Why India's States Are Being Punished for Investing in People

The Strange Economics of Indian Federalism

Imagine two governments.

The first government spends aggressively on highways, industrial incentives, and visible infrastructure projects. The second government spends heavily on public schools, universities, hospitals, research institutions, and human development.

In most developed countries, both approaches are considered investments in future prosperity.

In India's fiscal architecture, however, the second government often gets punished.

This is one of the least discussed but most consequential problems in Indian public finance. State governments that invest heavily in human capital frequently end up with larger fiscal deficits, higher borrowing costs, and less fiscal space to build the next generation of economic institutions.

As India pursues its ambitious vision of becoming a Viksit Bharat by 2047, an uncomfortable question deserves attention:

Can India become a developed nation if its fiscal federalism framework discourages states from investing in human capital?

The Borrowing Gap Nobody Talks About

Unlike the Union government, state governments borrow primarily through State Development Loans (SDLs). These bonds are issued in the market and purchased by institutional investors.

The problem is that states generally borrow at a premium over the Union government.

Recent borrowing data show that State Development Loan yields typically range between 6.5 percent and 7.5 percent, often remaining about 0.25 to 0.75 percentage points above comparable Union government securities. This spread reflects investor perceptions of fiscal risk and differences in borrowing capacity between the Centre and states.

At first glance, a difference of 0.5 percentage points may not seem significant.

In reality, for a state borrowing tens of thousands of crores annually, this translates into a substantial additional interest burden. The result is reduced fiscal flexibility precisely when states need resources to invest in long term development.

The irony is difficult to ignore.

The governments responsible for healthcare, school education, public universities, urban transport, local infrastructure, and much of India's human development agenda are forced to borrow at higher costs than the Union government.

Human Capital Investment Creates a Fiscal Penalty

Economists have long argued that spending on education and health should be treated as productive investment rather than pure consumption expenditure.

India's fiscal rules, however, do not make this distinction.

When a state government establishes a medical university, upgrades public schools, expands scholarships, funds research institutions, or improves healthcare systems, these expenditures increase fiscal deficits in the short term.

Financial markets often respond by demanding higher borrowing costs.

This creates a paradox.

States that prioritize human development can appear fiscally weaker, while states that underinvest in human capital may appear fiscally prudent.

The accounting framework effectively treats spending on a laboratory and spending on administrative overhead in broadly similar ways, despite their vastly different impacts on long term growth.

This creates incentives that may be rational from a fiscal management perspective but damaging from a developmental perspective.

Kerala Illustrates the Contradiction

Few states illustrate this dilemma better than Kerala.

For decades, Kerala invested heavily in public health, literacy, education, and social development. These investments produced remarkable social indicators, including literacy rates and health outcomes that rival many developed countries.

Yet Kerala today faces a difficult reality.

Large numbers of educated young people are leaving the state, either for higher education elsewhere in India or for opportunities abroad. Recent studies and migration surveys continue to document substantial educational migration from Kerala, driven partly by aspirations for better educational infrastructure and employment opportunities.

This is not simply a story of migration.

It is a story of fiscal constraints.

Building globally competitive universities, advanced research ecosystems, innovation clusters, and modern public transport systems requires enormous public investment over long periods. States facing high debt burdens and elevated borrowing costs often struggle to make such investments.

As a result, many talented students and professionals seek opportunities elsewhere, creating a cycle that reinforces regional inequality.

Why Fiscal Federalism Matters More Than Ever

Fiscal federalism refers to the distribution of financial powers and responsibilities between different levels of government.

In India, the Constitution envisages a cooperative federal framework where states receive financial support through tax devolution, grants, and other fiscal mechanisms.

However, several developments over the past decade have complicated this arrangement.

First, the increasing reliance of the Union government on cesses and surcharges has reduced the effective size of the divisible tax pool shared with states.

Second, the Goods and Services Tax fundamentally altered the fiscal autonomy of states.

Third, borrowing constraints imposed under fiscal responsibility frameworks have limited state level flexibility.

The cumulative effect has been a gradual reduction in the independent fiscal capacity of state governments.

This matters because states are not merely administrative units.

They are the primary providers of public goods that shape human development outcomes.

The GST Compensation Debate Exposed Structural Problems

The GST compensation dispute during and after the pandemic highlighted the fragility of India's fiscal federal architecture.

When GST was introduced, states were promised compensation for revenue losses arising from the transition to the new tax system.

However, the economic disruptions caused by the pandemic led to disagreements over compensation payments, borrowing responsibilities, and fiscal burden sharing.

The episode exposed a deeper structural problem.

States had surrendered substantial taxation powers in exchange for a promise of fiscal stability. When economic stress emerged, their reduced fiscal autonomy became painfully evident.

The debate was not merely about compensation.

It was about trust within the federal system.

It raised an important question: can states effectively perform their constitutional responsibilities without sufficient fiscal independence?

The Sixteenth Finance Commission Faces a Historic Challenge

The Sixteenth Finance Commission, whose recommendations cover the period from 2026 to 2031, has inherited perhaps the most complex federal finance challenge since economic liberalization. The Commission continues to examine tax devolution, grants, fiscal sustainability, and Centre state financial relations.

The traditional questions remain important.

How should taxes be shared?

How should grants be allocated?

How should fiscal discipline be maintained?

But a new question has become equally important.

How should India reward states that invest in human capital?

If states that prioritize education, healthcare, research, and social development continue to face fiscal disadvantages, the long term costs for the national economy could be enormous.

The challenge is not merely balancing budgets.

It is designing incentives that support developmental outcomes.

Why Viksit Bharat Requires a New Fiscal Compact

The vision of Viksit Bharat requires India to become a high income, knowledge driven economy.

This transition cannot occur through central government expenditure alone.

It requires state governments capable of building:

• World class universities.
• Advanced research institutions.
• Modern public transportation systems.
• Public health infrastructure.
• Innovation ecosystems.
• Skilled human capital networks.

Yet these investments require fiscal space.

A state government struggling with debt servicing costs cannot easily establish an ecosystem comparable to leading global knowledge hubs.

The current fiscal architecture often rewards expenditure restraint more than developmental ambition.

That incentive structure must change.

What Fiscal Federalism Reform Should Look Like

Meaningful reform requires moving beyond traditional debates about tax sharing percentages.

Several structural changes deserve consideration.

Human Capital Investment Should Receive Special Fiscal Treatment

Public spending on education, healthcare, and research should be partially exempt from conventional deficit calculations, similar to how some countries treat capital investment.

This would reduce the fiscal penalty associated with long term developmental spending.

States Need Greater Borrowing Flexibility

States with strong governance indicators and credible fiscal management frameworks should receive greater borrowing autonomy.

A uniform borrowing ceiling does not adequately reflect differences in state capacity.

Performance Based Development Grants Must Expand

Future Finance Commissions should consider grants linked to measurable improvements in education quality, research output, healthcare outcomes, and innovation indicators.

This would align fiscal incentives with developmental objectives.

The GST Framework Requires Strengthening

Greater predictability in revenue sharing and compensation mechanisms is essential to restore confidence in cooperative federalism.

Fiscal stability is impossible without institutional trust.

The Real Question India Must Answer

The debate about fiscal federalism is often reduced to technical discussions about deficits, borrowing limits, and tax shares.

But beneath these technical questions lies a far more important issue.

What exactly should India's federal system reward?

If the answer is merely fiscal restraint, then states will continue to underinvest in human capital.

If the answer is long term national development, then the fiscal architecture must evolve to support states willing to invest in people.

India's journey toward becoming a developed nation will not be decided solely in New Delhi.

It will also be decided in state universities, public hospitals, research laboratories, metro networks, and classrooms across the country.

The real fiscal federalism crisis is not that states borrow at higher interest rates.

It is that India's current system may be making its most important investments appear too expensive to undertake.