16th Finance Commission Recommendations May Strengthen States’ Fiscal Health Over Time: CRISIL

India’s 16th Finance Commission recommendations may gradually improve the financial position of state governments by encouraging fiscal discipline and prioritising productive capital expenditure, according to CRISIL Ratings. While the measures are expected to strengthen state finances over the long term, analysts suggest that limited additional fiscal support from the Centre could keep short-term challenges in place.

The finance commission has maintained the states’ share of central tax revenues at 41% for the period FY2027 to FY2031. This level is unchanged from the framework recommended by the previous commission and indicates continuity in fiscal transfers between the Centre and the states.

Focus on Fiscal Discipline and Capital Expenditure

CRISIL Ratings noted that the commission’s recommendations emphasise reducing revenue deficits while encouraging states to increase spending on infrastructure and other growth-oriented sectors. This approach may help improve fiscal sustainability by shifting expenditure from consumption-led spending to investments that support economic activity.

The long-term objective is to strengthen state balance sheets while enabling spending that contributes to economic expansion and development.

Removal of Revenue Deficit Grants

A notable recommendation from the commission is the discontinuation of revenue deficit grants that were previously provided to certain states. According to CRISIL, removing these grants could encourage governments to control expenditure and reduce dependence on central assistance.

The absence of these grants may also prompt states to reassess spending priorities, particularly those linked to welfare schemes and other recurring expenditures.

Rising Social Welfare Spending

CRISIL highlighted that social sector spending by states has increased in recent years. The agency estimates that such expenditure reached around 1.9% of gross state domestic product (GSDP) in fiscal 2026, compared with approximately 1.5% in fiscal 2024.

A significant portion of this increase is linked to direct cash transfer programmes and other welfare initiatives. These schemes have contributed to higher revenue expenditure and may affect fiscal flexibility for some states.

Higher Grants for Local Bodies

While revenue deficit grants have been discontinued, the commission has increased allocations to local governments. Funding for urban local bodies has seen a significant rise, which may support improvements in municipal infrastructure and public services.

Part of these grants is linked to governance-related conditions, including improvements in revenue collection at the local level and better management of waste and water resources.

Recommendation to Reform State Power Distribution Companies

The commission has also suggested the privatisation of state electricity distribution companies (discoms) to address financial stress in the power sector. According to CRISIL, debt levels of state discoms were estimated at roughly 2.3% to 2.5% of GSDP in fiscal 2025.

In addition, liabilities related to the power sector account for a substantial share of guarantees issued by state governments. Structural reforms in this sector could improve efficiency and reduce the financial burden on state finances over time.

Near-Term Fiscal Constraints May Persist

Despite the structural recommendations, states may continue to face fiscal pressures in the short term. With the vertical devolution of taxes maintained at 41% and grants broadly unchanged, the increase in central transfers is expected to remain limited.

CRISIL estimates that revenue deficits may remain around 0.9% of GSDP in fiscal 2027 due to moderate revenue growth and ongoing expenditure commitments.

Fiscal Deficit Limit Retained

The commission has also retained the fiscal deficit cap for states at 3% of GSDP. While this limit supports fiscal discipline, it may also restrict the ability of some states to significantly expand capital expenditure in the near future.

Read More: Middle East Conflict May Create Short-Term Economic Pressures for India, Says RBI MPC Member.

Conclusion

The recommendations of the 16th Finance Commission aim to promote fiscal discipline, improve transparency in spending and encourage productive investments by state governments. While these measures may strengthen fiscal stability over time, states could still face short-term financial constraints due to moderate revenue growth and continued expenditure commitments.

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