India's state debt is rising. Here's what a new fiscal bargain might look like

One option is to link state borrowing costs to their fiscal balances. States with weak public finances should pay higher interest rates on their debt. India has a variant of the problem Europe faces, where Greece could borrow at the same rate as Germany despite vastly different fiscal profiles.

Another option is for the Union government to direct grants toward capital expenditure rather than revenue deficits. The 16th Finance Commission has already moved in that direction by removing revenue deficit grants to states.

Both approaches would impose costs on states that do not manage their finances well. But inter-state inequality is high in India. Some states have a very weak tax base because of poverty. The social contract demands that every citizen gets access to a certain level of administration and public services regardless of their economic circumstances, so a workable balance is as much about politics as economics.

Eventually, fiscal stability depends on expanding the tax base through robust economic growth. More developed states generally cover a larger share of annual expenses through their own tax revenues -- state GST, state excise duties, stamp duties and vehicle registration fees. Those should grow slightly faster than the underlying state economy.

The structure of GST is central to the debate. The original federal bargain that introduced the indirect tax in 2017 included a guarantee that states would get compensated if their tax collections suffered. That compensation was not based on growth of the tax base. States received a revenue guarantee without any link to economic growth, so they had little incentive to maximize it. The Union government pushed a complicated GST, but states went along because of the guarantee. The streamlining over the past few years, often called GST 2.0, has tried to fix those original design problems.

Indian states collectively outspend the Union government because of their constitutional mandates and their proximity to citizens. Their fiscal stability matters for both economic and political reasons. The debate over new incentives -- pricing state bonds based on fiscal health, tying central transfers to capital spending, and differentiated fiscal rules -- is wrapped in the question of what a meaningful new federal bargain looks like.