States may be forced to widen their tax and non-tax revenue sources, rationalise committed expenditure and rein in subsidy payouts, as the 16th Finance Commission has recommended doing away with sector- and state-specific revenue deficit grants.
The Commission said such grants have created an “endless cycle of persistent revenue deficits” instead of addressing the problem.
“Our review and assessment of state finances in general, and that of tax revenues, committed expenditure and discretionary expenditures in particular shows that there is significant scope of increasing revenues and rationalising expenditure,” the finance panel said in its report.
Revenue deficit, or ‘gap’, grants are intended to bridge the post-devolution gap between revenues and expenditures on the states’ revenue account.
The Commission noted that despite a significant increase in devolution of funds from the Centre, several states continue to report sharp rise in revenue deficits, driven by higher committed expenditure such as salaries and pensions, as well as a “worrying” increase in subsidies and transfers in recent years.
“The revenue deficit grants create an adverse incentive whereby the expectation of such grants encourages states to be profligate rather than address the root causes of the revenue shortage,” it noted.
Historical Deficit Trends
The Commission pointed out that only eight special category states received revenue deficit grants during the 13th Finance Commission period (2010-15), while a revenue surplus had been projected for all general category states along with Assam, Sikkim and Uttarakhand.
“Unfortunately, by the time the 14th Finance Commission (2015-20) came along, revenue deficits of states had reappeared,” it noted.
The terms of reference of the 15th Finance Commission (2020-26) had already called for scrapping of the revenue deficit grants. However, such grants were included following demands from several states after the Covid-19 pandemic severely impacted state revenues.
The 15th FC set a goal of zero revenue deficit by 2025-26 for all non-North-East states and recommended revenue deficit grants to 17 states, heavily front-loading them in the first three years of the award period. This, the Commission noted, was largely due to the impact of Covid-19 and the projected post-pandemic recovery.
According to the latest FC report, a substantial portion of states’ revenues continues to be absorbed by committed expenditure, comprising salaries, pensions and interest payments. Per capita salary expenditure of non-North-East states in 2023-24 ranged from as high as `11,000 in states such as Punjab, Tamil Nadu and Kerala to about `4,500 in Bihar.
Similarly, per capita pension expenditure in the same year varied from nearly Rs 7,000 in Kerala to around Rs 2,000 in Bihar. The per capita salary and pension expenditure of North-East states was about double that of non-NE ones.
“Committed expenditure is not the only cause of revenue deficit of the states,” the Commission said, adding that discretionary expenditure on subsidies and transfers has also played a role. Spending on subsidies rose from about Rs 4 lakh crore in 2018-19 to nearly Rs 10 lakh crore in the 2025-26 Budget Estimates.
“Recent increase in subsidies and transfers is driven by unconditional cash transfers being given by states,” it said. State-level cash transfers increased sharply from about Rs 3,000 crore in 2018-19 to Rs 4.14 lakh crore in the 2025-26 Budget Estimates, far exceeding power subsidies in that year.
mproving Tax Efficiency
The Commission said states must improve tax efficiency and rationalise expenditure to eliminate revenue deficits, which remain around 0.3% of GDP in the post-Covid period.
“In continuation of the diminishing trend of the revenue deficit grants recommended by the 15th FC, which reduce to near-zero level by 2025-26, we do not recommend any revenue deficit grants to states,” it said.
However, the Commission recommended a restructuring of grants to local bodies. Grants for rural local bodies (RLBs) are to be classified into basic and performance components, while those for urban local bodies (ULBs) will be divided into basic, performance, special infrastructure and urbanisation premium components.
The aggregate national allocation for basic and performance grants has been split in a 60:40 ratio between RLBs and ULBs, with the basic-to-performance component further divided in an 80:20 ratio for both. The panel has recommended total grants of Rs 7,91,493 crore for duly constituted RLBs and ULBs for the period from 2026-27 till 2030-31.