Debt Is the New Devolution: Why Indian States Are Borrowing to Govern
Part 1: When Borrowing Becomes a Way of Governing
Governments cannot stop governing.
Teachers expect their salaries at the end of every month. Hospitals continue treating patients regardless of the government’s fiscal position. Pensioners wait for their monthly payments. Police forces remain on duty, roads require maintenance, electricity subsidies continue to flow, and welfare schemes cannot simply be suspended because tax collections fall short.
Unlike businesses, governments cannot pause operations until finances improve.
Governance is a continuous obligation.
This raises a simple but important question.
What happens when a State’s responsibilities continue to expand but its financial flexibility steadily contracts?
The answer increasingly lies in one word.
Borrowing.
For decades, borrowing was viewed as a tool of development. Governments issued loans to finance highways, irrigation projects, ports, power plants and universities—assets expected to generate future economic growth. Debt was seen as an investment in tomorrow.
Today, however, that relationship is changing.
Across several Indian States, borrowing is no longer financing only the future.
It is financing the present.
That quiet shift may be one of the most significant changes taking place within India’s federal system.
From Development Finance to Survival Finance
State governments primarily borrow through State Development Loans (SDLs), securities issued in the market under the management of the Reserve Bank of India.
Historically, SDLs were designed to fund capital expenditure—projects that created durable public assets and expanded productive capacity.
Increasingly, they are performing a very different function.
They are helping governments bridge revenue gaps, finance routine expenditure, sustain welfare commitments and keep day-to-day administration functioning.
In other words, debt is gradually moving from being development finance to becoming survival finance.
Punjab illustrates this transformation clearly.
Instead of borrowing primarily to build infrastructure, the State has increasingly relied on borrowing to bridge revenue deficits and finance recurring expenditure such as salaries and pensions. Borrowing no longer creates new assets alone; it increasingly keeps existing government machinery running.
This distinction matters.
Debt used to build an expressway may generate economic returns for decades.
Debt used to pay salaries creates no comparable financial asset.
The liability remains.
The asset often does not.
That is what makes today’s borrowing fundamentally different from the borrowing of previous decades.
The GST Turning Point
This transformation cannot be understood without recognising one of the biggest structural changes in India’s fiscal architecture.
The introduction of the Goods and Services Tax (GST) in 2017 fundamentally altered the relationship between States and taxation.
Before GST, States possessed considerable autonomy over indirect taxes through instruments such as Value Added Tax (VAT), allowing them to respond to local economic conditions and raise additional revenue when necessary.
GST changed that equation.
States voluntarily surrendered much of their indirect tax-raising authority in return for a nationally integrated tax system. While GST simplified India’s indirect tax regime and strengthened the common market, it also made States structurally more dependent on Central transfers and compensation mechanisms.
The link between a State’s own tax effort and its fiscal flexibility weakened.
This change became particularly visible during the COVID-19 pandemic.
The economic shock of 2020 sharply reduced revenues across the country. At precisely the moment when States needed greater financial support to manage public health, relief measures and welfare expenditure, tax collections declined dramatically. Borrowing through SDLs accelerated because devolution alone proved insufficient to absorb the fiscal shock.
Since then, dependence on borrowing has become far more structural than temporary.
States are no longer borrowing merely because of an extraordinary crisis.
They are borrowing because the fiscal architecture itself has changed.
Debt Is Becoming Structural
The numbers illustrate how rapidly this transformation has unfolded.
State Development Loans now account for nearly 35% of Tamil Nadu’s total revenue receipts and around 26% of Maharashtra’s.
A decade ago, such figures would have been regarded as fiscally exceptional.
Today, they are increasingly becoming the norm.
This is not simply a story of rising debt.
It is a story of debt acquiring a new constitutional role.
For much of independent India’s history, tax devolution functioned as the principal stabiliser of State finances. When States experienced fiscal stress, shared taxation helped absorb the shock.
Increasingly, that stabilising role is being performed by market borrowing.
As one observation emerging from recent debates on fiscal federalism puts it:
“If debt, rather than devolution, becomes the primary shock absorber in India’s federal system, fiscal sustainability itself comes under strain.”
That sentence captures the heart of the issue.
Borrowing is no longer an exceptional policy response.
It is becoming part of the normal machinery of governance.
Debt, in effect, is beginning to replace devolution as the mechanism through which States remain financially functional.
Debt Is Not Always a Sign of Failure
Public debate often treats rising State debt as evidence of fiscal irresponsibility.
The evidence suggests a far more nuanced picture.
Consider Kerala.
Its Debt-to-GSDP ratio stands at approximately 34.87%, one of the highest among Indian States.
Viewed in isolation, this appears alarming.
But another figure provides important context.
Nearly 78% of Kerala’s total revenue receipts are already absorbed by committed expenditure—salaries, pensions and interest payments.
This leaves very limited fiscal space for new investments, regardless of the government’s intentions.
Tamil Nadu presents a similar but equally instructive example.
The State raises nearly 75% of its revenue from its own resources, making it one of India’s strongest revenue-generating States. It has also invested consistently in education, healthcare and social development for decades, producing some of the country’s strongest human development indicators.
Those achievements, however, come with long-term financial obligations.
Hospitals require doctors.
Schools require teachers.
Public welfare requires continuing expenditure.
Development creates recurring costs.
Ironically, States that invested heavily in human capital during the past five decades now carry some of the highest committed expenditures in the country.
Their debt is not merely the consequence of fiscal mismanagement.
It is also the consequence of developmental success.
This reveals what may be called the performance paradox of Indian federalism.
States that performed well in building human capital often find themselves under greater fiscal pressure precisely because sustaining that success requires continuous public expenditure.
Debt, therefore, should not always be interpreted as evidence of failure.
Sometimes it is the price of long-term investment.
The Borrower’s Federalism
A broader pattern now begins to emerge.
The debate is no longer about whether States should borrow.
Every government borrows.
The real question is why borrowing has become indispensable for routine governance.
States that once relied primarily on tax revenues and fiscal transfers increasingly rely on market loans to keep essential public services functioning.
That represents a profound shift in the character of Indian federalism.
The Union continues to possess greater fiscal flexibility through mechanisms unavailable to the States, while the States increasingly finance their constitutional responsibilities through debt.
Borrowing is no longer merely an economic decision.
It is becoming one of the defining features of Centre-State financial relations.
The implications of this shift extend far beyond State budgets.
For debt does not merely finance governments.
Over time, it also begins to shape their autonomy.
And that raises an even deeper constitutional question.
If States increasingly govern through borrowed money, who ultimately controls the terms on which that borrowing takes place?
That question leads us directly to Article 293 of the Constitution—and to the evolving relationship between debt and federal power.
Part 2: When Debt Begins to Shape Federalism
By now, the larger pattern becomes difficult to ignore.
States are not borrowing because they have suddenly abandoned fiscal discipline.
They are borrowing because the structure of Indian federalism increasingly leaves them with few alternatives.
When revenues become less flexible while expenditure commitments continue to expand, borrowing ceases to be an emergency measure.
It becomes the normal way of governing.
But debt creates another question that receives far less attention.
Who controls borrowing?
Unlike taxation, borrowing is not entirely within the States’ own discretion.
And this is where India’s constitutional framework begins to influence the balance of federal power.
Borrowing Is Also a Constitutional Relationship
The Constitution recognises that excessive borrowing can threaten macroeconomic stability.
Accordingly, Article 293 governs the borrowing powers of State governments.
The provision allows States to raise loans but also empowers the Union Government to impose conditions on borrowing whenever a State owes outstanding loans to the Centre.
When the Constitution was framed, this provision was largely viewed as a safeguard against reckless borrowing.
Today, however, it operates in a very different fiscal environment.
As States increasingly depend upon borrowing to finance routine governance rather than exceptional development projects, borrowing itself becomes an instrument through which fiscal discipline—and consequently fiscal autonomy—is negotiated.
The constitutional distribution of legislative powers remains unchanged.
Yet the practical ability of States to exercise those powers increasingly depends upon their capacity to borrow.
Fiscal autonomy is therefore no longer determined only by revenue.
It is increasingly determined by borrowing permissions.
This represents a subtle but important constitutional shift.
The Cost of Borrowing Is Not the Same for Everyone
Borrowing is expensive.
But it is not equally expensive for every government.
The Union Government enjoys significant advantages.
It raises money at lower interest rates, possesses a much broader tax base and increasingly benefits from revenues that remain outside the constitutional sharing framework.
One recent example illustrates this clearly.
The Reserve Bank of India transferred a record surplus of ₹2.87 lakh crore to the Union Government for FY26.
The transfer substantially strengthened the Union’s fiscal position.
Yet none of this amount entered the divisible pool.
States did not receive any share of this windfall.
The contrast is striking.
The Union strengthens its finances through additional revenues.
States strengthen theirs through additional liabilities.
One expands fiscal space.
The other expands debt.
This reflects what many observers describe as a “shadow centralisation” of public finance.
Without changing the Constitution, the Union steadily accumulates greater fiscal flexibility through mechanisms unavailable to the States.
Meanwhile, States increasingly monetise their fiscal stress through market borrowing.
The constitutional formula remains unchanged.
The balance of fiscal capacity evolves nonetheless.
The Interest Trap
Borrowing solves today’s problem.
Interest payments create tomorrow’s problem.
Every State Development Loan eventually requires repayment.
Until then, it generates annual interest obligations.
Over time, those obligations begin to consume a growing share of government revenue.
This has direct consequences for development.
Money spent servicing past debt cannot simultaneously finance new schools, hospitals, irrigation systems or urban infrastructure.
Economists describe this phenomenon as the crowding out of capital expenditure.
Instead of investing in future growth, governments increasingly spend available resources paying for yesterday’s borrowing.
The cycle gradually becomes self-reinforcing.
Growing Welfare Obligations
↓
Revenue Shortfall
↓
Borrowing through SDLs
↓
Higher Interest Payments
↓
Reduced Capital Investment
↓
Lower Fiscal Flexibility
↓
Greater Dependence on BorrowingThe problem is no longer the existence of debt.
The problem is that debt itself begins generating additional debt.
This is why economists increasingly describe India’s State finances as entering a vicious cycle.
The Hidden Debt That Rarely Appears in Budgets
Not every government liability appears directly in the Budget.
As borrowing limits tighten, several States have increasingly relied upon State Public Sector Undertakings (PSUs) and Special Purpose Vehicles (SPVs) to raise funds.
These entities borrow on behalf of the government to finance projects or expenditure that would otherwise increase official State debt.
Such borrowing is commonly described as off-budget borrowing.
While it offers temporary fiscal flexibility, it also obscures the true extent of public liabilities.
The debt exists.
It is simply shifted away from the main Budget.
Over time, guarantees extended to these entities can themselves become liabilities for the State government.
The result is a fiscal picture that often appears healthier than the underlying reality.
For policymakers, this creates a difficult dilemma.
Restrict borrowing too aggressively, and governments struggle to maintain essential public services.
Allow excessive borrowing, and long-term fiscal sustainability comes under strain.
There are no easy choices.
Are States Really Being Fiscally Irresponsible?
The public debate often frames rising State debt as evidence of fiscal populism.
The evidence suggests a more complex story.
The Sixteenth Finance Commission itself acknowledged the growing mismatch between the responsibilities assigned to States and the revenues available to discharge them.
Yet despite recognising this imbalance, the Commission retained the 41% vertical devolution framework, leaving the broader fiscal architecture largely unchanged.
This explains why many States argue that their borrowing is increasingly structural rather than discretionary.
The paradox becomes even more striking when viewed alongside the Union’s own fiscal performance.
Over the past five years, the Union has succeeded in significantly reducing its fiscal deficit ratio.
At the same time, States are frequently criticised for rising debt.
Yet these same States are expected to finance expanding commitments in healthcare, education, rural employment, urban infrastructure and social protection.
Policies such as the proposed VB-G RAM G framework illustrate this contradiction.
By shifting rural employment towards a 60:40 Centre-State funding model, the projected State expenditure could rise from roughly ₹7,700 crore to over ₹51,000 crore.
States are therefore encouraged to spend more.
But when borrowing increases to finance those commitments, they are criticised for fiscal indiscipline.
The contradiction is obvious.
The issue is no longer simply about responsible borrowing.
It is about whether the fiscal framework itself produces structural borrowing.
When Negotiation Fails, Borrowing Takes Its Place
Ideally, disagreements over fiscal federalism should be resolved through political institutions.
Bodies such as the NITI Aayog Governing Council were envisioned as forums where the Union and the States could negotiate development priorities and fiscal concerns.
In practice, however, these forums meet relatively infrequently, often only once a year.
As a result, many States argue that meaningful fiscal negotiation has become increasingly limited.
When institutional dialogue weakens, financial adjustment replaces political negotiation.
Instead of renegotiating responsibilities, governments borrow.
Instead of redesigning fiscal arrangements, they issue more debt.
Borrowing thus becomes a substitute for institutional reform.
Debt Is Becoming the New Federal Compact
Taken individually, each of these developments appears technical.
Article 293 concerns borrowing.
State Development Loans concern finance.
Interest payments concern budgeting.
Off-budget borrowing concerns accounting.
Viewed together, however, they reveal a profound transformation.
For much of independent India’s history, fiscal federalism was stabilised primarily through shared taxation.
Today, it is increasingly stabilised through shared indebtedness.
The Union continues to shape national priorities.
States increasingly finance those priorities through borrowing.
The burden of adjustment has quietly shifted from taxation to debt.
This is why the phrase “Debt is the new devolution” captures something much larger than a financial trend.
It describes a changing model of federal governance.
The stability of the federal system no longer depends only upon how taxes are shared.
It increasingly depends upon how much debt States can sustain.
That is a far more fragile foundation.
Because tax revenues expand with economic growth.
Debt compounds with interest.
And when interest payments begin to consume the resources required for education, healthcare and infrastructure, borrowing ceases to be merely a fiscal instrument.
It becomes a constitutional constraint on governance itself.
Perhaps that is the most important lesson emerging from India’s evolving federal landscape.
The first article showed that the divisible pool is smaller than the headline numbers suggest.
The second demonstrated that States are increasingly expected to finance national welfare commitments.
This article completes the fiscal story.
When less flexible revenue meets greater expenditure responsibility, the gap does not disappear.
It is financed.
Increasingly, it is financed through debt.
And when borrowing becomes the principal mechanism through which States keep governments functioning, federalism itself begins to change—not through constitutional amendment, but through the quiet arithmetic of public finance.
For if the twentieth century built India’s federal compact on shared taxation, the twenty-first century may increasingly test it through shared indebtedness.