Revenue deficit, capital spends: Key takeaways from 15th finance commission

The fiscal relationship between the Government of India (GoI) and the States is governed to a great extent by the recommendations of the Finance Commission (FC). These recommendations, which are typically provided for five years, outline the extent of annual transfer of funds from the GoI to the states, fiscal deficit targets of states, among other things.  As the 15th FC period draws to a close, states and other market participants await the recommendations of the 16th FC for the period FY2027-FY2031. 

 

We have studied the audited fiscal data of 26 state governments for FY2022-FY2024 and provisional actual data (PA) for FY2025, published by the Comptroller and Auditor General of India (CAG). Our analysis reveals a widening of revenue deficit and fiscal deficit as a proportion of gross state domestic product (GSDP) in FY2025 PA from FY2022, amid a welcome increase in capital spending.   

 

On the revenue side, the combined revenue receipts of the 26 states governments declined by 1.1 per cent of GSDP in FY2025 PA from FY2022. While there was an uptick in tax devolution and own revenues of the states, grants compressed to 1.2 per cent of GSDP in FY2025 PA from 2.4 per cent of GSDP in FY2022. The steep decline in FC recommended grants (by 0.5 per cent of GSDP) and GST compensation grants (by 0.4 per cent of GSDP) in FY2025 PA from FY2022 were the key contributors to the dip in revenue receipts.  

  Revenue deficit grants 

The 15th FC had recommended a sizeable Rs. 2.9 trillion as revenue deficit grants (RDG) to a select number of states for FY2022-FY2026. The RDG is recommended by the FC to those states whose revenue expenditure is not being fully met from tax devolution and own revenues of the state. The RDG’s importance to the states is enhanced as there are no conditions attached to the usage of this grant. However, a somewhat less appealing feature of the RDG historically is that it tends to be highly front ended.  

 

Based on the 15th FC’s recommendations, a modest Rs. 245 billion RDG was released by the GoI to the states in FY2025 compared to a sizable Rs. 1.18 trillion in FY2022. This was one of the key reasons for the sharp decline in FC grants to the states in FY2025 PA from FY2022. 

 

Out of the Rs. 2.9 trillion RDG, nearly 58 per cent was recommended for Andhra Pradesh (AP), Himachal Pradesh (HP), Kerala, Punjab and West Bengal (WB) in a range of Rs. 260-400 billion during FY2022-FY2026. Among these states, the revenue deficit of AP, HP and Punjab as a proportion of GSDP worsened sharply in FY2025 PA compared to FY2022, as their revenue spending remained elevated despite a decline in their revenues.  Kerala and WB reported some improvement in their revenue deficit in FY2025 PA relative to FY2022, although it remained unfavourable. Overall, the RDG were not sufficient to sustainably reduce the revenue deficits of all the major recipient states.

 

Moreover, states reduced their revenue expenditure relative to GSDP to a lesser extent, compared to the dip in revenues of 1.1 per cent of GSDP between FY2022-FY2025 PA. Accordingly, the revenue deficit increased to 0.7 per cent of GSDP in FY2025 PA from 0.5 per cent of GSDP in FY2022.  On an encouraging note, the combined capital spending of the 26 states increased to 2.5 per cent of GSDP in FY2025 PA from 2.3 per cent of GSDP in FY2022. The incremental capital expenditure of the 26 states was around Rs. 1.0 trillion during FY2022-FY2024, and a lower Rs. 700 billion in FY2025 PA.

 

The spending ability of the state governments in a fiscal is effectively constrained by the borrowing limits affixed by the GoI based on the recommendations of the successive FCs.  For the period FY2022-2026, the 15th FC had recommended a step down in the net borrowing ceiling (NBC) of state governments from 4.0 per cent of GSDP for FY2022, to 3.5 per cent in FY2023 and to 3.0 per cent each during FY2024-FY2026. Over and above these limits, the 15th FC had recommended an additional borrowing of 0.5 per cent of GSDP for the states, in each of the years during FY2022-FY2025, linked to the completion of the prescribed power sector reforms. 

 

The GoI accepted the 15th FC’s recommendations regarding borrowing limit of the states, however, it made three policy decisions in this period which affected the actual borrowings of at least some states.  The GoI (a) disbursed interest-free capex loans to states in each of the years during FY2022-FY2026 which are over and above the NBC (b) included off-budget borrowings of the states within the NBC from FY2023 onward (c) extended the additional borrowing of 0.5 per cent of GSDP linked to power sector reforms to FY2026 which was to end in FY2025. During FY2022-2025, the GoI has disbursed over Rs. 3 trillion as capex loans to states while some states borrowed Rs. 1.3 trillion by completing the power-sector reforms.  

 

Overall, with the rise in revenue deficit and capital spending by 0.2 per cent of GSDP each between FY2022-FY2025 PA, the fiscal deficit of the states enlarged to 3.2 per cent of GSDP in FY2025 PA (Rs. 10.1 trillion) from 2.8 per cent of GSDP in FY2022 (Rs. 6.1 trillion). Notably, the fiscal deficit of 3.2 per cent of GSDP in FY2025 PA is higher than the NBC of 3 per cent of GSDP set for that fiscal. This reflects the usage of capex loans by all the states and power sector related borrowings by some of the states. 

 

All eyes are now on the 16th FC and its recommendations, for the share of states in the Centre’s tax revenues, the inter se distribution between the states, and its various other suggestions, including on the different types of grants. These will keenly inform state fiscal trends in the medium term, amidst other changes wrought by the upcoming pay revision as well as GST related modifications, in an increasingly uncertain global environment.

 

(Aditi Nayar is the Chief Economist, Head- Research & Outreach, ICRA. Views are her own.)