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Relevance: GS Paper II — Fiscal Federalism; GS Paper III — Government Budgeting Source: Opinion analysis (Jayan Jose Thomas) / RBI data, 2026

The Fiscal Tightrope for State Governments

1 · What happened

Recently, states like Kerala and Tamil Nadu have released reports showing their mounting public debt. Often, politicians blame this on lazy or poor management by the state leaders. However, economist Jayan Jose Thomas argues that the real issue is a structural mismatch in how India is designed to work.
The problem is simple: India’s Constitution expects state governments to do almost all the heavy lifting for citizens—building schools, running hospitals, and providing farming subsidies. However, the Constitution gives the Central Government the power to collect almost all the major taxes. So, states are forced to spend massive amounts of money, but have very few ways to actually earn it.

2 · The “Spend-More, Earn-Less” Trap

Because states can’t collect enough taxes to cover their expenses, they are forced to borrow money from the market. These loans come with high interest rates. Eventually, paying back the interest takes up so much of the state’s budget that there is barely any money left over to build long-term assets, like new roads or hospitals.

The Root Cause
States Spend, Centre Taxes
States handle welfare and development, but the Centre collects the big taxes. To make things worse, Article 293 of the Constitution restricts how freely a state can borrow money.
Expensive Loans
Paying a Premium
When states borrow money (using State Development Loans), they are charged a higher interest rate (about 6.5-7.5%) compared to the Central Government. This makes their debt grow faster.
Kerala’s Squeeze
Little Left to Build
Nearly 90% of Kerala’s budget is eaten up by daily running costs—salaries, pensions, and loan interest. This leaves only a tiny 10% actually available to build new infrastructure.
The Wasted Savings
Money Sitting Idle
Kerala’s citizens save a lot of money in banks, but banks lend very little of it back out locally. The state needs to find a way to tap into these local savings to fund public projects.

  • Breaking Down the Budget: In Kerala, salaries consume 22.7% of the budget, pensions 15.3%, and loan interest 16.5%. Some critics say Kerala should cut welfare spending, but doing so would destroy the state’s famous high standards of education and healthcare.
  • The Savings Gap: The national average for how much of people’s bank deposits get lent back out as credit is around 79-80%. In Kerala, it is only 66%. Meanwhile, states like Tamil Nadu and Maharashtra aggressively lend out more than they hold.
  • How China Does It: Chinese local governments borrow money extremely cheaply (near 2%) to fund massive infrastructure projects. Economist Thomas argues that since domestic government debt is just money owed to its own citizens, spending it on schools and hospitals is actually good for long-term growth, rather than obsessing over strict deficit targets.

UPSC Prelims Quick Facts
Article 293(3) A crucial constitutional rule: If a state still owes money to the Central Government, it cannot take out a new loan without the Centre’s explicit permission.
State Development Loans (SDLs) The official bonds that state governments sell to the market to raise money. The RBI manages the auction of these bonds.
Revenue vs Capital Expenditure Revenue spending is money gone forever on daily expenses (salaries, interest). Capital spending is money invested into creating physical assets (bridges, schools).
Credit-Deposit (CD) Ratio How much of the money people deposit into banks is actually given out as loans. A low ratio means money is sitting idle.
Finance Commission The constitutional body that acts as an umpire, deciding exactly how the massive tax pool collected by the Centre should be shared with the states.

MCQ Practice
Q. Consider the following statements regarding how state governments borrow money in India:

  1. State Development Loans (SDLs) are market borrowings raised by states, and their auctions are managed by the Reserve Bank of India (RBI).
  2. Under Article 293, if a state still owes money to the Central Government, it must obtain the permission of the Reserve Bank of India before taking a new loan.
  3. States generally have to pay a higher interest rate when borrowing from the market compared to the Union government.

Which of the statements given above is/are correct?
(a) 1 and 2 only    (b) 2 and 3 only    (c) 1 and 3 only    (d) All of the above

Answer: (c) 1 and 3 only

  • Statement 1 is Correct: States raise money via SDLs, and the RBI facilitates this process.
  • Statement 2 is Incorrect (UPSC Trap): Article 293 requires the state to get permission from the Government of India (The Centre), not the RBI. The RBI just manages the auction; the Centre holds the political power to approve it.
  • Statement 3 is Correct: Because the Central Government is seen as a safer bet, states always have to pay a slightly higher interest rate (a premium) to convince people to lend them money.
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