The recent breach of the hallowed 3% fiscal deficit norm by several Indian states has set off alarm bells among fiscal purists. The narrative often frames it as a simple trade-off: populist welfare schemes are cannibalizing the funds needed for growth-enhancing roads, bridges, and factories. However, a closer look at the fiscal data from the post-pandemic period (FY2021–FY2025) reveals a more complex and arguably more strategic picture. This isn’t a story of fiscal indiscipline; it’s a story of institutionally orchestrated flexibility that has allowed states to navigate an unprecedented crisis while investing in both their people and their physical capital.

The Myth of “Indiscipline”

The immediate assumption is that states have gone on a borrowing binge to fund freebies. The reality is that the elevated deficits were largely permitted, even encouraged, by the Union Government and the 15th Finance Commission. The 3% limit was not broken in a regulatory vacuum; it was expanded through sanctioned channels:

· Reforms-Linked Borrowing: States like Andhra Pradesh and Rajasthan accessed extra funds for undertaking tough power sector reforms. This is not rewarding profligacy; it’s incentivizing efficiency.
· Extraordinary Central Support: The massive ₹2.6 trillion GST compensation loan and the game-changing 50-year interest-free capex loans (₹3.7 trillion) were lifelines from the Centre. The capex loan surge, in particular, directly explains how states could simultaneously announce big welfare schemes and yet see their capital expenditure double.

The system consciously chose temporary flexibility over rigid adherence to a pre-pandemic norm. This was the correct call to prevent a sub-national fiscal collapse.

The Welfare vs. Growth False Dichotomy

The most compelling finding is that the feared “crowding out” of capital expenditure has not materialized at the aggregate level. State capex grew at a stellar 18.5% annually in this period. This shatters the simplistic binary that every rupee spent on a woman’s cash transfer is a rupee stolen from a water treatment plant.

The real trade-off has been subtler and potentially more concerning. To accommodate new welfare promises while keeping revenue deficits in check, states have likely compressed other revenue expenditures. The axe may have fallen on routine maintenance, allocations to older social schemes, or incremental budgets for health and education. This inter-sectoral compression is the hidden cost, not a collapse in infrastructure spending. It questions the quality and sustainability of social spending, not just its quantity.

The Looming Cliff Edge: What Happens After FY2026?

The current model is built on a transitory foundation. The special borrowing windows, the capex loan bonanza, and the 15th Finance Commission’s provisions have a sunset date. The central challenge for the 16th Finance Commission, which is now deliberating, is to manage this transition without triggering a fiscal cliff for states.

States have grown accustomed to a larger fiscal envelope. A sudden reversion to a rigid 3% ceiling, without addressing their structural revenue challenges or committed welfare expenditures, could force brutal cuts, derailing both growth and social stability.

The Way Forward: From Flexibility to Sustainable Frameworks

The 16th Finance Commission’s task is historic. It must move beyond managing a crisis to designing a resilient system.

1. Anchor Stability in Own Revenues: The Commission must prioritize recommendations that strengthen State GST collections, property taxes, and user charges. Dependence on borrowed resources for core welfare is unsustainable.
2. Make the Borrowing Framework Predictable: Clear, transparent, and rules-based criteria for additional borrowing (for reforms, disaster management, etc.) must be institutionalized, reducing ad hoc central discretion.
3. Formalize the Capex Push: The transformative impact of central capex loans is undeniable. The Commission should consider a permanent, formula-based mechanism for capital transfers to states, insulating long-term infrastructure planning from annual budgetary swings.
4. Incentivize Outcomes, Not Just Outlays: The success of reforms-linked borrowing is a template. Future flexibility could be tied to measurable outcomes in education, health, or financial inclusion, not just inputs.

Conclusion

The past five years have demonstrated that Indian fiscal federalism can be dynamic and responsive. States used sanctioned flexibility to support households and build assets. The breach of the 3% deficit was not a failure of rules but a proof that the rules had the necessary built-in elasticity for a crisis.

The task now is to learn from this experience. We must not retreat to rigid austerity. Instead, we must build a new, smarter framework that rewards responsible governance, strengthens own revenues, and provides predictable resources for states to meet their dual—and not contradictory—mandates: to care for their citizens today and build for their prosperity tomorrow. The 16th Finance Commission’s blueprint will decide whether this period was a masterclass in adaptive policy or a one-off escape that leaves states staring at a fiscal wall.