Finance Commission changes pose transition risks for states' fiscal balance

The 16th Finance Commission throws up a transition challenge for states facing strict fiscal limits

With every new Finance Commission’s award period coming into effect, there are subtle changes in the resource positions of the states. Some Commissions have increased the share of states in vertical devolution. Most have recommended changes in the formula for horizontal devolution, implying an increase in the share of some states and a decline for others, depending on the variables chosen and the weightings assigned. The report of the Sixteenth Finance Commission has left the vertical devolution unchanged while revising the formula for horizontal devolution. Clearly, there are both gainers and losers. Andhra Pradesh, Gujarat, Haryana, Karnataka, Kerala and Punjab emerge as the gainers, with an increase in their share. On the other hand, Arunachal Pradesh, Madhya Pradesh, Uttar Pradesh and West Bengal have seen a reduction in their share. 

Any moderation in the receipts of states could induce them to seek out additional sources of borrowing to bridge emerging gaps. Based on the monthly key indicators put out by the Comptroller and Auditor General of India, for 26 of the 28 states, the ratio of fiscal deficit-to -gross state domestic product (GSDP) for 2024-25 is at 3.3 per cent, compared to 2.9 per cent for 2023-24. To understand the evolution of trends over time, the table juxtaposes the fiscal deficit-to-GSDP in 2023-24 with the change in fiscal deficit-to-GSDP ratio between 2023-24 and 2025-26 (BE). The table suggests that there is some evidence of convergence towards 3.5 per cent. Many states with a higher deficit in 2023-24 have proposed a reduction in deficit while a significant share of those with a lower deficit have proposed an increase in deficit. 

The states marked in red in the table indicate those with a reduction in share. A reduction in receipts or a slowdown in growth for a range of states could mean upward pressure on deficits. 

In particular, the impact on the year of transition needs to be closely examined. It would be instructive to examine the profile of change in tax devolution in 2026-27 against the prevailing debt profile of states. The figure plots change in receipts from central tax devolution between 2025-26 and 2026-27 against the debt-to-GSDP ratio for individual states (2023-24 is the latest date for which data is available). While no clear trend is visible, two points need to be noted. First, of the states with debt-to-GSDP exceeding 40 per cent, 4 experience a decline in the level of devolution available in 2026-27 when compared to 2025-26. This represents not just a decline in the rate of growth but, more importantly, a decline in nominal transfers. These also happen to be states with relatively high dependence on central transfers — own resources account for 10-20 per cent of total revenue receipts. The fiscal situation of these states could come under strain during the transition without support.

 

The second issue to note is that most of the states that will experience a decline in devolution or a low growth (less than 5 per cent over last year) have a debt-to-GSDP ratio over 30 per cent. In other words, these are the states that should be nudged to reduce their debt-to-GSDP ratio. A moderation in the devolution to these states could create upward pressures on their fiscal deficit.

 

Another dimension pertaining to resource flows from the Union government needs attention. There is a gentle pivot in the central programmes towards adopting a challenge mode. The challenge mode is presented as a mechanism to induce proactive decision-making by states — the design of the scheme provides funding for a limited number of states. From a value-for-money perspective, this could be an interesting tool, since states are expected to make an effort to present their best foot forward in both design and execution. However, for fiscally constrained states, such an approach introduces an additional element of uncertainty in resource availability.

 

Juxtaposing these observations against the recommendations on fiscal consolidation in the report of the Sixteenth Finance Commission throws up a transition challenge. It is recommended that the fiscal deficit of the Union government be reduced from 4.4 per cent in 2025-26 to 3.5 per cent by 2030-31, while the states are expected to keep their deficits at 3 per cent of GDP, through the entire period. The Commission recommends that, “To ensure the stability of State Government debt, this limit should be strictly enforced in accordance with clause (3) of Article 293 of the Constitution.” In other words, the adjustment for lower devolution cannot be through a higher fiscal deficit, it needs to be implemented through additional revenue mobilisation or expenditure compression. As a general principle, this is acceptable, but at a point of transition, a less disruptive glide path might be required. 

 

 

The author is director, National Institute of Public Finance and Policy