Who Decides How Much a State Can Borrow: The Quiet Fight Over Fiscal Federalism

In early 2024, the Kerala government moved the Supreme Court challenging the Union government's authority to cap the state's borrowing, arguing that the Centre had used its power under Article 293 of the Constitution, which requires states with outstanding central loans to obtain Delhi's consent for further borrowing, to impose conditions that went well beyond fiscal prudence into what Kerala characterised as an infringement on the state's constitutionally protected fiscal autonomy. The case remains one of the more consequential pending fiscal federalism disputes in the country, and it crystallises a tension that has been building for years across states of different political persuasions, even if Kerala's case has drawn the most attention.

How the borrowing ceiling actually works

Under the Fiscal Responsibility and Budget Management framework that states have their own versions of, mirroring the central FRBM Act of 2003, state governments are generally permitted to run a fiscal deficit of up to 3 percent of gross state domestic product, a limit the Fifteenth Finance Commission recommended maintaining with some flexibility, including an additional 0.5 percentage point tied to specific conditions such as power sector reforms, and further headroom during the pandemic years when the Centre temporarily relaxed limits to 4 or 5 percent to help states cope with revenue collapse and health expenditure surges.

The mechanics matter because the Centre does not merely set an aggregate ceiling; it also determines what counts toward a state's borrowing for the purposes of that ceiling, including, controversially, off-budget borrowings by state public sector undertakings and loans guaranteed by state governments for entities like power distribution companies. When the finance ministry decided in recent years to count certain off-budget borrowings by Kerala's state-owned entities against the state's overall borrowing limit, retroactively in Kerala's telling, the state's effective headroom for the year shrank sharply, precipitating the legal challenge and a broader political argument about whether the Centre was using technical fiscal rules to constrain a state it did not politically favour.

The case for central oversight

The argument for maintaining strong central oversight of state borrowing is not merely centralising instinct; it rests on a genuine macroeconomic concern. India's combined centre-and-state general government debt remains elevated by international emerging market comparisons, and if individual states borrowed without any coordinated ceiling, aggregate sovereign risk could rise in ways that affect India's borrowing costs and credit ratings as a whole, since international investors and rating agencies assess India's fiscal position on a consolidated general government basis rather than state by state. Additionally, states have historically shown a tendency toward populist fiscal slippage ahead of elections, whether through loan waivers, free electricity schemes or cash transfer programmes announced without corresponding revenue measures, and a hard external borrowing ceiling provides some discipline against this tendency that pure political accountability at the state level has not reliably supplied on its own.

The off-budget borrowing scrutiny specifically has a defensible rationale too: state governments across the political spectrum, not merely opposition-ruled ones, have used state-owned corporations and special purpose vehicles to borrow off their formal budget books precisely to evade FRBM ceilings while still ultimately relying on state government guarantees that create real contingent liability, a practice that predates the current dispute and that Telangana, Punjab and several BJP-ruled states have also been found to have used at different points. Bringing these borrowings into the ceiling calculation closes a genuine loophole rather than arbitrarily targeting any one state.

The case for state autonomy

The counter-argument, and it carries real weight, is that the Constitution's federal design gives states primary responsibility for a wide range of expenditure areas, including health, education infrastructure and welfare delivery, while leaving the Centre with disproportionate control over major revenue sources, especially after GST subsumed states' independent power to set indirect tax rates on most goods, a trade-off states accepted in 2017 partly on the understanding that they would receive compensation and retain reasonable fiscal flexibility elsewhere. If the Centre can also tightly constrain borrowing, including retroactively reclassifying what counts against the ceiling, states argue they are left with neither independent revenue-raising power nor borrowing flexibility to fund the expenditure responsibilities the Constitution assigns them, a genuinely awkward position for any federal system to leave its constituent units in.

Kerala's specific complaint, that the disallowance of certain off-budget borrowings was applied without adequate advance notice and disproportionately affected a state already fiscally stressed by high committed expenditure on pensions and salaries, points to a legitimate procedural concern distinct from the substantive question of whether off-budget borrowing scrutiny is warranted at all. Even economists sympathetic to fiscal discipline have argued that changes to borrowing rules should be prospective and clearly communicated well in advance of a budget cycle, rather than applied in ways that leave states scrambling mid-year.

The Finance Commission's evolving role

The Finance Commission, constitutionally tasked with recommending the formula for tax devolution between the Centre and states, has periodically tried to address these tensions by linking devolution shares and fiscal grants to state fiscal performance, incentivising discipline through the devolution formula itself rather than through borrowing ceiling enforcement alone. The Fifteenth Finance Commission's approach of tying incremental borrowing headroom to power sector reforms specifically reflects an attempt to use fiscal federalism mechanisms constructively, encouraging genuinely value-adding reforms like reducing distribution company losses, rather than merely punitively constraining state finances. Whether the Sixteenth Finance Commission, currently at work, will refine this into a more transparent, rules-based and less discretionary framework, reducing the scope for disputes like Kerala's to arise in the first place, will be one of the more important but under-discussed outcomes of its eventual report.

A tension without a clean resolution

There is no fiscal federalism design that perfectly reconciles national macroeconomic stability with full state fiscal autonomy, and India's current arrangement, however contested, reflects a reasonable if imperfect attempt to balance both. What the ongoing disputes reveal most clearly is the need for greater transparency and predictability in how borrowing ceilings are calculated and communicated, so that legitimate fiscal discipline does not become entangled, in perception or in fact, with the political relationship between whichever party governs in Delhi and whichever governs in a given state. Until that transparency is built more firmly into the system, every borrowing ceiling dispute will carry the double burden of being both a genuine fiscal federalism question and a proxy battle in India's broader Centre-state political contest.