CRISIL reports that the 16th Finance Commission's reforms, emphasizing capital spending and fiscal discipline, will aid states long-term. However, with tax devolution unchanged at 41%, limited central support may create near-term fiscal stress.
The Finance Commission, mandated to recommend fiscal transfers between the Centre and states for fiscal years 2027-31, has retained the vertical devolution, the states' share in central taxes, at 41 per cent. It has also introduced a new criterion for distributing taxes among states based on their contribution to the national gross domestic product (GDP), aimed at encouraging states to focus on long-term growth-oriented capital outlays.
Push for Fiscal Discipline
The Commission has also discontinued revenue deficit (RD) grants recommended by previous finance commissions, a move expected to improve fiscal discipline among states.
"Discontinuation of RD grants can compel states to constrain populist spending. The 16th FC has also recommended uniform disclosure and rationalisation of subsidy expenditures, especially unconditional cash transfers, which have been a drain on state finances over the last couple of years," said Anuj Sethi, Senior Director at CRISIL Ratings.
According to CRISIL, social welfare expenditure by states has increased sharply to around 1.9 per cent of gross state domestic product (GSDP) in fiscal 2026, compared with around 1.5 per cent in fiscal 2024, with about 43 per cent of the increase linked to direct transfer schemes.
Increased Grants for Local Bodies
While RD grants have been discontinued, the Finance Commission has increased allocations to local body grants by about 81 per cent for the current period. Urban local body grants have seen a particularly sharp rise of about 145 per cent, aligning with efforts to modernise civic infrastructure in urban areas and strengthen local governance.
Recommendation for Discom Privatisation
The Commission has also recommended privatisation of state electricity distribution companies (Discoms), noting that earlier interventions have not achieved the desired results. Discom debt currently stands at about 2.3-2.5 per cent of GSDP in fiscal 2025, while the power sector accounts for nearly 45 per cent of outstanding guarantees provided by states and about 5-6 per cent of their revenue expenditure.
Near-Term Fiscal Pressures to Persist
However, CRISIL cautioned that states may continue to face short-term fiscal pressures.
"With vertical devolution retained at 41 per cent and Finance Commission grants budgeted at similar levels for fiscal 2027, incremental revenue support to states from the Centre is limited," said Aditya Jhaver, Director at CRISIL Ratings. He added that this could keep the revenue deficit elevated in fiscal 2027 due to moderate revenue growth and persistent committed and welfare expenditures.
Additionally, the fiscal deficit limit of states has been retained at 3 per cent of GSDP, which may constrain significant expansion in capital spending in the near term. CRISIL said that how states navigate these near-term challenges and implement the Finance Commission's recommendations will be key factors in assessing their credit profiles going forward. (ANI)
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