Will 16th Finance Commission push states toward fiscal discipline? CRISIL sees long-term gains

The recommendations of the 16th Finance Commission will strengthen the fiscal health of states over the long term by encouraging higher capital spending and curbing revenue deficits, CRISIL Ratings said on Friday.

The rating agency, however, indicated that near-term challenges may persist due to limited additional fiscal support from the Centre.

The finance commission has retained the states’ share in central taxes, known as vertical devolution, at 41% for the period FY2027–FY2031, the same level recommended earlier by the 15th Finance Commission.

According to CRISIL Ratings, the panel’s focus on fiscal discipline and growth-oriented capital outlays will improve states’ financial position in the long run.

“The 16th FC’s emphasis to reduce mounting revenue deficits and undertake growth-oriented capital outlays augurs well for states’ fiscal health in the long term. In the near term, however, constraints persist with limited incremental fiscal support for states,” the agency said.

A key change recommended by the commission is the discontinuation of revenue deficit grants that were provided under earlier finance commissions.

“Discontinuation of RD grants can compel states to constrain populist spending,” said Anuj Sethi, senior director at CRISIL Ratings.

The commission has also recommended uniform disclosure and rationalisation of subsidy expenditures, especially unconditional cash transfers, which have strained state finances in recent years.

CRISIL estimates social welfare spending by states has risen sharply to about 1.9% of gross state domestic product (GSDP) in fiscal 2026, from around 1.5% in fiscal 2024.

Nearly 43% of the increase is linked to direct transfer schemes, it said.

While revenue deficit grants have been scrapped, the commission has increased allocations to local bodies.

Grants to urban local bodies alone have been raised by 145%.

The higher allocation is expected to support modernisation of civic infrastructure in urban areas and reduce dependence of local bodies on state governments, the agency said.

It could also improve governance standards as part of the grants are linked to conditions such as improving own-source revenues and better waste and water management.

The commission also recommended privatisation of state electricity distribution companies (discoms) to address persistent financial stress in the power sector.

Discom debt stood at around 2.3%–2.5% of GSDP in fiscal 2025, while power-related commitments account for roughly 45% of guarantees issued by states, Crisil said.

Privatisation could improve operational efficiency and financial sustainability of the sector while freeing up state resources for productive spending, the rating agency said.

However, the agency cautioned that states may continue to face fiscal constraints in the near term.

“With vertical devolutions retained at 41% and finance commission grants budgeted at a similar level for fiscal 2027, incremental revenue support to states from the Centre is limited,” said Aditya Jhaver, director at CRISIL Ratings.

As a result, revenue deficits could remain elevated at around 0.9% of GSDP in FY2027 amid moderate revenue growth and persistent committed and welfare expenditures, he added.

The commission has also retained the annual fiscal deficit limit for states at 3% of GSDP, which could restrict significant expansion in capital expenditure in the next fiscal year.

The report of the 16th Finance Commission, chaired by Arvind Panagariya, was tabled in Parliament on February 1.