India’s fiscal federalism is under strain, and much of it stems from a growing yet largely concealed debt burden that states are accumulating threw off-budget borrowings. While state governments face increasing financial pressures, their reliance on opaque funding mechanisms ~ often with the tacit approval of the Union government ~ undermines fiscal discipline and long-term economic stability.

The core issue is not just mounting debt but the lack of transparency, political favouritism and structural imbalances in financial governance. For years, states have resorted to borrowing through public sector enterprises and special-purpose vehicles instead of directly raising debt under their own names. These off-budget liabilities, while not formally reflected in state budgets, impose real financial obligations that will ultimately fall on taxpayers. The Union government, too, has engaged in similar practices by shifting its own fiscal burdens onto public sector undertakings. However, when states follow suit, the Centre has selectively raised concerns ~ often when it suits political considerations rather than economic prudence. A key source of strain is the delayed release of tax revenues and grants by the Union government.

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The Goods and Services Tax (GST) reform, meant to unify India’s indirect tax structure, has instead created persistent friction between the Centre and states over compensation payments. Several states have struggled to meet expenditure obligations due to delayed fund transfers, forcing them to take on additional borrowings. The centralisation of fiscal power, coupled with discretionary allocations of grants and loans, has further tilted the balance against states. Adding to the crisis, many state governments have indulged in populist spending, particularly in the form of subsidies and welfare schemes that lack long-term revenue backing. This is not to say that social spending is inherently reckless ~ many welfare measures are essential. However, financing them through short term off-budget borrowings instead of sustainable revenue sources only deepens the fiscal hole. In some cases, states have even mortgaged their future revenues to raise funds, creating a ticking time bomb that will burden future administrations.

Meanwhile, the Union government’s selective intervention in state finances raises concerns about fiscal federalism. While it has criticized certain states for excessive borrowing, it has been more lenient toward others, depending on political alignments. This selective scrutiny erodes the spirit of cooperative federalism and fuels perceptions that financial decisions are driven more by political expediency than economic logic. What is needed is a commitment to transparency, both at the Union and state levels. Off-budget liabilities must be fully accounted for, and states should be incentivised to maintain fiscal discipline without being selectively penalised. The Finance Commission should take a stronger role in ensuring fair and predictable revenue-sharing mechanisms.

Most importantly, India needs a bipartisan approach to fiscal policy that prioritises economic stability over short-term political gains. If left unaddressed, the current trajectory risks leading to a financial crisis where states will struggle to meet their obligations, further widening the economic divide between different regions of the country. The real challenge is not just managing debt but restoring trust in India’s fiscal federalism before it becomes unsustainable.