Demographic shift: State finances reflect the rapid transition ahead

The Reserve Bank of India’s (RBI’s) latest report on state finances, released last week, shows that the consolidated fiscal deficit of the states widened to 3.3 per cent of gross domestic product (GDP) in 2024-25 after three years of consolidation. Factors responsible for this are slower revenue growth and higher capital expenditure. States have budgeted for the same level of fiscal deficit this financial year too. While the quality of expenditure has improved with the capital outlay rising and revenue expenditure compressed, this adjustment has relied on central support and borrowing. Revenue vulnerabilities persist due to the narrow concentration of the states’ own tax bases. It will also be worth watching how the reduction in rates of goods and services tax plays out. A variety of cyclical and structural factors drives state finances. One such factor with long-term implications is demographics. The RBI has done well to focus on this aspect.

 

Nationally, the working-age population is expected to peak around 2031, but several states have already crossed that point. By 2036, more than half the Indian states will have over 15 per cent of their population aged 60 and above. Kerala is projected to cross 22 per cent, with Tamil Nadu, Punjab, and Himachal Pradesh close behind. These states are ageing faster than their finances can adjust. Ageing is beginning to show up in fiscal outcomes. States with an ageing population face weaker revenue prospects with a gradual erosion in the tax base. However, expenditure pressures are rising. Pension spending has become a dominant component of social-sector expenditure in ageing states, accounting for close to 30 per cent in several cases. This has reduced the fiscal space for health, education, and capital investment, even as health care needs rise sharply with age. The debt position also reflects demographic stress. Ageing states tend to have a higher ratio of debt to gross state domestic product (GSDP) and heavier interest burdens because slower revenue growth and rising committed spending. These pressures could become more binding over time.

 

Younger states face a different challenge. States such as Uttar Pradesh, Bihar, Madhya Pradesh, and Rajasthan will continue adding to the working-age population well beyond 2031, in some cases into the 2050s. However, these states remain fiscally weaker, with lower own-revenue capacity and higher dependence on central transfers. States face different kinds of challenges. Younger states, for instance, bear the cost of educating and skilling future workers. Migration partially offsets labour shortages in ageing states and absorbs surplus labour from younger ones, but fiscal systems do not reflect this reality. The costs of urban infrastructure, housing, health care, and transport fall on destination states, while source states lose part of their future tax base. As the report suggests, existing fiscal frameworks may not be well suited to these divergent demographic trajectories.

 

Further, simply increasing expenditure on skilling or human capital will not resolve the structural fiscal effects of ageing. Policy responses need to be explicit and targeted. Transfers by Finance Commissions can incorporate ageing and old-age dependency alongside population and income criteria. Pension systems require firm institutional rules that prevent the accumulation of unfunded future liabilities. Migration, female labour force participation, and longer working lives could address the problem to some extent. More broadly, both the Union and state governments need to create the fiscal capacity to deal with emerging challenges, including ageing. The debt stock of the states is expected to increase to 29.2 per cent of GDP this year. A high cost of debt servicing limits state capacity and can be a drag on long-term growth.