State of budgets: Repair to redesign

The fiscal position of Indian states in 2025-26 reflects relative stability rather than comfort. The Reserve Bank of India (RBI)’s State Finances: A Study of Budgets of 2025-26 indicates that while states have recovered from pandemic-era fiscal stress, the nature of pressures has shifted from short-term deficit control to deeper structural challenges. Policymakers now face the task of redesigning state finances to manage demographic transition, rising social expenditure, and limits to conventional revenue mobilisation. At the aggregate level, fiscal discipline has largely been maintained, with the consolidated gross fiscal deficit rising from below 3% of GDP in the previous three years to 3.3% in 2024-25 and budgeted at the same level for 2025-26. This deviation reflects higher capital expenditure and the accounting treatment of the Centre’s 50-year interest-free loans for capital investment, rather than fiscal laxity.

The quality of state spending has shown significant improvement. Revenue expenditure, which peaked at 14.9% of GDP in 2020-21, declined to 13.3% in 2024-25 before being budgeted to rise moderately to 14.6% in 2025-26, without any significant compression of social sector spending, suggesting rationalisation of non-essential outlays rather than welfare retrenchment. Simultaneously, capital expenditure increased sharply from 2.3% of GDP in 2020-21 to a budgeted 3.2% in 2025-26, raising its share in total expenditure from 13.4% to 18%. Most notably, the share of revenue deficit in the gross fiscal deficit fell from over 46% to below 7%, signalling a structural shift from consumption-oriented borrowing towards an investment-led fiscal strategy.

Yet, this improvement masks vulnerabilities. Outstanding liabilities of states stood at 28.1% at the end of March 2024 and are budgeted to rise again to 29.2% by March 2026. While debt sustainability indicators remain favourable due to softer interest burdens and longer maturity profiles, the absolute level of debt constrains future fiscal flexibility, especially as interest-free central loans taper off. The RBI report repeatedly flags contingent liabilities and guarantees as latent risks that could crystallise in an adverse macroeconomic environment.

On the revenue side, states face a more structural challenge. Revenue receipts declined as a share of GDP in 2024-25, largely due to the sharp fall in grants-in-aid following the end of GST compensation and post-devolution revenue deficit grants. While tax revenues have shown resilience, driven mainly by state GST, excise duties, and stamp duties, these sources remain highly concentrated, with four taxes accounting for nearly 90% of collections, making state revenues vulnerable to sector-specific shocks and cyclical downturns.

Tailoring the approach

The most compelling argument in the RBI report, however, comes from its focus on demographic transition. States are moving along sharply divergent demographic trajectories. Youthful states such as Bihar and Uttar Pradesh enjoy expanding working-age populations, while ageing states such as Kerala and Tamil Nadu face rising old-age dependency ratios and shrinking tax bases. The report shows that the old-age dependency ratio ranges from around 14 in youthful states to over 30 in ageing states, with direct implications for pension liabilities, healthcare spending, and long-term fiscal sustainability. A uniform fiscal strategy is, therefore, increasingly untenable.

This demographic divergence fundamentally alters the priorities for the upcoming budgets, both at the Union and state levels. For youthful states, the fiscal window of opportunity is narrow and time-bound. The RBI’s analysis indicates that unless higher spending on education, skilling, and health translates into productive employment, the demographic dividend could easily turn into a demographic liability. For intermediate states, the challenge is to sustain growth while preparing fiscally for ageing through pension reforms and health system strengthening. For ageing states, the emphasis must shift towards revenue augmentation, healthcare efficiency, and workforce participation reforms, including greater female and elderly labour force participation.

The implications for the next budget are clear: the focus must shift beyond aggregate deficit targets towards differentiated fiscal strategies aligned with demographic realities. While continued support for state capital expenditure remains essential, it must be complemented by stronger incentives for human capital investment, institutional reforms, and efforts to broaden states’ revenue bases through improved tax administration, digital enforcement, and rationalisation of user charges, rather than reliance on volatile transfers.

The RBI’s study makes it evident that India’s state finances are no longer in crisis but are entering a phase of structural stress driven by long-term forces. Fiscal repair has largely been achieved; fiscal re-engineering is now unavoidable, and the success of the 2025-26 budget will hinge on whether policymakers respond with forward-looking, demographically informed, and institutionally grounded strategies rather than incremental adjustments to an increasingly strained fiscal architecture.

(The writer is an associate professor at the Department of Economics, Christ University)