In 1841, the state of Mississippi made history by refusing to repay its public debt, a bold repudiation that sent shockwaves across global financial markets. Mississippi, along with several other US states like Pennsylvania and Arkansas, had borrowed heavily to fund canals, railroads, and banks, often backed by European investors. But overambitious spending, weak revenue systems, and economic downturns led to defaults that crippled public infrastructure and tarnished creditworthiness for decades. This 19th-century crisis is a powerful reminder of how fiscal profligacy at the subnational level can derail broader economic stability. Today, as Indian states pile on off-budget borrowings and subsidy obligations, the American experience offers a stark warning: subnational defaults may be rare, but fiscal stress is real, and its consequences are long-lasting.
One should read the latest State Finances report by the Reserve Bank of India (RBI). It notes that over the last three years, Indian states have broadly complied with the 3% GFD-GSDP norm under Fiscal Responsibility Legislation, with consolidated GFD declining to 2.7% in 2022–23 before rising slightly to 2.9% in 2023–24 (PA). However, significant interstate divergence remains. For instance, Bihar (8.9%), Himachal Pradesh (6.1%), and Chhattisgarh (7.3%) significantly overshot the average, raising sustainability concerns. The compression in revenue expenditure and improved tax buoyancy aided consolidation, but the primary deficit (PD-GDP) widened to 1.8% in 2023–24. Revenue deficit, a critical marker of fiscal health, persisted in 17 states, with Punjab (3.2%), Kerala (2.1%), and Andhra Pradesh (2.7%) among the highest. This indicates structural imbalances in revenue mobilisation versus committed expenditure obligations.
On the receipts side, states' own tax revenue (SOTR) has shown strong post-GST convergence, with beta convergence analysis confirming that states with initially low tax-GSDP ratios, like Jharkhand and Odisha, witnessed faster revenue growth. The average buoyancy of own tax revenue improved from 0.86 (pre-pandemic) to 1.44 (post-pandemic). However, the share of central grants has fallen sharply from 2.5% of GDP in 2022–23 to 1.8% in 2023-24. It is mainly due to the cessation of GST compensation and tapered Finance Commission transfers. Mineral-rich states like Jharkhand and Odisha are set to benefit from the July 2024 Supreme Court ruling enabling retrospective royalty and tax claims on minerals, but these gains will only materialise post-2026. Until then, revenue compression remains a binding constraint, especially for states like Kerala and West Bengal, which have limited fiscal flexibility.
The quality of expenditure has improved with the revenue expenditure-to-capital outlay ratio (RECO) declining from 6.3 in 2021–22 to 5.2 in 2024–25 (BE). Yet, several states exhibit alarming inefficiencies. Punjab's RECO stands at 17.1, reflecting an extreme skew toward revenue spending, largely driven by subsidies and freebies, at the cost of developmental investments. In contrast, states like Odisha and Gujarat maintain more balanced RECO ratios (~4.5), enabling sustained capex growth. Capital expenditure has been bolstered by the Centre's interest-free loans scheme, with Andhra Pradesh (50.6%) and Rajasthan (41.7%) among the most dependent on these transfers. A sudden withdrawal of these loans could create fiscal shock, particularly for states overleveraged on Centre-driven capital plans without internal resource augmentation.
The most severe structural risk, however, lies in states' debt dynamics. Despite a decline from 31% of GDP in 2021 to 28.2% in 2023, the debt-GSDP ratio is budgeted to rise again to 28.8% by 2025, with over 25 states projected to exceed the 25% threshold. Andhra Pradesh, Punjab, and West Bengal carry particularly high debt burdens while also maintaining high fiscal deficits and revenue deficits. Moreover, the composition of debt has shifted: 68.8% of outstanding liabilities are now market borrowings, increasing interest payment obligations. The debt-service ratio (IP/RR) remains elevated in states like Kerala and Punjab (>18%), crowding out fiscal space for productive expenditure. The escalation of contingent liabilities guarantees now at 3.8% of GDP - and the lack of robust GRF buffers (not maintained by 10+ states) compound fiscal fragility, posing systemic risks to subnational public finance.
NITI Aayog, through its recent Fiscal Health Index, has also come to the same conclusion. It has also highlighted deep structural asymmetries in subnational public finance across 18 major states. States like Odisha (rank 1), Chhattisgarh (2), and Goa (3) exhibit robust fiscal profiles due to a confluence of high capital outlay-to-GSDP ratios, efficient revenue mobilisation (including non-tax revenues such as mining royalties), and prudent debt management. Odisha, for instance, tops both the Debt Index (99.0) and Debt Sustainability sub-index (64.0), suggesting low debt servicing pressures and strong solvency metrics. In contrast, states like Punjab (rank 18), Andhra Pradesh (17), and West Bengal (16) suffer from poor performance across multiple dimensions, including high fiscal deficits, weak revenue bases, and unsustainable debt profiles. Punjab scores zero on the Debt Index and just 5.6 on Fiscal Prudence, indicating systemic fiscal stress. These disparities point to underlying differences in governance models, resource endowments, and political incentives, which cumulatively shape states' ability to manage their public finances effectively.
A closer dissection of the sub-indices reveals concerning trends, particularly in states with low capital outlay and high revenue expenditure ratios. Punjab, Kerala, and Andhra Pradesh not only exhibit deteriorating quality of expenditure but also rank among the lowest on debt sustainability, signalling a growing fiscal vulnerability. Andhra Pradesh, with a GFD-GSDP ratio of over 4%, allocates a disproportionate share of expenditure to revenue items, crowding out investments in infrastructure and human capital. The data also reveal sub-optimal revenue mobilisation in states like Bihar and West Bengal, whose own tax revenue constitutes less than 6% of GSDP, limiting fiscal autonomy. Despite post-GST convergence, such states continue to lag due to weak tax compliance, limited economic diversification, and over-reliance on central transfers. The FHI methodology, by using both improvement and deprivation indices, highlights that while a few states are moving toward sustainable fiscal trajectories, others are slipping into structural deficits, with rising contingent liabilities and subdued long-term investment, raising red flags for intergovernmental transfers, credit markets, and overall macroeconomic stability.
To avert a potential subnational debt crisis, Indian states must urgently recalibrate their fiscal strategies across three critical dimensions: revenue augmentation, expenditure rebalancing, and debt containment. On the revenue front, states should diversify their income sources beyond the GST by tapping into underutilised non-tax revenues such as mineral royalties, user charges, and land monetisation. For instance, Odisha and Chhattisgarh have effectively leveraged mining premiums, constituting over 20% of their revenue receipts. Simultaneously, enhancing tax compliance through digital tools like AI-driven analytics and faceless assessments can improve the buoyancy of both direct and indirect taxes. States like Bihar and West Bengal, which have their own tax revenues constituting less than 6% of their GSDP, need to institutionalise dedicated revenue policy units to identify and address sector-specific inefficiencies in tax administration.
Secondly, states must address the imbalance between revenue and capital expenditures. The revenue expenditure-to-capital outlay (RECO) ratio, a measure of expenditure quality, is budgeted at 20.7% for FY25, with Punjab having the lowest ratio at 6.2% and Gujarat leading at 36.2%. High RECO ratios indicate a skew towards revenue spending, often driven by subsidies and freebies, at the expense of developmental investments. Implementing a rule-based framework to maintain a RECO ceiling can serve as a soft constraint, encouraging prudent allocation. Additionally, institutionalising mandatory outcome evaluations of major schemes and public investment management systems (PIMS) would help in rationalising schemes and reallocating funds more efficiently.
Lastly, building credible fiscal buffers is essential. With 68.8% of liabilities now financed through market borrowings, states are more exposed to changes in interest rates and credit conditions. Adopting medium-term fiscal frameworks (MTFFs), publishing risk-weighted guarantee registers, and adhering to debt sustainability thresholds can enhance market confidence and reduce borrowing costs. Establishing Consolidated Sinking Funds (CSF) and Guarantee Redemption Funds (GRF) is crucial to insulate against shocks and absorb contingent liabilities. A national template for sub-sovereign credit ratings, possibly overseen by the Finance Commission or the Comptroller and Auditor General (CAG), would further incentivise discipline. The historical precedent of Mississippi's default underscores the importance of addressing structural imbalances to prevent fiscal peril. Indian states still have time to course-correct, but the window is closing rapidly.
(Aditya Sinha is a public policy professional)
Disclaimer: These are the personal opinions of the author
