State Finances in Transition: Deficits, Debt, and Fiscal Space

State governments anchor India’s fiscal architecture, with combined expenditure exceeding the Centre’s. Their fiscal position has a direct bearing on development outcomes, macroeconomic stability, and cooperative federalism.

After the pandemic-induced spike in fiscal deficit (around 4.1 per cent of GDP in 2020–21), states consolidated, with deficits falling below 3 per cent during 2021–24. That, however, was short-lived, as the consolidated deficit edged up to about 3.3 per cent in 2024–25 and is budgeted similarly for 2025–26. This increase has been driven by slower revenue growth as well as sustained expenditure commitments.

This article examines the linkages between deficits, debt accumulation, and the changing composition of revenues and expenditures.

Fiscal Deficit: From Discipline to Stress and Partial Recovery 

Before 2020, most states broadly adhered to Fiscal Responsibility and Budget Management (FRBM) targets keeping their deficit near 3 per cent of GSDP. COVID-19 induced disruptions and policy measures widened deficits to 4–5 per cent in 2020–21. While afterwards, states started consolidating and brought deficits below 3 per cent during 2021–24, this trend could not be sustained. The deficit rose to about 3.3 per cent of GDP in 2024–25 due to decreasing revenue receipts from lower central grants and is expected to stay at similar levels in 2025–26. 

Though, the aggregate masks wide inter-state variation. Among 18 major states (98.8 per cent of India’s GDP), the highest 2025–26 (BE) fiscal deficits are in Madhya Pradesh (4.7 per cent of GSDP), Andhra Pradesh (4.4 per cent), Rajasthan (4.3 per cent), Punjab (3.8 per cent), and West Bengal (3.6 per cent). Year-on-year, Madhya Pradesh and Rajasthan show further deterioration, while Punjab and West Bengal have recorded notable reductions despite remaining high-deficit. Bihar’s steep decline (–6.2 per cent) largely reflects an unusually high 2024–25 base, driven by front-loaded capex and revenue shortfalls, rather than a structural shift. The persisting deficits feed directly into borrowing patterns, making states’ debt structure central to fiscal sustainability.

The Debt Structure of States and Borrowing Patterns

Fiscal deficits are financed through market borrowings, Central loans, small savings, and other public account liabilities. Market borrowings by the states have risen steadily as a share of GDP, from 13.6 per cent in 2018–19 to 18.7 per cent in 2020–21, before moderating and rising again to 20.1 per cent in 2025–26 (BE), exposing states to interest rate and refinancing risks.

Market borrowings are expected to finance about ₹81 billion, or 76 per cent of the consolidated GFD in 2025–26 (BE), up from ₹78 billion in 2024–25. Gross market borrowings of states and UTs rose 6.6 per cent to ₹107.3 billion in 2024–25. For 2025–26, the budgeted figure stands at ₹124.5 billion. Central loans have also gained prominence post-COVID, including GST compensation loans and the Special Assistance Scheme for Capital Investments— 50-year interest-free loans that, though counted within GFD, reflect policy-driven capex rather than fiscal stress.

States’ consolidated debt declined to 28.1 per cent of GDP by end-March 2024 from a peak of 31 per cent in 2020–21, supported by consolidation and strong nominal GDP growth. However, liabilities remain elevated at around 29 per cent in 2025–26 pointing to persistent financing needs..

Changing Composition of State Finances

Revenue expenditure (net of interest) is the largest share of state spending, spiking to 12.9 per cent of GSDP in 2020–21 and rising again to 12.8 per cent in 2025–26 (BE). Interest payments have stayed sticky at 1.7–1.8 per cent of GSDP (2018–2026), reflecting persistent high debt. Committed expenditure consisting of salaries, pensions, and interest continues to limit fiscal flexibility despite rising capital outlay. Social sector spending overall is estimated at 8.2 per cent of GDP in 2025–26. 

Capital outlay has risen from 2.3 per cent pre-pandemic to 3.0 per cent in 2025–26 (BE), aided by the Centre’s interest-free loan scheme for asset creation, especially in areas related to irrigation, transport, and urban infrastructure. However, committed expenditure (32.4 per cent of total spending), subsidies, and centrally sponsored schemes continue to constrain discretionary spending.

The share of revenue deficit in fiscal deficit has fallen from 46.1 per cent (2020–21) to 6.9 per cent (2025–26 BE), indicating that borrowing increasingly funds productive investment. States’ R&D spending remains muted at 0.2–0.3 per cent of GSDP, concentrated mainly in medical, health, sanitation, and agriculture research. 

On the revenue side, states’ total receipts (excluding borrowings) have remained broadly stable as a share of GSDP in recent years. Own tax revenue, concentrated in SGST, sales tax, excise duties, and stamp duty/registration fees, has improved from 5.9 per cent of GDP in 2020–21 to 7.1 per cent in 2025–26 (BE).

Revenue receipts were constrained in 2023–24 and 2024–25 by falling central grants in the form of GST compensation and post-devolution deficit grants, as the 16th Finance Commission recommended eliminating the post-devolution revenue deficit grants, previously significant for several states including West Bengal, Kerala, Andhra Pradesh, Himachal Pradesh, and Punjab,. Central transfers overall remain stable at around 6 per cent of GDP.

Emerging Issues and Way Forward

A key concern beyond conventional deficit and debt metrics is the rise in off-budget borrowings through state-owned entities such as DISCOMs, which create future repayment obligations and weaken transparency; the 16th Finance Commission has mandated their termination. Contingent liabilities, which include state guarantees, have also been rising, with outstanding guarantees nearly doubling over the past decade, compounded by expanding welfare schemes, subsidies, DBT programmes, and emerging climate-related and disaster expenditures.

Addressing these structural pressures requires a balanced approach that maintains fiscal discipline without losing sight of development needs. States must strengthen revenue mobilisation and use resources more efficiently to create a fiscal space without compromising investment in infrastructure, human capital, and social welfare.

Note: This article was first published in the March 2026 issue of CII ARTHA (Issue 10)