Tamil Nadu has recently appointed a committee headed by economist Montek Singh Ahluwalia to recommend ways to increase state government revenues, which includes taxes as well as other levies.
Maharashtra has slashed the number of women who were getting money from its cash transfer scheme. Four out of every ten beneficiaries have been dropped from the list of beneficiaries, or an estimated 9.2 million women.
Such instances are hopefully indicative of broader attempts by state governments to do something about their deteriorating finances.
Here is the big picture to provide context. Data on state finances collated by the Reserve Bank of India (RBI) shows that the aggregate fiscal deficit of Indian states as a percentage of gross domestic product (GDP) went up from 2.7% in fiscal year 2022-23 to 3.5% in the revised estimates for 2024-25.
This 0.8 percentage point increase in the fiscal deficit of states is exactly equal to the reduction in the fiscal deficit ratio of the Union government, leaving the overall fiscal position of the country unchanged at a time when the burden of high public debt is a continuing concern.
The aggregate numbers hide a diversity of experience that can eventually be a strain on Indian federalism: states with stable finances, those with deteriorating finances and others with brittle finances.
States such as Gujarat and Maharashtra can be placed at one end of the spectrum, while states such as Punjab and West Bengal can be placed at the other end. However, even states that have done well in terms of economic growth have debt ratios that are quite high. Tamil Nadu and Andhra Pradesh are two examples.
The division of responsibilities is clear in the Seventh Schedule of the Constitution. New Delhi is responsible for the debt of the Indian Union. The states are responsible for their respective public debts. This is why there are separate fiscal responsibility legislations for the Union government and each state.
However, in practice, the Centre and RBI have leverage over state governments, which is just as well since the overall financial stability of the country is under their control.
The question then is whether there can be incentives embedded in the fiscal architecture to ensure that states are more careful with the way they manage their public finances.
One option is to link the borrowing costs of states with their underlying fiscal balances. States that have weak public finances should ideally pay a higher interest rate on their borrowings. India has a variant of the problem that Europe grapples with, as Greece could borrow at the same rate as Germany despite their different fiscal profiles.
Another option is that the Union government gives grants to states to fund capital expenditure rather than revenue deficits. The 16th Finance Commission has gone down that road by removing revenue deficit grants to states.
Both options will impose costs on states that do not manage their public finances well. However, such initiatives must be balanced against the fact that inter-state inequality is very high in India, which in effect means that some states have a very weak tax base compared to others.
It could be argued that states with weak tax bases because of poverty should spend less on their citizens, but that flies in the face of the broader social contract that each citizen should get access to a certain level of administration and public services, irrespective of their economic circumstances. Finding a workable balance is as much about politics as it is about economics.
Eventually, the fiscal stability of states will depend on an expansion of the tax base through robust economic growth. The more developed states are generally able to cover a larger slice of their annual expenses through their own tax revenues, which include state GST, state excise duties, stamp duties and vehicle registration fees. These should ideally grow slightly faster than the underlying state economy.
The structure of GST is an important issue here. The original federal bargain that led to the introduction of this new indirect tax in 2017 included a guarantee that states would get compensated in case their tax collections suffered under GST.
The compensation promised was not based on the growth of the tax base. In other words, states were given a revenue guarantee without any consideration of economic growth. States thus had very little incentive to maximize growth.
The Union government was undoubtedly a major reason why India rolled out an unnecessarily complicated GST in 2017, but the states could play along because of the revenue guarantee. The streamlining of the indirect tax system over the past few years, aka GST 2.0, has tried to fix many of these original design problems.
Indian states collectively outspend the Union government thanks to their constitutional mandates as well as the fact that they are closer to the lives of citizens. Their fiscal stability is thus important from an economic as well as political angle. There needs to be a wider debate on whether India now needs to consider different incentives to ensure state finances do not go off the rails.
These options include pricing of state government bonds based on their fiscal situation, discretionary central transfers only for capital spending rather than subsidies, and differentiated fiscal rules for states depending on the state of their finances. All wrapped in a meaningful new federal bargain.
Ananya Sarda contributed to this piece.
The author is executive director at Artha India Research Advisors.