State-led capital spending
Kartavya Desk Staff
Source: IE
Subject: Fiscal Federalism
Context: State governments’ ability to sustain capital expenditure has come under focus as several States breached the 3% fiscal deficit norm using enhanced borrowing space during FY2021–FY2025.
About State-led capital spending:
What it is?
• State-led capital spending refers to expenditure by State governments on asset creation such as roads, irrigation, power, health, education infrastructure, and urban development.
• It is distinct from revenue spending as it raises long-term productive capacity and crowds in private investment.
Trends in India (FY2021–FY2025):
• Strong capex growth: Combined capital expenditure and loans & advances of 28 States grew at a CAGR of 18.5%, doubling to ₹8.4 trillion.
• Role of Centre’s support: Expansion driven by GST compensation loans (₹2.6 trillion in FY21–22) and 50-year interest-free capex loans (₹3.7 trillion over FY21–FY25).
• Borrowing flexibility: Additional borrowing of 0.5–1.1% of GSDP allowed under Union government relaxations and 15th Finance Commission provisions.
• Reforms-linked borrowing: Power sector reforms enabled several States to access ~₹1.3 trillion in extra borrowing between FY22–FY25.
Current Spending Pattern of States:
• Surge in Lado-Virhu Style Transfers: Cash transfers to women jumped from ₹120 billion in FY23 to ₹1.5 trillion in FY26, representing a massive 1,150% increase in just three fiscal years.
• Expenditure Switching Strategy: States contained revenue deficits at approximately 0.5% of GSDP by aggressively retiring older, high-cost subsidies in the power and fertilizer sectors.
• Divergent Capex Growth: Maharashtra and Gujarat maintained a Capex-to-GSDP ratio above 3.5%, while others relied on Central Scheme for Special Assistance to keep infrastructure numbers afloat.
• Borrowing Cap Constraint: Despite a 10.5% growth in nominal GSDP, state spending remains strictly anchored to the Article 293(3) permissions granted by the Union Ministry of Finance.
• Fiscal Capacity Bifurcation: States like Karnataka and Tamil Nadu leverage a high Tax-to-GSDP ratio of over 8%, allowing them to fund welfare without breaching the 3% fiscal deficit target.
Challenges Associated:
• End of 50-Year Interest-Free Loans: The potential phasing out of the ₹1.3 trillion Central capex support scheme creates a massive funding vacuum for state-led rural infrastructure.
• Sticky Revenue Expenditure: Once committed, cash transfers become obligatory spending, leaving less than 20% of total budget receipts for discretionary development projects.
• Interest Payment Stress: States with Debt-to-GSDP ratios exceeding 30%, such as Punjab and Rajasthan, now spend over 20% of their revenue receipts solely on debt servicing.
• Regulatory Compliance Burden: Access to the extra 0.5% borrowing headroom is currently tied to specific power sector reforms, which many states find politically difficult to implement.
• Execution Bottlenecks: Despite higher allocations, actual Value for Money is declining as project cost overruns in irrigation and road sectors average 15-20% across several regions.
Expectations from the 16th Finance Commission:
• Recalibrated Article 293 Benchmarks: States are seeking a shift from a uniform 3% borrowing limit to a performance-linked range between 3% and 4% based on debt-servicing capacity.
• Institutionalizing Capex Support: There is a proposal to convert the current ad-hoc interest-free loan windows into a permanent, formula-based grant for green infrastructure.
• Fiscal Buffer Provisions: The Commission is expected to allow states to “bank” unused borrowing limits during high-growth years to be used during cyclical economic downturns.
• Standardization of Welfare Accounting: States want clear definitions to distinguish merit goods (education/health) from non-merit freebies to avoid unfair fiscal penalties.
• GST Compensation Integration: With the 2022-26 transition period ending, states require a new mechanism to bridge the revenue gap as the GST compensation cess expires.
Way Ahead:
• Targeting Multiplier Sectors: Analysis shows road and bridge projects offer a multiplier of 2.5 times, compared to 0.9 times for cash transfers, necessitating a shift toward asset creation.
• Implementation of PFMS: Universal adoption of the Public Financial Management System is required to track Just-in-Time fund releases and reduce idle cash balances in state accounts.
• Sunset Clauses for Welfare: New cash transfer schemes should include periodic eligibility audits and income-based graduation criteria to prevent permanent fiscal leakage.
• Expanding Non-Tax Revenue: States must aggressively modernize mining auctions and user-charge frameworks to reduce the current 35% reliance on Central transfers.
• Medium-Term Fiscal Frameworks: Moving toward a three-year rolling budget will provide the predictability needed for private contractors to commit to long-term state infrastructure bids.
Conclusion:
State-led capital spending has emerged as a critical engine of India’s post-pandemic growth, supported by exceptional fiscal flexibility. However, sustaining this momentum will depend on how the 16th Finance Commission balances fiscal discipline with growth needs. A stable borrowing framework, efficient capex, and prudent welfare design are essential for durable state finances.
Q. “Capital expenditure in India faces both structural and cyclical challenges”. Examine the reasons behind the flagging capex and suggest measures to improve fiscal spending efficiency. (15 M)