Economic Survey: Unconditional cash transfers a risk to states' borrowing

Economic Survey warns that rising state-level freebies and revenue deficits could raise India's borrowing costs by crowding out capex and weakening fiscal discipline

States in India face mounting pressure to rein in fiscal populism as revenue deficits go up and unconditional cash transfers (UCTs) threaten to crowd out critical capital investment, the Economic Survey has warned, spotlighting risks to the nation’s sovereign borrowing costs and long-term growth.  

 

The document called for reprioritisation within state Budgets.

 

“Preserving fiscal space for capital formation and human-capital investment yields stronger and more persistent gains in household incomes, labour productivity, and welfare than a steady expansion of open-ended UCTs,” it said. 

 

The Survey has cautioned that the long-term costs of the “insidious impact” of unconditional fiscal transfers on incentives for self-improvement, upskilling, and employability could be significant, but suggested that better targeting, periodic reviews, and outcome-oriented designs could help mitigate fiscal rigidities.

 

 

As government bonds become increasingly scrutinised by global investors on a consolidated basis, “weak fiscal discipline at the State level”, the Survey urges, is no longer a local concern but a potential risk to the costs of sovereign borrowing.

 

Stating that the yield on the 10-year bond is at 6.7 per cent, higher than Indonesia’s 6.3 per cent despite matching BBB ratings, the Survey reckons that persistent revenue deficits or an expansion of committed expenditures at state level could affect sovereign bond yields. 

 

“This underscores the importance of coordinated fiscal discipline across levels of government, where fiscal policy is oriented toward expanding productive capacity and income growth rather than creating permanent expenditure commitments,” it highlighted. 

 

The Survey notes that in FY24 and FY25PA (Provisional Accounts), the revenue deficit increased by 40 basis points across all states, driven by lagging revenue growth relative to nominal growth in gross domestic product (GDP) and UCTs. 

 

While incentives like the Special Assistance to States for Capital Expenditure (Sasci) has incentivised states to maintain capital expenditure (capex) steady at 2.4 per cent of GDP in FY25, it masks a troubling shift. According to the Survey, revenue expenditure now tilts heavily toward open-ended UCTs, which lack sunset clauses or reviews, locking in rigidity and sidelining growth-enhancing outlays on infrastructure and human capital. 

 

For 28 states combined, while the debt-to-GDP ratio is 28.1 and the interest payments-to-revenue receipts ratio is approximately 12.6 for FY25 (PA), there exists considerable variation on both fronts across states. 

 

“These differences are not yet adequately reflected in State borrowing costs,” it said, adding that state development loans are predominantly held by domestic institutions, with limited secondary market trading.

 

The Survey calls for better data disclosure on off-Budget liabilities and guarantees to let markets price credit risk properly, broadening investor bases and lengthening maturities.

 

“Broadening the investor base and enhancing secondary market liquidity would lead to better pricing of SDLs,” it added. 

 

Urging states to strengthen the fiscal health of urban local bodies, municipalities and gram panchayats, Madhavankutty G, chief economist at Canara Bank, said this would reduce dependence on transfers and, over time, enable them to issue bonds.

 

“This can’t happen overnight but has to start. The culture of freebies has to be avoided at any cost because it eats into capex. There should be a revenue deficit glide path of below 1.5 per cent also for states,”