State Finances Signal a Federal Reset: More Autonomy, Smarter Spending, Safer Debt
From tax powers to borrowing norms, the RBI flags why India’s fiscal federal framework needs redesign, not incremental repair
A background note can be accessed here: RBI’s Report on State Finances 2025-26
Dr. V. N. Alok: Professor, Indian Institute of Public Administration (IIPA)
Madhulika Jatoliya: Consultant, Indian Institute of Public Administration (IIPA)
SDG 8: Decent Work and Economic Growth | SDG 10: Reduced Inequalities
Reserve Bank of India | Ministry of Finance
The RBI study highlights how central transfers, devolution, and state own-tax efforts shape fiscal space, with wide variation in revenue performance across states. How should India’s intergovernmental fiscal architecture be recalibrated to strengthen state fiscal autonomy while preserving equity?
In a multi-order federal system, sub-national fiscal autonomy is key to maintaining fairness. In 2025-26, states’ own tax revenues (SOTR) averaged about 6.8 percent of gross state domestic product (GSDP) and although its share in total revenue receipts rose from 46 percent in 2021-22 to 50 percent in 2024-25, many poor or small states still depend on intergovernmental fiscal transfers (IGFT) for over two-thirds of their revenues. Thus, in efforts to strengthen the fiscal autonomy of states, expanding the own-tax base should be the priority.
Strengthening states’ taxation powers - like amending Article 276 and allowing the states to fix rates on profession tax, broadening tax bases after GST changes, streamlining non-shared cesses and surcharges, and gradually bringing petroleum, supply of electricity and real estate into the tax net - will boost fiscal autonomy and responsibility. Market-linked property tax valuations, especially in urban areas, can further enhance revenues.
Secondly, since central tax devolution constitutes about one third of states revenue, rethinking devolution criteria is critical. Horizontal distribution formulas overemphasise equity criteria (income distance, population), and underweight efficiency parameters (fiscal discipline, tax efforts). The Future Union Finance Commission should balance equity and efficiency criteria and discourage squandermania by states. In addition, it should review the high weights to static metrics such as 2011 census population, consider demographic challenges (like an aging population and workforce ratios), rolling averages and unexpected events like climate changes or health crises. Finally, designing an IGFT system that matches incentives with fiscal capacity, need and performance would be beneficial. Grants linked to specific outcomes (like women safety, potable drinking water, primary education results, primary healthcare access, or GST compliance) can encourage efficiency while ensuring fair distribution. These reforms together would strengthen state autonomy, reward efforts, and ensure fairness across India’s varied regions.
State budgets continue to be dominated by revenue expenditure, limiting room for capital spending and development outlays. What structural budgeting reforms could enable states to reallocate toward growth-enhancing investments without compromising essential services?
States face a real challenge in investing in infrastructure, education, and climate resilience without cutting back on essential services because most of their revenue is tied up in committed expenditures like salaries, pensions, interest payments, and subsidies. The RBI’s State Finance Study and an ICRA survey show that these committed expenditures account for 62 percent of states’ revenue receipts. Further, in recent years, several states have started giving unconditional cash transfers. Such practices leave little room for investments essential for growth. Thus, states need smarter budgeting to use funds effectively and boost growth.
First, states should use outcome-oriented budgeting linking allocations to measurable performance indicators such as women safety, access to potable tap water, improved children’s learning outcomes, primary healthcare access, and infrastructure. This improves service delivery, reduces inefficiencies and prioritises high-impact social services that have direct links to productivity, without cutting essential services.
Second, states need to review where funds are actually being allocated. Many subsidies lack proper targeting and several central schemes overlap with each other. Streamlining these programs, outlawing freebies and asset monetisation would free up budget space for real investment, while maintaining safety nets for vulnerable populations.
Third, integrating medium-term expenditure frameworks (MTEFs) into state budgets can improve planning and predictability. Long-term limits for major spending categories, based on realistic revenue forecasts, would help stabilise investment and prevent ad-hoc cuts and improve transparency and performance monitoring across budget cycles.
Together, outcome-orientation, programme rationalisation, and MTEFs can help states balance priorities, strengthen fiscal discipline, and allocate resources for growth while maintaining the provision of essential public services.
The study notes elevated state debt levels and uneven fiscal buffers in the face of asymmetric shocks. In a system with limited market discipline, how can India design risk-sensitive borrowing frameworks to improve debt sustainability and incentivise prudent fiscal management?
To improve debt sustainability, India’s subnational borrowing framework should move away from rigid, uniform limits to adopt flexible mechanisms reflecting states’ financial health and economic conditions. The RBI report states that the total outstanding liabilities of states are expected to reach about 29.2 percent of GDP by March 2026, with significant differences across states. It also highlights that state borrowings heavily depend on the market and have shifted from standard 10-year State Development Loans (SDL) issuances to a wider range of longer maturities. This situation creates risks from refinancing pressures and interest rate changes, and thus requires a shift from standard deficit limits to emphasise the quality and structure of borrowing. Flexible debt goals tied to income and growth, staggered maturities, and market-timed borrowing can reduce costs and avoid crowding out private investment.
Second, establishing independent state credit ratings based on clear fiscal metrics such as debt-to-GSDP, revenue effort, contingent liabilities, and pension burdens would bring market discipline without harsh consequences. These ratings could differentiate borrowing costs or limits, rewarding stronger performers with lower costs or more access, while encouraging weaker states to improve their governance and fiscal management.
Third, improving the disclosure of off-budget and contingent liabilities, along with regular stress testing, would increase transparency, risk evaluation and encourage sustainable borrowing. Finally, it’s essential to acknowledge demographic variations among states, permitting younger regions to invest in promoting growth, while guiding older states to manage liabilities and implementing reforms to increase revenue – ensuring that market borrowing supports development instead of fiscal strain.
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