Rising state debts in India widen fiscal divide, posing economic risks: NCAER report

A recent study by the National Council of Applied Economic Research (NCAER) highlights the growing divergence between heavily indebted states and those maintaining fiscal discipline, which could impact their ability to fund essential development programs.

The states with the highest debt-to-GDP ratios are Punjab, Rajasthan, Bihar, West Bengal, and Kerala, with Punjab's debt nearing 50% of its state GDP, making it the most indebted state in India.

These states have seen a sharp rise in their debt burdens due to high revenue expenditures, growing subsidies, and limited revenue generation.

Currently, state governments account for a third of India's total public debt, a proportion that has remained high compared to other federal economies.

The paper, titled “The State of the States: Federal Finance in India”
and authored by NCAER Director General Dr Poonam Gupta and Visiting
Distinguished Professor Barry Eichengreen.

While states like Odisha, Maharashtra, and Gujarat have kept their debt levels below 20% of their state GDP, states such as Punjab have seen debt burdens rise to nearly 50%.

The paper suggests reforms to strengthen fiscal discipline at the state level as high level of public debt limits their ability to fund social and developmental needs.

Over the past decade, half of India’s larger states have added more than 10 percentage points to their debt-to-state-GDP ratios, deepening the divide between financially stable and debt-laden states.

The high debt levels are straining state finances, limiting spending on critical areas such as infrastructure, education, and public health.

As debt service obligations grow, states will have fewer resources for long-term development, making it harder to sustain growth and address climate risks such as floods and droughts.

A key reason for rising state debts is the failure of fiscal rules and market discipline.

Many states consistently violate borrowing limits, and there is little variation in interest rates on state-issued bonds, suggesting that market forces are not adequately penalizing excessive borrowing.

The Reserve Bank of India (RBI)’s intervention in debt markets has further shielded high-debt states from paying risk-adjusted interest rates, effectively subsidizing financially imprudent states at the cost of fiscally responsible ones.

Despite these concerns, the trend is unlikely to reverse under the current policy framework.

Projections indicate that under a business-as-usual scenario, debt levels will continue to rise across most states, exacerbating regional fiscal disparities.

The study recommends stronger fiscal discipline measures, better debt management strategies, and incentives for states to adopt prudent financial policies to ensure long-term stability.

Experts recommend institutional reforms to tackle rising state debt

As India's state-level debt continues to climb, experts have outlined several key recommendations to enhance fiscal discipline and improve debt management.

Independent fiscal councils for states

The authors suggest that each state should establish an independent Fiscal Council, comprising academics, financial market participants, and other experts, to strengthen institutional capacity. These councils would provide realistic revenue and expenditure forecasts and assess the credibility of state government projections.

Strengthening market discipline through RBI’s role

The paper highlights the need for the Reserve Bank of India (RBI) to review its practice of capping bond spreads for heavily indebted states, which currently shields them from financial penalties.

“Without market discipline, there can be no fiscal discipline,” the study asserts, emphasizing the need for risk-based pricing in state borrowing.

Reforming finance commission mandates

The report criticizes the Finance Commission’s current approach, arguing that it unintentionally rewards fiscal mismanagement by allocating more resources to states with larger revenue deficits.

“Finance Commissions have never considered overall fiscal prudence when recommending allocations. The horizontal devolution of taxes among states, awarded every five years, does not provide incentives for fiscal rectitude,” the paper notes.

Debt relief for heavily indebted states in exchange for oversight

The study proposes a “grand bargain” where the worst-performing states could receive partial debt relief in exchange for greater central oversight and a temporary reduction in fiscal autonomy.

Forensic audit and revenue mobilization

To understand why some states are in deeper debt than others, the authors suggest a forensic analysis of worst-performing states to identify the root causes of their fiscal distress. Additionally, states should focus on increasing revenue through:

• Broadening the tax base
• Raising property taxes
• Introducing new taxes
• Reorienting spending towards infrastructure and capacity-building

Managing contingent liabilities and debt risks

The report urges states to acknowledge the risks posed by contingent liabilities—such as guarantees on loans to state-run entities—and adopt institutional reforms for forecasting liabilities and executing a structured debt management strategy.

India’s alarming subnational debt levels

The study highlights that India has the highest subnational debt-to-GDP ratio among BRICS countries and the highest debt-to-revenue ratio globally, making immediate reforms critical to maintaining fiscal stability.