Bridging the gap: Lagging states need a growth push amid rising debt

The Sixteenth Finance Commission this week submitted its report to the government. The report has not yet been made public, although it is expected to be tabled in Parliament during the Budget session next year. The Finance Commission’s recommendations will cover five years beginning April 1, 2026. They will shape the distribution of tax revenues between the Union and the states, along with the allocation of funds among the states under various categories. In this regard, it is worth noting that several southern states have raised concerns over their declining share. As a recent analysis in this newspaper showed, the combined share of the five southern states in the central tax devolution declined from 19 per cent in 2010-11 to 16 per cent in 2025-26. It is, therefore, likely that the issue will resurface, assuming the Sixteenth Finance Commission’s recommendations do not mark a significant departure from the past.

 

While the concerns of the southern states are understandable, in a federal structure it will always be expected that the lagging states are supported to ensure more equitable development. Further, as the data shows, on a per capita basis, the southern states are better resourced. For instance, while Kerala’s per capita expenditure in the current year is over ₹86,000, Bihar will spend only about ₹24,000. Notably, between 2020-21 and 2025-26, per capita expenditure in poorer states has nearly doubled, albeit on a low base, while in richer southern states it has gone up by about 59 per cent in the aggregate. However, faster growth in expenditure has not translated into faster growth in income. Average per capita income in the five southern states has gone up from 2.1 times that of poorer states in 2009-10 to 2.8 times. This suggests that while a greater share in tax devolution may be necessary to enable poorer states to undertake developmental work, it may not be sufficient for rapid economic growth, which can help increase per capita income to bridge the gap.

 

This presents a complex policy challenge that both the lagging states and the Union government must address collectively, since fiscal transfers alone may not be sufficient to bring the transformation required. There are no easy answers here. It can be argued that more private investment could be nudged towards these states. However, businesses are likely to prefer investing in better-off states because these are expected to provide the required enabling environment. Thus, it will be important that lagging states use their resources more judiciously to create the basic infrastructure needed for attracting investment. They will also need to proactively deal with businesses and address their concerns to improve the ease of doing business.

 

In the context of state finances, there is another challenge that the Union and the states concerned will have to deal with. Some states have very high levels of debt, which can affect growth prospects. As a recent report by PRS Legislative Research has shown, outstanding liabilities exceed 30 per cent of gross state domestic product (GSDP) in 19 states, including Kerala. In states like Punjab and Himachal Pradesh, it exceeds 40 per cent. A mechanism will be required to address the issue. Higher debt in states increases general government debt and borrowing requirements, affecting the cost of money for the entire economy. Bridging the income gap among states and addressing elevated levels of debt are major policy challenges. It will be interesting to see how the Finance Commission has approached these issues.