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State governments are responsible for the bulk of public expenditures on social services, including education, health, and welfare.
They also manage infrastructure services (excluding telecommunications, civil aviation, railways, and major ports), and are tasked with maintaining law and order.
Deterioration in their investment capacity directly impacts human development, internal security, and economic growth.
During the late 1980s, capital expenditure by state governments began to decline.
As with the central government, rising debt service payments became a major fiscal concern for the states.
In addition, other committed expenditures like pensions increased significantly over time.
This combination of falling capital investment and rising fixed costs has restricted fiscal flexibility at the state level.
The decline in central transfers and a rise in the average cost of debt negatively affected state finances, particularly during the 1990s.
As a result, primary expenditure (net of interest payments) as a share of GDP showed a downward trend.
This reflects a shrinking fiscal space for Indian states to invest in essential services and development.
If we exclude wages, salaries, and pension obligations, the residual fiscal space for operations and maintenance as well as new investments in social and economic services has been steadily declining.
In 1994–95, committed expenditures (interest, wages, salaries, and pensions) constituted about \( 65\% \) of total revenue receipts.
By 2002–03, this rose to more than \( 85\% \), leaving minimal room for discretionary developmental spending.
Although the overall fiscal position of Indian states appears grim, the severity of the fiscal crisis varies significantly across states.
Key indicators of variation include:
Levels and quality of the fiscal deficit
Debt-servicing obligations
Size and structure of the debt stock
Available fiscal space for policy initiatives
Between 2004–05 and 2008–09, state finances improved markedly, supported by high economic growth.
This period was seen as a fiscal turnaround, where growth lifted revenues and reduced deficits across most states.
However, beginning in 2008–09, fiscal deterioration returned. According to the RBI’s State Finances: A Study of Budgets, the number of states with revenue deficits rose from four in 2007–08 to 11 in 2009–10.
By 2010–11, nine states had budgeted revenue deficits, and that figure was expected to rise in revised estimates.
State debt has grown faster than output, and many states now budget for revenue deficits.
West Bengal spends over two-thirds of its revenue on interest payments, salaries, and pensions, compared to one-third in Tamil Nadu and Maharashtra, and less than one-fifth in Chhattisgarh.
Reverting to fiscal consolidation is crucial to free up resources for productive investments and complement structural reforms at the state level.
Despite economic liberalisation in 1991, states did not initially take a systematic approach to tax reform.
Reform efforts picked up in the late 1990s, leading to the implementation of a uniform Value Added Tax (VAT) to replace sales tax.
The Central Government played a facilitative role, and the VAT rollout has shown encouraging results.
Economic liberalisation increased competition among sub-national governments, reinforcing the role of incentives in ensuring fiscal prudence.
Key policy innovations include:
(i) State-level FRBM Acts (14 states) for rule-based fiscal control
(ii) Linking transfers to fiscal performance via Finance Commissions
(iii) Use of MoUs for state-specific discretionary transfers
(iv) Sub-national adjustment lending by the ADB and World Bank
(v) Reforms aligned with macro-economic policy adjustments
The core objective of state-level fiscal reform is consolidation through:
Revenue enhancement
Expenditure reduction and restructuring
Subsidy reforms and power sector loss mitigation
Investment financing by states is increasingly unsustainable due to the lack of linkage between borrowing and capital expenditure outcomes.
There has also been a rise in state government guarantees for public sector borrowing directly from the market.
The budgeted gross fiscal deficit of the states is \( 3.2\% \) of SGDP — twice the level in 2007–08.
The adoption of rule-based fiscal policy by state governments has led to improved fiscal discipline.
The key challenge now is to sustain and deepen this consolidation process.
Higher devolutions recommended by the Thirteenth Finance Commission (FC) are expected to strengthen state finances.
Important factors influencing consolidation include:
Implementation of the Goods and Services Tax (GST)
States’ initiatives to raise non-tax revenue
Expenditure prioritisation and rationalisation
Amending state-level FRBM Acts is essential for credible fiscal progress.
Empowering State Finance Commissions will help ensure effective allocation to local bodies, supporting inclusive growth.
This is especially important given the expanding developmental role of local governance.
States with lower per capita income and higher fiscal deficits tend to have larger public debt stock.
This leads to a heavier interest burden and reduces fiscal space for primary expenditure.
After economic liberalisation, fiscal and financial sector reforms at the national level have often weakened sub-national fiscal capacity.
The rising cost of borrowing has further shrunk the states' developmental budgetary space.
Corrective action is needed to ensure debt sustainability and restore fiscal viability.
RBI has rightly pointed out the decline in states’ own tax revenue and emphasised reforms in this area:
(i) Improve tax compliance and collection
(ii) Reduce under-valuation in property to enhance stamp duty collections
(iii) Phase out exemptions under sales tax
On the non-tax front, states must enhance user charges and recover service costs:
Timed tariff revisions (e.g., water supply)
New charges in health, education, veterinary services
Cost recovery from social and economic services
Currently, non-tax revenue is around \( 10\% \) of total revenue — low by international standards.
What is urgently required is strong political will at the state level.
Union Finance should set the benchmark for fiscal responsibility that states can follow.
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