In the post-economic liberalisation era, financial sector and fiscal reforms by the central government have adversely affected sub-national finances. The centre's fiscal consolidation measures have contributed to the sharp decline in vertical transfers and the financial liberalisation-induced increase in interest rates has widened the resource gap of the states through an increase in the interest outgo on the stock of debt. This paper examines the effect of the fiscal imbalance on the sub-national fiscal space. Econometric estimates reveal that though the effect of the cost of debt on total expenditure is expansionary, it is negative with respect to the fiscal space. As the sub-national fiscal space has been shrinking, corrective measures are required to increase the states' ability to fulfil developmental fiscal needs.
