Whalesbook
Welfare Spending Locks in Higher Deficits
Campaign promises focused on welfare programs in Indian state elections are cementing a pattern of higher budget deficits. Unlike temporary spending boosts, these pledges lead to a lasting increase in expenditure, especially on revenue items that stay high even after elections. Consequently, the long-held 3% GDP deficit target for states is becoming a common floor, rather than a ceiling, a view shared by many economists and seen in recent budget plans.
States Run Bigger Deficits, Debt Grows
Recent figures show this shift clearly. The combined budget deficit for all states reached 3.3% of GDP in the fiscal year 2024-25, rising after three years below the 3% mark. Several states are projecting deficits above this level: Tamil Nadu aims for 3.48% in FY26 RE, while West Bengal's FY26 RE stood at 4% and its FY27 projection is 2.91%. Kerala reported 3.86% in FY25, and Assam’s was 5.75% for FY25. These numbers illustrate how hard it is for states to meet the 3% target. Meanwhile, total state debt is expected to reach 29.2% of GDP by March-end 2026, well above the 20% suggested by an FRBM Review Committee. States like Punjab and Himachal Pradesh have debt levels over 45% of their state GDP, with Tamil Nadu and West Bengal above 30%. Kerala's debt-to-GSDP ratio stood at 38.2% in 2022-23.
Investment Spending Suffers
A direct result of rising revenue spending is the stagnation or slow growth of capital expenditure. While efforts have been made to keep capital spending steady at 2.7% of GDP in 2023-24 and 2024-25, with a budget of 3.2% for 2025-26, ongoing fiscal pressure suggests that crucial long-term investments are being sidelined. For example, election pledges in Tamil Nadu could add 2.2% of GDP to overall spending, potentially affecting future projects. This reduction in capital investment harms the economy's long-term growth prospects.
Borrowing Costs Rise, Wider Risks Emerge
As states struggle with larger deficits, borrowing has become more expensive. The difference in yields between State Development Loans (SDLs) and government securities has widened significantly, now around 0.65-0.75%—nearly double the long-term average. This higher spread signals increased perceived risk and higher financing costs for states. The large volume of state debt being issued also puts pressure on central government bonds, potentially pushing up borrowing costs across the wider debt market. This combination of sustained high deficits and rising borrowing expenses intensifies fiscal pressures, creating broader economic risks and potentially affecting India's credit rating.
Underlying Weaknesses Remain
The ongoing budget shortfalls in many states indicate underlying structural problems, not just temporary issues. Although some states, like West Bengal, forecast deficit reductions, the overall trend and the political drive for election promises suggest continued spending increases. A key vulnerability is the use of borrowed money for regular expenses, as shown by revenue deficits in several states. The growing divide between wealthier and poorer states, partly due to differing population needs, adds to the challenge. This path risks a steady rise in debt-to-GDP ratios, possibly settling at unsustainable levels above 30% for many states.
Outlook: Continued Fiscal Strain Likely
The outlook points to ongoing fiscal pressure for Indian states. With more elections approaching in key states, the temptation to make populist promises will likely continue, further solidifying higher deficit levels. While the Reserve Bank of India and the central government aim for fiscal discipline and stronger financial markets, the spending habits of states—fueled by weak tax collection and election-focused spending—pose a significant challenge to India's overall debt-to-GDP ratio and its long-term economic health. The 3% fiscal deficit mark is clearly becoming a baseline, with experts predicting this trend will persist, necessitating close attention to states' ability to manage their debt and borrowing costs.