The Tug of War, Fiscal Federalism in Flux as States Navigate Welfare, Capex, and Central Mandates

The Tug of War, Fiscal Federalism in Flux as States Navigate Welfare, Capex, and Central Mandates

India’s economic architecture is fundamentally shaped by the delicate, and often tense, dance of fiscal federalism—the financial relationship between the Union and the states. In recent years, this balance has been stretched, tested, and redefined by a confluence of crises and political imperatives. As Aditi Nayar of ICRA articulates, two critical questions now dominate economic discourse: How have states managed to sustain fiscal deficits beyond traditional limits, and is the burgeoning political economy of social welfare spending cannibalizing the crucial capital investment needed for long-term growth? The answers, emerging from the intricate data of the FY2021-FY2025 period, reveal a story of exceptional central interventions, strategic state choices, and a fiscal landscape whose future hinges almost entirely on the upcoming recommendations of the 16th Finance Commission.

Unpacking the Fiscal Slippage: Not Profligacy, but Permitted Expansion

The first question—how states breached the conventional 3% of Gross State Domestic Product (GSDP) fiscal deficit ceiling—is often framed in public debate as a symptom of fiscal indiscipline. The reality, as Nayar clarifies, is far more structured. The elevated deficits were not a wild departure from norms but a centrally sanctioned and orchestrated expansion of states’ borrowing envelopes in response to extraordinary circumstances.

The baseline fiscal space for states is determined by the Finance Commission, with the 15th FC setting a limit of 3-4% of GSDP for most states (with additional headroom for specific performances). However, the pandemic and its aftermath necessitated a Keynesian-style fiscal push. This was achieved through several parallel channels of “additional borrowing,” amounting to 0.5-1.1% of GSDP beyond the base limit:

1. GST Compensation Loans (Rs. 2.6 lakh crore, FY2021-FY2022): As the GST regime failed to yield the promised revenue growth, the Centre stepped in with back-to-back loans to bridge the compensation gap. While not a grant, these loans were outside the normal borrowing limit, providing crucial liquidity.

2. 50-Year Interest-Free Capex Loans (Rs. 3.7 lakh crore, FY2021-FY2025): Perhaps the most significant lever. The Union government transformed into a long-term, zero-cost financier for state capital expenditure. This scheme exploded from ₹10,000 crore in FY2021 to a staggering ₹1.5 lakh crore in FY2025. It served a dual purpose: it incentivized capex by making it financially attractive for states, while ensuring the Centre retained strategic influence over the infrastructure built across the country. These loans were availed by almost all states, indicating their universal appeal.

3. Reforms-Linked Borrowings: The Centre used borrowing limits as a carrot to drive state-level reforms. In FY2021, ₹1.1 lakh crore was availed by states for undertaking prescribed reforms (like the ‘One Nation One Ration Card’). Subsequently, the 15th FC’s provision for an additional 0.5% borrowing for power sector reforms saw states like Andhra Pradesh, Tamil Nadu, Uttar Pradesh, and West Bengal collectively avail ₹1.3 lakh crore between FY2022-FY2025. This created a direct fiscal reward for administrative improvements.

4. Carry-Forward Provisions: The flexibility to carry forward unutilised borrowing space from one year to the next (first as a pandemic measure, then embedded by the 15th FC) provided states with critical fiscal breathing room. It softened hard annual constraints, allowing for more flexible, multi-year project planning and spending.

Therefore, the higher deficits were not a breach but a managed and conditional expansion of the fiscal framework. The Centre effectively acted as a financial conductor, orchestrating a stimulus by loosening the strings on state purses, but with attached conditions—spend on capex, implement reforms.

The Welfare vs. Capex Conundrum: A Zero-Sum Game?

The second question strikes at the heart of India’s development model. The rise of state-level direct benefit transfer (DBT) schemes—particularly cash transfers to women in states like Telangana, Karnataka, Tamil Nadu, and now nationally—represents a tectonic shift in the political economy. Nayar’s analysis provides a crucial, data-led insight: aggregate state fiscal health has not yet collapsed under this weight.

The numbers are telling. Combined cash transfers to women across 11 major states are projected to balloon to ₹1.5 lakh crore (0.8% of GSDP) in FY2026, from a mere ₹12,000 crore (0.1% of GSDP) in FY2023. This is a monumental reallocation of resources. Yet, the aggregate revenue deficit of states widened only “slightly.” How is this possible?

The answer lies in fiscal substitution and prioritization. States are not magically generating new revenue for these schemes. Instead, they are engaging in a complex internal re-budgeting exercise. To accommodate these politically popular, welfarist commitments, states are employing a mix of strategies:

• Trimming Other Revenue Heads: Spending on non-essential administrative expenses, subsidies, and older, less politically salient schemes is being squeezed.

• Optimizing and Rationalizing: Some states are merging or fine-tuning existing welfare programs to reduce overlaps and inefficiencies, freeing up funds.

• Leveraging Improved GST Collections: As the GST system matures and collections show buoyancy, some states are seeing a natural revenue boost that partially funds new commitments.

• The Prudent vs. The Profligate Dichotomy: Nayar notes a key divergence. States with “reasonable fiscal space” may not need to squeeze other spending harshly. However, states already facing high debt and weak revenue bases are forced into more painful trade-offs, potentially cutting into essential social sector spending on health or education to finance direct cash transfers.

Crucially, and encouragingly, this scramble for welfare funding has not universally crashed capital expenditure. In fact, the combined capex and loans & advances of 28 states grew at a compound annual growth rate (CAGR) of 18.5% from FY2021 to FY2025, doubling to ₹8.4 lakh crore. The Union’s interest-free capex loan scheme is the undeniable hero here, acting as a firewall that protected, and indeed supercharged, infrastructure spending even as revenue budgets faced new pressures.

The Looming Inflection Point: The 16th Finance Commission

All these dynamics lead to a precipice. The exceptional measures of the FY2021-FY2025 period are winding down. The GST compensation era is over. The future of the massively expanded capex loan scheme is uncertain. The 15th FC’s award period concludes in FY2026.

This makes the 16th Finance Commission, currently deliberating, the most consequential arbiter of India’s economic trajectory for the latter half of this decade. Its recommendations will either lock in a new, sustainable framework for fiscal federalism or trigger a period of severe constraint and tension. The key variables it will determine are:

1. Vertical Devolution: The share of the central tax pool that goes to states (currently 41%). Arguments for an increase cite states’ expanding responsibilities, while the Centre points to its own massive spending commitments on defense, railways, and national schemes.

2. Base Borrowing Limits: Will the FC revert to a stricter 3% GSDP ceiling, or endorse a permanently higher floor, acknowledging the states’ enhanced role in driving growth?

3. Continuity of Flexibility: Will the carry-forward provision become a permanent feature of fiscal federalism, granting states much-needed predictability?

4. Conditionality and Incentives: Will the model of reform-linked or sector-specific (e.g., for climate goals, health outcomes) additional borrowing be expanded, further tightening the Centre’s steering capacity?

5. Treatment of Off-Budget Items: How will it view the liabilities of state power distribution companies (discoms) and other quasi-fiscal burdens that distort true fiscal health?

The Commission’s report will essentially answer whether the last five years were an aberration or a new normal. A restrictive report could force a brutal triage by states between welfare promises and growth-creating investment. A generous one could risk aggregate fiscal profligacy if not paired with strong incentives for performance.

The Road Ahead: Strategic Choices for States

In this uncertain climate, states must navigate strategically. The era of blanket revenue spending expansion is likely over. The path forward demands:

• Own Revenue Maximization: Aggressive measures to improve property tax collections, user charges for utilities, and efficiency in state excise and stamp duties are non-negotiable. Fiscal autonomy begins at home.

• Quality of Expenditure: With constrained space, every rupee counts. Welfare schemes must move beyond pure cash transfers to include investments in human capital (nutrition, skilling) that enhance productivity. Capex must be focused on projects with the highest economic returns, not political vanity.

• Embracing Public-Private Partnerships (PPPs): To supplement constrained public capex, states must become adept at structuring and managing PPPs to attract private investment into infrastructure.

• Cooperative Federalism 2.0: States must move beyond debates over share to collaborate with the Centre on grand national projects—in logistics, energy transition, and water management—where pooled resources and coordinated action yield dividends for all.

Conclusion: Balancing Empathy with Economics

The narrative of the past five years reveals that India’s fiscal federalism proved remarkably adaptable in crisis. The Centre deployed innovative tools to pump-prime the economy through the states’ machinery, while states, in turn, balanced immediate social needs (welfare) with long-term growth imperatives (capex), aided significantly by central schemes.

Now, the system stands at a reset. The choices made by the 16th Finance Commission will define the fiscal oxygen available to states. The challenge is to design a framework that is neither overly restrictive—stifling regional development and responsive governance—nor irresponsibly lax, endangering macroeconomic stability. The goal must be to empower states to be both compassionate providers of social security and efficient architects of physical and human capital, ensuring that the Indian growth story remains not just a national aggregate, but a sum of its vibrant, investing, and caring federal parts.

Q&A: Understanding State Finances and the Fiscal Federalism Debate

Q1: The article mentions states used “carry-forward” provisions to manage deficits. How does this work, and why is it significant?
A: The carry-forward provision allows a state that does not fully utilize its permitted borrowing limit (say, 3.5% of GSDP) in a given financial year (e.g., FY2023) to “carry forward” the unutilized portion (e.g., 0.4%) and add it to its borrowing limit for the next year (FY2024). This was first allowed as a pandemic-era emergency measure and later institutionalized by the 15th Finance Commission. It is significant because it transforms a rigid annual constraint into a more flexible multi-year fiscal envelope. It allows states to plan large, multi-year infrastructure projects without the fear of losing allocated borrowing space if project execution is delayed. It provides crucial fiscal predictability and reduces the temptation for rushed, wasteful spending at the end of a financial year just to meet targets.

Q2: The 50-year interest-free capex loan is highlighted as a major boost. Isn’t a loan still debt? Why is it seen as so beneficial for states?
A: Yes, it is debt on the state’s books. However, its terms make it uniquely beneficial:

• Interest-Free: The state pays zero interest over the entire 50-year period. This makes the effective cost of borrowing null, freeing up future revenue that would have gone towards interest payments for other expenditures.

• Extremely Long Tenure: A 50-year maturity means the principal repayment is a distant, almost negligible annual burden spread over generations.

• Targeted for Capex: It ring-fences funds for capital expenditure, which states might otherwise defer due to political pressure to spend on immediate welfare or revenue items. It forces an increase in productive asset creation.
  In essence, it is as close to a grant as a loan can be, providing a massive, cheap, and directed infusion of funds for infrastructure without immediately worsening the state’s debt service metrics.

Q3: The article suggests states are funding new welfare schemes by cutting other spending. What are the potential risks of this fiscal substitution?
A: The risks are substantial and often hidden in the short term:

• Erosion of Social Infrastructure: Cuts may fall on “non-glamorous” but vital areas like preventive healthcare, school maintenance, or anganwadi worker salaries, eroding the quality of public services and human capital formation.

• Neglect of Operation & Maintenance (O&M): Reducing O&M budgets for existing assets (roads, buildings, water plants) leads to rapid deterioration, wasting past capex investments. This is a classic false economy.

• Populist Cycle: Once a direct cash transfer scheme is launched, it becomes politically impossible to withdraw. This can lock states into ever-increasing recurring expenditure, forcing ever-deeper cuts elsewhere in a vicious cycle.

• Inequality in Service Delivery: The burden of cuts may fall disproportionately on essential services used by the poorest (who may benefit from cash but also rely on public health/education), while administrative bloat or inefficient subsidies remain untouched.

Q4: What are the key arguments for and against increasing the states’ share of central taxes (vertical devolution) beyond the current 41%?
A:

• For an Increase:

  • Subsidiarity Principle: States are closer to the people and have a larger basket of responsibilities (health, education, agriculture, law & order). They need more resources to fulfill these effectively.

  • Capex Drivers: States now account for a significant portion of public capital expenditure, which is critical for national growth.

  • Welfare Burdens: Newly assumed welfare commitments (pensions, cash transfers) are straining state budgets and require greater own resources.

• Against an Increase (or for maintaining status quo):

  • Central Responsibilities: The Centre has its own massive spending needs on defense, national infrastructure (railways, highways), centrally sponsored schemes, and debt servicing.

  • Macroeconomic Management: The Centre needs a large enough fiscal pool to manage national crises (pandemics, economic shocks) and implement counter-cyclical policies.

  • Inefficiency Concerns: Some argue that not all states utilize funds efficiently, and greater devolution without accountability could lead to waste. The Centre’s role in directing resources to strategic national priorities would diminish.

Q5: Beyond the Finance Commission’s recommendations, what can states do independently to strengthen their fiscal position for the coming years?
A: States must focus on fiscal self-reliance through:

1. Tax Administration Reforms: Leveraging technology to expand the property tax net, curb evasion in state GST and excise, and rationalize stamp duty rates to boost collections without raising rates.

2. Rationalizing Subsidies: Conducting a thorough audit of all subsidies (power, water, agriculture) to target them better to the truly needy, plugging leaks, and reducing the burden on discoms and state budgets.

3. Asset Monetization: Systematically identifying under-utilized state-owned lands, buildings, and infrastructure to unlock capital through leases or sales, which can be recycled into new capex.

4. Improving Credit Ratings: By demonstrating fiscal prudence and revenue growth, states can improve their credit ratings, allowing them to borrow from the market at lower interest rates, reducing the cost of debt.

5. Outcome-Based Budgeting: Shifting the focus from outlay to outcome, ensuring that every rupee spent, whether on welfare or capex, delivers measurable results in terms of service quality, asset creation, or poverty reduction.