Wednesday, 11 Feb, 2026
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Despite two decades of fiscal rules, state debt has not converged. Highly indebted states such as Kerala, Punjab, Rajasthan, Andhra Pradesh and West Bengal still carry heavy debt and revenue gaps
The state governments have become better at meeting fiscal targets, but not necessarily at fixing their finances. A World Bank report submitted to the 16th Finance Commission makes this distinction uncomfortably clear. While fiscal responsibility laws have helped reduce headline deficits, the gains are fragile, uneven and, in many cases, achieved at the cost of long-term economic health.
Nearly two decades after states adopted fiscal responsibility laws in the mid-2000s, debt levels across states have failed to converge. The expectation was that common fiscal rules would gradually narrow the gap between heavily indebted states and their better-managed peers. Instead, states that began with high debt and large fiscal deficits continue to carry heavier debt burdens today.
Highly indebted states such as Kerala, Punjab, Rajasthan, Andhra Pradesh and West Bengal remain under pressure, with elevated debt levels and persistent revenue gaps. By contrast, a few states demonstrated that improvement was possible. Gujarat, for instance, reduced its debt from over 30 per cent of gross state domestic product (GSDP) to below 20 per cent. Yet for states like Kerala, Punjab and Rajasthan, debt ratios remain high despite years of compliance with fiscal rules.
The World Bank’s analysis of seven major states — Andhra Pradesh, Haryana, Kerala, Punjab, Rajasthan, Tamil Nadu and West Bengal — shows why outcomes diverged so sharply. Rising contingent liabilities, off-budget borrowing and high committed expenditure on salaries, pensions and interest payments have steadily pushed up debt levels. These pressures have left many states with little fiscal room to manoeuvre, even when economic growth has been reasonably strong.
The report places this in historical context and arrives at a sobering conclusion. While the adoption of fiscal rules is associated with reductions in subnational fiscal deficits, consolidation has rarely been achieved through durable reforms. Instead, adjustment has largely come through cuts to capital expenditure and development-related revenue spending.
In relatively richer states, revenue mobilisation contributed little to deficit reduction during consolidation episodes. More than 80 per cent of the improvement in fiscal balances came from reductions in capital expenditure and development spending rather than from higher revenues or structural changes. In practice, states protected salaries, pensions and interest payments—expenses that are politically difficult to touch—while trimming investment in infrastructure, health, education and other growth-enhancing areas.
This approach may satisfy fiscal targets in the short run, but it weakens the foundations of future growth. Lower capital spending reduces economic momentum, erodes future revenue potential and increases dependence on borrowing later. It also helps explain why debt ratios remain stubbornly high even after years of apparent fiscal discipline.
The problem has been compounded by the growing use of off-budget borrowing and contingent liabilities. By shifting borrowing to public sector enterprises and special-purpose vehicles, states have managed to keep headline deficits within limits while quietly accumulating debt. When these liabilities are included, the true fiscal position of several states looks far weaker than official numbers suggest.
At the core of the World Bank’s critique is India’s one-size-fits-all fiscal framework. All states are bound by a uniform fiscal deficit ceiling of 3 per cent of GSDP, regardless of their debt levels, revenue capacity or spending obligations. The report argues that this approach ignores the heterogeneity of fiscal conditions across states and creates incentives for cosmetic compliance rather than genuine reform.
To address this, the report recommends moving away from a uniform deficit ceiling towards a differentiated, debt-anchored regime. Under the proposed framework, states would be assessed using a “traffic light” system based on debt-to-GSDP ratios (including off-budget borrowings), a three-year average operating balance and the ratio of interest payments to own revenue.
States classified as high risk would see their borrowing limit reduced to 2.5 per cent of GSDP. States under observation would be allowed to borrow up to 2.8 per cent, while fiscally sustainable states could borrow as much as 3.25 per cent. All states would be guided by a medium-term debt anchor of 25 per cent of GSDP.
The economic logic is straightforward. States with weaker finances need tighter constraints to prevent further deterioration, while better-performing states should be rewarded with some flexibility. Shifting the focus from annual deficits to debt sustainability would also reduce incentives for off-budget borrowing and accounting manoeuvres.
The report recognises, however, that rules alone will not solve the problem. It calls for stronger fiscal institutions, better accounting practices and greater transparency around contingent liabilities. For the most indebted states, it also moots conditional debt restructuring, linked explicitly to medium-term structural reforms.
The broader message to the Finance Commission is hard to ignore. India’s subnational fiscal framework has improved appearances, but not resilience. Deficits have come down, yet debt has not. Investment has been cut to protect current spending, and fiscal stress has been postponed rather than resolved.
For states, the warning is clear. Cutting capital expenditure to meet targets is a dead end. Sustainable public finances require higher-quality revenues, realistic expenditure commitments and honest accounting. Two decades after fiscal responsibility laws were adopted, the question is no longer whether states are following the rules, but whether the rules themselves are producing the outcomes India’s economy needs.
