Welfare Spending, Weak Revenues Contribute to Elevated State Deficits Amid Centre's Fiscal Efforts

India's State Governments Become Pressure Point in Country's Fiscal Story

India's state governments are increasingly becoming the focal point in the country's broader fiscal narrative, as slowing revenues and politically challenging welfare spending commitments continue to elevate deficits even as the Centre tightens its finances. According to a report by Morgan Stanley, the divergence between New Delhi and the states has grown large enough to have a significant impact on bond markets, public investment, and India's medium-term fiscal trajectory.

While the Centre has successfully reduced its fiscal deficit from the pandemic-era peak of 9.2% of GDP in FY21 to an estimated 4.4% in FY26, aggregate state deficits have remained stuck at 3.2% of gross state domestic product (GSDP) for two consecutive years, surpassing the 3% benchmark set by the Union government. Notably, states now account for approximately 53% of India's total government spending and remain crucial for infrastructure creation, welfare delivery, and local economic activity.

The report highlights that the sharper concern is not merely the size of the deficits but what states are spending on. Revenue expenditure, including subsidies, welfare schemes, and cash transfers, has remained elevated, while capital expenditure has softened at the margin. Subsidies and direct transfers are currently running at 2.7-3% of GSDP, while states' capex has moderated to 2.4% of GSDP from pre-pandemic levels.

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This shift has coincided with weakening revenue growth. Aggregate revenue receipts of states fell to 12.1% of GSDP in FY26 from 13.8% before the pandemic, dragged by slower tax collections and a decline in non-tax revenues such as grants from the Centre. The brokerage pointed out that non-tax revenues have nearly halved to 2.2% of GSDP from 3.5% before Covid, partly reflecting Finance Commission-led efforts to reduce states' dependence on central transfers and push fiscal discipline.

The revenue slowdown is becoming visible in borrowing numbers as well. Gross market borrowings by states rose nearly 19% year-on-year to a record Rs 12.8 lakh crore in FY26, equivalent to roughly $145 billion. For debt markets, this is where the issue becomes more relevant. Higher state borrowing means a larger supply of state development loans (SDLs) in the bond market, at a time when investors are already watching India's combined fiscal deficit closely amid elevated global yields and tighter global liquidity conditions.

The note said rising state borrowings and longer-duration issuances have already contributed to a steeper yield curve and higher borrowing costs. The concern for markets is not an immediate fiscal stress event, but that the Centre may increasingly end up carrying the bulk of India's public investment push if states struggle to create fiscal room for capex.

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That divergence is already visible. While the Centre's capital expenditure has remained broadly stable at around 3.1% of GDP, states' capex has moderated to around 2.4% of GDP. The report expects aggregate state deficits to remain range-bound at 3.2% of GSDP in FY27 as cyclical pressures continue to constrain revenues.

It also highlighted a growing divergence across individual states. Fourteen states are estimated to remain above the 3% fiscal deficit threshold in FY26. Punjab, West Bengal, and Rajasthan continue to carry relatively high debt burdens, while Odisha, Gujarat, and Maharashtra remain among the fiscally stronger states. Over time, the report said, these differences in fiscal management could begin influencing borrowing costs, investment flows, and competitiveness across states more meaningfully.