Scrapping revenue deficit grants may strain fragile states: Economists

Economists warn that removal of revenue deficit grants could hurt fiscally weak and hill states, forcing them to seek alternative support from the Centre

The 16th Finance Commission’s recommendation to scrap revenue deficit grants (RDGs) could adversely affect fiscally fragile and low-population states, many of which may face adjustment pressures and seek alternative support from the Centre, economists said.

 

Although RDGs were already tapering off, a handful of fiscally stressed states, including Himachal Pradesh, Punjab, and Andhra Pradesh, continued to rely on them, said economists. Their discontinuation could therefore have a detrimental impact on states with high revenue deficits.

 

The impact is expected to be most pronounced in the northeastern and hill states, given their precarious financial positions. Without a dedicated RDG cushion, these states are likely to approach the Union Ministry of Finance for alternative support, such as relaxed borrowing limits, special grants or a new institutional mechanism, said Arvind Mehta, member secretary of the 15th Finance Commission. 

Drawing a parallel with the 1990s, when the end of the Gadgil-Mukherjee formula led to the formation of the Rangarajan Committee to address the structural deficits of hill states, Mehta warned that India could be headed for a similar committee-based solution. “We may land up in a similar kind of a position where some other committee may have to be formed to look at the peculiar problems of especially the Himalayan states,” he reckoned.

 

With population remaining a key determinant of devolution, these states may find that formula-based transfers fall short of meeting their administrative costs. This could necessitate closer engagement between state governments and the Union finance ministry in the future.

 

The Arvind Panagariya-led 16th Finance Commission, in a major departure from earlier commissions, recommended doing away with RDGs altogether. It argued that states have significant scope to raise revenues and rationalise expenditure, and that grants weaken fiscal discipline by embedding dependency rather than resilience.

 

“The impacted states would have to explore ways to raise their own revenues, both tax and non-tax, which would require more effort as they also have to rein in deficits,” said Madan Sabnavis, chief economist at Bank of Baroda.

 

Some economists, however, concur with the rationale behind removing RDGs, adding that the pain for RDG-dependent states could be partly offset by a higher share in tax devolution compared with the 15th Finance Commission period.

 

“The discontinuation of RDG will impact these states heavily, albeit we note that the share of devolution for most of these states has increased versus the 15th Finance Commission. This may help offset some of the losses due to RDG going away,” said Mahavi Arora, chief economist at Emkay Global Financial Services.

 

Icra said that during the 15th Finance Commission award period, 17 states received revenue deficit grants totalling ₹2.9 trillion. Of these, 13 states are expected to receive lower transfers during the 16th Finance Commission period due to the discontinuation of RDGs. “Among these 13, the 16th Finance Commission has recommended a higher inter se share for Andhra Pradesh, Assam, Himachal Pradesh, Kerala, Mizoram, Punjab and Uttarakhand, which is a positive,” it said in a note on Tuesday.

 

The agency, however, said several states could perceive the discontinuation as a negative, because the RDG was an unconditional and an untied source of funds.