Will the 16th Finance Commission’s proposal to end revenue deficit grants weaken a fiscal safety net for states?

Any FC begins with a fiscal asymmetry baked into the Indian Constitution. Following its three-list division, state governments account for roughly 60% of general government spending; but they collect only 36% of revenues. This vertical imbalance is inherent to India’s federal design. The 16th FC has chosen not to alter vertical devolution, or the aggregate share of the divisible tax pool flowing to states.

Therefore, this piece focuses on horizontal devolution—i.e., how that pool is distributed across states—and one significant change that the 16th FC has introduced.

On the horizontal side, the 16th FC report departs meaningfully from its predecessor. It introduces contribution to GDP as a new criterion, rewarding states for their share in national output. It revises the definition of ‘demographic performance,’ shifting from the (inverse of) total fertility rate to population growth between the 1971 and 2011 Censuses. It removes ‘tax effort’ as a criterion, a change with implications we will return to.

The FC has tightened its role in making grant recommendations by tying local body transfers to strict audit and election milestones, making performance-based transfers the cornerstone of its architectural shift.

Yet, perhaps the single most consequential change is the abolition of revenue deficit grants (RDGs). The structural squeeze on state finances has deepened in recent years.

The shareable pool has been quietly eroded by the proliferation of cesses and surcharges, which do not enter the divisible pool. These have grown to ₹6.8 trillion, a cumulative increase of more than 30% over five years. States have no equivalent constitutional authority to impose cesses. Since cess receipts are not always deployed for their statutorily stated purposes, they seem to constitute de facto tax revenues for the Centre that are not counted as part of the shareable pool of resources.

Against this backdrop, RDGs served an important compensatory function: they assisted the states that were unable to meet their spending obligations even after receiving their share of tax devolution. They functioned as a built-in fiscal backstop, an ex-ante compensatory mechanism designed to bridge projected revenue gaps.

The FC’s case for abolishing them is well-documented. The report shows that actual revenue deficits consistently exceeded the normative deficits that FCs had projected and sought to compensate.

The number of states receiving grants and total amounts disbursed grew with each successive commission, with beneficiaries rising from 8 to 11 and then to 17 over the previous three FC periods. Revenue gap-filling had created an ex-ante moral hazard; states had weak incentives to improve their fiscal positions if their deficits would be covered regardless. The harder question is whether the adjustment burden falls proportionately on states where fiscal discipline was most lacking.

Our analysis of actual state revenue deficits for 2023-24, the best available proxy for what states would have received under a continuing RDG regime, reveals a less tidy picture. The states facing the steepest adjustment are not necessarily those that were the most fiscally profligate. If anything, the relationship points the other way.

We construct one measure of fiscal profligacy: the ratio of committed expenditures and subsidies to a state’s own revenues. The states likely to face the largest revenue gap from the absence of RDGs —Punjab, Andhra Pradesh, Himachal Pradesh and Rajasthan—are not, by this measure, the most expansive spenders.

Assam faces a projected gap of about 0.5% of GSDP, significant for a smaller economy, despite not ranking among the high committed-expenditure states. Analysis using 2025-26 budget estimates shows a consistent pattern.

This does not undermine the case for reform. Moral hazard is a genuine problem. But it does raise an important question about the transition design: what support exists for states with genuine structural revenue constraints, as distinct from willful fiscal profligacy? International evidence is clear that major economic reforms are more durable when the transition period accommodates those most exposed to adjustment costs.

The more tractable response lies on the revenue side. Restraining committed expenditures such as salaries, pensions and debt servicing, while also containing competitive transfers, is politically fraught. States facing pressure on welfare delivery tend to prioritize political survival over fiscal reform, fuelling the well-documented race for freebies. The 16th FC report engages with this reality at length.

Several states likely to face the largest adjustment burden also have below-average own tax and non-tax revenues. A two-pronged approach—expanding the tax base and improving collection efficiency—could materially strengthen their fiscal positions over the award period.

Property tax reform stands out as an obvious lever, with demonstrable scope for improvement in states with growing urban populations and appreciating land values.

How can we make property taxes administratively implementable, especially in states with greater spending needs? Strengthening the GST mechanism to increase state GST collections, following practices adopted by the Centre and better performing states, is another opportunity.

There is also an internal tension worth flagging. The removal of ‘tax effort’ as a criterion for horizontal devolution sits uneasily with the goal of fiscal self-reliance. The 16th FC report makes a strong assumption: “the contribution to GDP serves as a surrogate for efficiency-based criteria such as tax effort and fiscal discipline.” If states are not explicitly rewarded for improving their own revenue mobilization, the incentive structure is incomplete and the transition away from deficit grants would be harder to sustain.

Overall, the 16th FC has made a considered decision in abolishing RDG, addressing a real problem in India’s intergovernmental fiscal architecture. But the reform’s success will depend on whether states with structural revenue gaps receive the support needed to close these through their own efforts. The report has laid out its diagnosis with clarity, but the harder work following the implementation lies ahead.

Shohan Mukherjee contributed to this piece.

These are the authors’ personal views.

The authors are, respectively, professor of economics at Ashoka University and director and head of Ashoka Isaac Centre for Public Policy (ICPP); and senior fellow at ICPP.