devolved to States. This weakens the predictability of State revenues.
As a result, formal devolution figures mask a substantive centralisation of fiscal power.
Ignoring this erosion risks hollowing out the constitutional promise of cooperative federalism.
“The essence of federalism lies not merely in constitutional form, but in fiscal substance.” — B.R. Ambedkar
Fiscal federalism fails when constitutional shares do not translate into usable resources.
5. GST and the Weakening of the Tax Effort–Reward Link
The introduction of the Goods and Services Tax (GST) in 2017 significantly altered State revenue structures. A large share of indirect tax revenues is now collected by the Centre and redistributed through formula-based transfers.
For industrialised States with a strong indirect tax base, this has weakened the link between tax effort and fiscal reward. States that generate higher revenues do not necessarily retain proportional fiscal benefits.
This disincentivises efficiency and complicates long-term fiscal planning at the State level.
If unresolved, this may reduce States’ motivation to expand their own tax bases.
Fiscal incentives shape governance outcomes as much as legal mandates.
6. Welfare Commitments and Crowding Out of Capital Expenditure
States face rising welfare obligations, including pensions for the elderly and retired employees, and mass health insurance schemes for the poor. These are politically and socially non-negotiable.
Increasingly, such commitments are being financed through domestic borrowing rather than stable revenue streams. This constrains fiscal space for public capital expenditure.
Reduced public investment, in turn, limits private investment and undermines the sustainability of economic growth.
If welfare spending crowds out capital formation, long-term growth prospects weaken.
Short-term social protection cannot substitute for long-term growth financing.
7. Comparative Evidence from Major States
Borrowing patterns across Punjab, Uttar Pradesh, Tamil Nadu, Maharashtra, and West Bengal over the last five years reinforce the systemic nature of the problem.
West Bengal, despite being structurally dependent on Central devolution — averaging about 47.7% of revenue receipts over five years — continued heavy market borrowing.
SDLs constituted roughly 35% of West Bengal’s revenues on average, even as nominal tax devolution increased. This highlights that higher devolution alone has not reduced borrowing dependence.
West Bengal: - Average Central devolution share: ~47.7% - SDLs as share of revenues: ~35%
Structural dependence does not insulate States from debt accumulation.
8. Macroeconomic and Federal Implications
The growing reliance on debt as the primary shock absorber signals a steady erosion of State fiscal autonomy. As debt-to-GSDP ratios rise, assured revenue streams weaken.
This has macroeconomic consequences, including higher interest burdens, reduced fiscal flexibility, and potential spillovers into the broader financial system.
If borrowing replaces devolution as the norm, fiscal sustainability itself comes under strain.
“Fiscal federalism is not merely about sharing resources, but about sharing risks.” — Finance Commission Principle
Debt-driven federalism amplifies rather than absorbs economic shocks.
9. Way Forward: Recalibrating Fiscal Federalism
India requires higher effective devolution, not just higher nominal shares. This necessitates addressing the expanding use of cesses and surcharges.
There is also a strong case for reworking horizontal devolution criteria to assign greater weight to tax effort and efficiency, especially for revenue-generating States.
Bringing cesses and surcharges into the divisible pool would restore transparency, predictability, and trust in Centre–State fiscal relations.
Policy measures:
- Include cesses and surcharges in the divisible pool
- Rebalance devolution criteria towards tax effort
- Reduce reliance on debt for routine expenditure
Predictable revenue, not perpetual borrowing, sustains cooperative federalism.
Conclusion
The increasing reliance of States on market borrowing reflects a deeper weakening of India’s fiscal federal architecture. Restoring effective tax devolution, strengthening the link between tax effort and reward, and curbing excessive centralisation are essential to preserve fiscal sustainability. Without these reforms, debt — rather than constitutional transfers — will define Centre–State relations, with long-term costs for growth and governance.
