Context:

• In recent years, several Indian states have reported fiscal deficits exceeding the conventional 3% of GSDP threshold, while simultaneously expanding social welfare schemes and capital expenditure (capex).
• This has triggered debates on fiscal discipline, state borrowing limits, and whether rising welfare commitments are crowding out growth-enhancing investments.
• The article analyses the institutional and policy factors behind these trends, especially in the post-pandemic period (FY2021–FY2025).

States Breaching the 3% Fiscal Deficit Norm:

• Enhanced borrowing flexibility (FY2021–FY2025):
  • States’ base borrowing limit was fixed at 3–4% of GSDP.
  • Additional borrowing of 0.5–1.1% of GSDP was permitted by the Union Government and 15th Finance Commission (FC).
• Centre’s loans outside normal borrowing limits:
  • The Centre disbursed GST compensation loans of Rs 2.6 trillion to states in FY2021–FY2022.
  • It also transferred Rs 3.7 trillion during FY2021-FY2025 under the 50-year interest-free capex loans.
  • The surge in states’ capital spending in recent years benefited from the expansion in capex loans to around Rs 1.5 trillion in FY2025 from Rs 0.1 trillion in FY2021.
  • These loans were over and above the states’ normal borrowing ceilings.
• Reforms-linked additional borrowings:
  • States completing specified reforms were allowed extra borrowing. For example, ₹1.1 trillion availed for reforms in FY2021.
  • The 15th FC had recommended additional borrowing flexibility of 0.5% of GSDP for power sector reforms.
  • States benefitting from power sector reforms - Andhra Pradesh, Himachal Pradesh, Kerala, Odisha, Rajasthan, Tamil Nadu, Uttar Pradesh, West Bengal - availing a total of Rs 1.3 trillion between FY2022-FY2025.
• Carry-forward of unutilised borrowings:
  • For example, the Union Government (FY2021–FY2022) allowed carry-forward of unused borrowing to support growth during the pandemic.
  • The 15th FC (FY2022–FY2026) permitted carry-forward of unutilised borrowing limits.
  • This softened fiscal deficit constraints in recent years. 

Rising Welfare Spending - Welfare Schemes Crowding Out Capital Expenditure:

• States expanded social welfare programmes, including social security pensions, cash transfers to women, and transfers to low-income households.
• The combined cash transfers to women across 11 states added up to around Rs 1.5 trillion or a sizable 0.8% of GSDP in FY2026, up from Rs 120 billion or 0.1% in FY2023.

Managing Revenue Deficits:

• Despite higher welfare spending revenue deficits widened only marginally.
• How states adjusted to this:
  • By curtailing expenditure under other heads.
  • By trimming allocations to older schemes.
• States with adequate fiscal space may avoid such compression.

Encouraging Trend in Capital Expenditure:

• The combined capital expenditure and loans and advances of 28 states reported a healthy 18.5% CAGR during FY2021–FY2025, doubling to Rs 8.4 trillion.
• This indicates that welfare expansion has not necessarily come at the cost of capex.

Key Challenges and Way Ahead:

• Sustaining high welfare spending: This should be achieved without undermining fiscal sustainability. Continued reforms-linked borrowing incentives (power sector, urban governance).
• Dependence on extraordinary borrowing relaxations: Rather than stable revenue growth. Balance between redistributive welfare and growth-oriented capex. Predictable and transparent Finance Commission transfers.
• Potential inter-sectoral compression of expenditure (health, education): Strengthening state own tax and non-tax revenues.
• Uncertainty over future borrowing space post-FY2026: Clear borrowing framework, aligned with medium-term fiscal consolidation.
• Role of the 16th Finance Commission: Crucial in determining vertical and horizontal resource sharing, base borrowing limits, scope for additional borrowing, and continuation (or otherwise) of carry-forward provisions.

Conclusion:

• The breach of the 3% fiscal deficit norm by states in recent years is largely a result of institutionally sanctioned borrowing flexibility, exceptional Centre-led loans, and Finance Commission provisions, rather than fiscal indiscipline.
• Simultaneously, states have demonstrated the capacity to expand welfare spending without significantly crowding out capital expenditure, aided by reform incentives and borrowing relaxations.
• The forthcoming recommendations of the 16th Finance Commission will be pivotal in shaping the fiscal and developmental space of states in the next phase of India’s federal fiscal architecture.