Finance Commission proposals long-term positive for states: Crisil

However, in the immediate term, states may continue to face pressures as additional fiscal support from the Centre remains limited, it said.

The Commission, a constitutional body responsible for recommending the sharing of financial resources between the Union and states for the period FY2027–FY2031, has decided to retain the vertical devolution—the share of states in the Centre’s tax revenues—at 41%, unchanged from the previous arrangement.

At the same time, a new parameter has been added to the formula used to distribute tax revenues among states: the contribution of individual states to the national gross domestic product (GDP). This measure is intended to encourage states to prioritise investments that support long-term economic expansion, particularly through capital expenditure.

Another notable change is the discontinuation of revenue deficit (RD) grants, which had been provided by earlier finance commissions. Removing these grants is intended to correct the incentive structure that may have encouraged states to rely on central support to cover recurring expenditure gaps. The move signals a push for stronger fiscal discipline and greater accountability in managing revenue deficits.

“Discontinuation of RD grants can compel states to constrain populist spending,” said Anuj Sethi, Senior Director at Crisil Ratings. 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, primarily in the last couple of years, Sethi said. “Social welfare expenditureis estimated to have increased sharply to around 1.9% of gross state domestic product (GSDP) in fiscal 2026 (basis budget estimates) from around 1.5% in fiscal 2024, with around 43% of the increase pertaining to direct transfer schemes,” Sethi added.

While RD grants have been discontinued, the Commission has shifted its focus towards strengthening local governance by substantially increasing grants to local bodies. The allocation for these grants during the current award period has been raised by about 81% compared with the Rs 4.36 lakh crore allocated during FY21–FY26. A particularly sharp increase—around 145%—has been proposed for urban local bodies.

The aim is to support the modernisation of urban infrastructure, which is increasingly viewed as a key driver of economic growth. Higher allocations could also reduce the dependence of municipal bodies on state governments, while encouraging improvements in governance, transparency, and revenue generation. Some of these grants will be linked to performance metrics such as better solid waste management, improved water supply systems, and efforts to expand local revenue bases.

The Commission has also called for structural reforms in the power sector, including the privatisation of state-owned electricity distribution companies (discoms). Despite multiple policy interventions over the years, financial stress in the sector persists. The debt of distribution companies is estimated to be about 2.3–2.5% of GSDP in FY25. The power sector is also responsible for nearly 45% of the guarantees extended by state governments, and accounts for 5–6% of their revenue expenditure through tariff subsidies, loss funding, and debt servicing. Greater private sector participation is expected to improve operational efficiency, strengthen financial sustainability, and potentially free up state resources for more productive investments.

Despite these structural reforms, fiscal pressures for states are likely to remain in the near term.

“With vertical devolutions retained at 41% and FC 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.

 Further, annual fiscal deficit limit has been retained at 3% constraining any significant growth in capital outlay by states next fiscal, Jhaver added.