India’s federal system has long depended on both the Centre and the states working smoothly together. States handle around 60% of public spending — they run schools, hospitals, roads, welfare schemes, and local infrastructure. They prioritize spending based on local needs, and are considered more in sync with what their people need, compared with the Central government in Delhi, which is far from the constituents. But for years, the financial health of the states has been weakening, and recent reports show the problem is getting worse.

States’ debt touched 27.5% of GDP in FY25, far above the widely recommended limit of 20%. This affects how much they can budget for new projects, and future growth. A major turning point came in 2017, when GST was introduced, and states gave up many of their earlier taxing powers. This reduced their ability to raise money independently.

At the same time, routine expenses like salaries, pensions, subsidies, and even “freebies” now consume over 60% of their revenues, leaving far less room for development projects.

Adding to this, the way the Centre transfers money has also changed. More funds come with conditions, limiting how states can spend them. Devendra Pant, Chief Economist at India Ratings & Research, notes, “Because cesses and surcharges are not shared with states, the pool is shrinking — even if the Centre’s tax collections grow, the actual money that comes back to states keeps falling.”

Put simply, states are losing financial freedom, and this affects their ability to function effectively. In this edition of Chart of the Week, we look at why this is not just a money problem — it affects states’ independence and the historical way India has grown, where both the Centre and the states drive the economy together.

The squeeze begins with GST shifts

The stress on state finances comes from three forces: changes in tax powers after GST, rising day-to-day expenses, and changes in how the Centre shares revenue. The introduction of GST in 2017 was the biggest turning point. Before GST, states could set their own value-added tax (VAT) and sales tax rates. After GST, most of these powers moved to the GST Council.

As a result, combined (Centre + states) revenue from taxes replaced by GST fell from 6.5% of GDP in FY16 to 5.5% in FY25, well below the 15th Finance Commission’s target of 7%. For states alone, these revenues declined from 2.9% of GDP in FY16 to 2.3% in FY21 before recovering again, though this is still short of earlier levels.

Meanwhile, the cost of running state governments has increased. Salaries, pensions, and subsidies — especially in electricity and agriculture — have steadily reduced the funds available for development.

Adding to the strain, some states spend a lot on popular ‘freebie’ schemes, which are politically attractive but put heavy pressure on their budgets. Bihar’s free electricity scheme of 125 units per month will cost the government over Rs 19,000 crore in FY26. The recent election-time freebies are projected at Rs 33,000 crore, equal to about 13.1% of the state’s revenue expenditure, adding to its debt of about Rs 4.1 lakh crore.

Andhra Pradesh lets women, girls, and transgender people travel free on many state buses, costing nearly Rs 1,940 crore a year. When combined with other welfare and schemes, the state’s outlay rises to nearly Rs 69,400 crore in FY25, absorbing 29.4% of its revenue expenditure.

Karnataka faces similar pressure. Its five guarantee schemes, including free electricity under Gruha Jyothi and free bus travel under Shakti, cost over Rs 53,000 crore in the FY25 budget, taking up around 18% of the state’s revenue expenditure. These programs divert funds from infrastructure, hospitals, roads, and factories — areas that support long-term growth.

Another issue is the Centre’s increasing use of cesses and surcharges to raise revenue, which are not shared with states. Based on FY26 budget estimates, the Centre is projected to collect around 13.8% of its gross tax revenue through these non-shareable levies. Even the International Monetary Fund noted that “the states bear most of the responsibility for delivering essential public services … but raise much less revenue than the Centre.”

GST 2.0 further bites into revenues

Pressure on states increased after the GST 2.0 rate cuts in September 2025. In October 2025, 20 out of 36 states and UTs recorded a drop in GST collections: Himachal Pradesh by 17% YoY, Jharkhand 15%, Uttarakhand 13%, Andhra Pradesh 9%, and Rajasthan 3%.

Analysts estimate the GST changes may cause a revenue shortfall of Rs 40,000–80,000 crore, with states likely to absorb most of the loss. As one Congress MP said, “The states will lose half or more of this, but neither GST nor cess will flow to them.”

In short, reduced tax power, rising fixed costs, and tighter central funding have squeezed states just when they need to spend more on development.

How are budgets being reshaped?

Growing financial stress is changing how states design their budgets. As debt increases, interest payments rise, leaving less room for new investments.

Only three states—Gujarat, Maharashtra, and Odisha—are within the recommended debt limit of 20% of GDP. Many others are far over it, with some exceeding 30-40%. Himachal Pradesh’s debt is close to 40% of GDP, West Bengal is around 38%, and Rajasthan is about 36%. In addition, state guarantees to loss-making public enterprises, especially electricity distribution companies, add further pressure that is not always visible in headline numbers.

This creates a difficult cycle. Weak revenue forces states to borrow more, higher borrowing raises interest payments, and rising interest costs leave even less room for investment. It also puts more pressure on the Centre, since the overall system depends on both sides contributing to economic progress.

To help with this, the Centre introduced the Scheme for Special Assistance to States for Capital Investment (SASCI), which provides long-term, interest-free loans. Between FY21 and August 2025, states received about Rs 4 lakh crore through this program. Initially, most loans were unconditional, but now only 38% of the funds are untied; the rest require states to meet specific reform-linked conditions.

Northeastern states, along with Sikkim and West Bengal, depend heavily on these central loans. Meanwhile, industrial and services-heavy states like Telangana, Gujarat, Maharashtra, and Karnataka rely on them for less than 10% of their capital spending.

The Reserve Bank of India has also raised the seriousness of the problem, urging states to borrow in a more predictable, planned manner, as total state borrowing is expected to reach a record Rs 12 trillion in FY26.

Rising tensions over resource sharing

As finances tighten, long-standing debates over how national resources are shared have become sharper. The current system, based on factors like income levels and population, aims to balance development needs. But richer states such as Maharashtra, Gujarat, Tamil Nadu, and Karnataka argue that the formula returns far less than what they contribute.

For every Rs 100 Maharashtra contributes in direct taxes, it receives only Rs 6.8 back. Karnataka receives Rs 12.5. Lower-income states receive far more than they contribute. Bihar gets roughly Rs 771 back for every Rs 100 of central taxes it contributes, while Uttar Pradesh receives around Rs 293. Rajasthan and several Northeastern states are also major net gainers because they have greater development needs and weaker tax bases. 

This imbalance has sparked political tension. In September 2025, the Congress party used a Comptroller and Auditor General (CAG) report to accuse the Centre of practicing “coercive federalism.” It argued that the jump in state debt from Rs 17.6 lakh crore in 2013 to Rs 83 lakh crore in 2024 shows a deep imbalance in how resources are shared. 

The larger risk is clear: if financially stressed states cannot invest in infrastructure and development, regional gaps will widen and the balance of India’s growth model will break, leaving the Centre to carry most of the load