That said, state fiscal policy is equally important as the Centre, with states’ capital expenditure almost at par. The fiscal prudence which marked state governments in the past has been weakening with a gradual pick-up in fiscal deficit over the last few years. State fiscal deficit has risen from 2.7% of GSDP* in FY23 to 3.3% of GSDP in FY25.
Rising state fiscal deficits and borrowing pressure in FY26
The rise in fiscal deficit has resulted in state government bond issuances rising over the last few years. Gross bond issuance by state governments reached 70% of the Centre’s issuance last year, at ₹10.7tn. In FY26 till August, state government bond issuances are tracking higher than last year by nearly 25%YoY. The rise in issuance comes at a time when market appetite has weakened considerably, with the RBI signaling that the rate-cutting cycle is close to the end with its neutral stance.
So, what’s ailing state government finances in FY26, forcing them to come to the market to borrow funds? Based on data available over April-July, the fiscal deficit of 16 state governments is tracking at 22% of the Budget Estimate v/s 18% for the same period last year.
The wider deficit reflects a slowdown in tax revenue collections growth to 6.6% in FYTD26 (Apr-July) v/s 12.1% in FYTD25. The sharp slowdown in tax revenue collection is spread across states’ own tax collections as well as tax devolution from the Centre. State governments’ own tax collections consist of indirect taxes such as SGST, stamp duty collection, etc.
Slowdown in tax revenues and decline in grants
Similar trend of weakness in tax collections is also visible for the Centre with gross tax collection growth slowing to 0.8% in FYTD26 (Apr-Jul) v/s 21.3% for the same period last year. Hence, the tax devolution to state governments has slowed down. Unlike the state government, whose tax collections consist only of indirect taxes, the Centre has access to both direct and indirect taxes.
The weakness in tax collections for both the Centre and state governments reflects a slowdown in income growth as well as policy changes such as the substantial income tax cut. Nominal GDP growth has slowed to a three-quarter low in Q1FY26, and we expect full-year growth at 8% v/s 9.8% in FY25. A slowdown is seen in urban incomes in nominal terms as well as listed company profits in Q1FY26.
Another drag on state government revenue collection is the decline in grants from the Centre. These consist of GST compensation cess, schemes, revenue deficit grants, finance commission grants, etc. Since FY24, there has been a sharp reduction in grants, reflecting the discontinuation of the sharing of GST cess with states. A key factor which has continued to reduce grants to states is the Centre’s just-in-time cash management reform. This is a key reform which ensures that funds for key schemes are only released once past funds have been utilized.
In FY25, grants to state governments were lower by 19.2% YoY v/s the state budgets, which had penciled in a 32.9% increase. In FYTD26, the decline continues with grants tracking lower by nearly 6%YoY. State budgets have once again over-budgeted grants for FY26, penciling in a 69% increase over FY25 actuals.
Expenditure trends, capex push, and bond market impact
On the expenditure front, there has been a lot of focus on targeted income schemes, threatening to worsen expenditure quality. As per state budgets in FY26, 18% YoY growth has been penciled in. Based on expenditure trends to date, revenue expenditure is actually slowing, led by a slowdown in committed expenditure such as wages, pensions, and subsidies.
In fact, overall subsidy expenditure, which includes income schemes, is tracking lower by 7.9% in FYTD26 (April-July) after surging by 52.2% last year.
So, the income schemes haven’t caused further deterioration in expenditure quality in FY26. The rise in expenditure in the current financial year is led by capital expenditure, which is tracking higher by 17.0% after contracting last year. The front-loading of capital expenditure by states is a key support to the capex cycle, along with the Central government capex.
For the year, the consolidated state government fiscal deficit target is 3.1% of GSDP in FY26. Usually, state governments always undershoot the Budget Estimate, as the expenditure side is more modest than the targets. However, given the weakness in revenue collection and the expected impact of the GST cut, the fiscal deficit is unlikely to undershoot target levels. As per our estimates, the cost of the GST cut to states is 0.2% of GDP.
For the bond market, it implies that the net supply of government securities (Centre plus state government bonds) will be higher in H2 than in H1. Almost 60% of total state government borrowing takes place in the second half, while the Centre usually borrows more in H1. Based on our estimates, the net supply of bonds could rise to ₹10.1tn vs ₹8.4tn in H1.
The RBI had purchased G-secs worth ₹2.4tn in H1FY26 (OMO purchases), which effectively reduced the supply available with the market to ₹6.1tn. Hence, there is likely to be a big pick-up in bond supply in H2FY26, when market appetite is weak.
*GSDP Gross state domestic product, which is the sum of state domestic product included in the analysis
Gaura Sengupta – Chief Economist at IDFC FIRST Bank
