The strain between the central government and state governments is likely to get more pronounced. India’s fiscal federalism has rarely been free of friction, but a recent recommendation by the Sixteenth Finance Commission may sharpen disappointments. The commission has proposed scrapping revenue deficit grants, a long-standing fiscal safety net for weaker states.
The commission is betting on discipline and self-reliance. Economists fear the change could push fragile hill and northeastern states into financial stress, and back to Delhi’s mercy for ad hoc support.
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How fiscal federalism is designed to work
Centre-state financial relations are already uneasy. The fault lines have widened for over a decade. The Constitution assigns the Union the dominant tax powers, while states carry a large share of expenditure responsibilities, including health, education, law and order, and agriculture.
This is where the Finance Commission steps in. Every five years, it recommends how central tax revenues should be shared and what grants should be given to states. The point is to depoliticise transfers and balance equity with fiscal discipline.
Revenue deficit grants are one of the tools in that balancing act. They were designed for states that, even after receiving their share of central taxes, still faced a gap in meeting routine revenue expenditure. In practice, this is the money that keeps government running: salaries, pensions, maintenance of schools and hospitals, and basic administrative costs. For fiscally weak states, especially those with difficult geography or limited tax bases, these grants have functioned as a stabiliser. They allowed states to meet essential commitments without slipping further into debt.
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Revenue deficit grants matter to weak states
The recommendation to do away with these grants is not a marginal tweak for some states. It is a shock to their revenue accounts.
The commission, led by Arvind Panagariya, has argued that states now have greater scope to raise their own revenues, strengthen tax administration, and rationalise expenditure. Its diagnosis is that continuing revenue deficit grants entrenches dependency, blunts incentives for reform, and weakens accountability for fiscal slippages. The states want a cushion. The commission wants to harden budget constraints.
India’s general government debt is high, and the concern about unconditional transfers is not frivolous. But fiscal policy does not operate in a vacuum. Timing and context matter. The relationship between the Union and many states is already strained on financial grounds. Removing a safety net in a period of heightened distrust changes how the move will be read, and how it will be resisted.
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GST and shrinking fiscal autonomy
The most visible bone of contention has been the design and functioning of the Goods and Services Tax. GST subsumed several state taxes and reduced the fiscal autonomy states once had. A harmonised, centrally coordinated tax system came with a trade-off: states gained a national market, but lost room to manoeuvre on their own revenue instruments.
The phase-out of the compensation mechanism has added to the discomfort. Earlier, states had a clearer cushion against revenue uncertainty. Now several are grappling with volatility and slower growth in GST collections. Disputes over compensation dues and rate-setting have exposed the asymmetry of power inside the GST framework.
Add the friction around centrally sponsored schemes. States argue that tightly designed guidelines and branding reduce their flexibility. Matching fund requirements strain budgets, especially for fiscally stressed states. Then there is the Union’s reliance on cesses and surcharges that are not shareable with states. Many states say their responsibilities remain large while predictable resources have not expanded in step.
In that setting, scrapping revenue deficit grants does not land as a neutral technocratic correction. It lands as another squeeze on state fiscal space.
The hard choices ahead
Not all states face the same adjustment. Some are industrialised and have buoyant tax bases. For hill states, northeastern states, and fiscally stressed states, the adjustment could be sharp.
States such as Himachal Pradesh, Punjab and Andhra Pradesh have in recent years relied on such grants to bridge gaps in their revenue accounts. The charge of fiscal irresponsibility does not settle the argument. These states often struggle for structural reasons: geography, legacy debt, subsidy commitments, and limited avenues for expanding the tax base.
In hilly and northeastern states, the cost of delivering public services is inherently higher. Industrial activity and large-scale formal sector employment are limited. These are precisely the engines that typically shore up tax revenues.
Without revenue deficit grants, states are left with two unpalatable options. One is to curb revenue expenditure. That is politically difficult and socially costly, because revenue expenditure includes the everyday functions of the state. The other is to borrow more. That pushes already stressed states closer to debt sustainability concerns and raises the risk of future compression under fiscal rules.
Revenue deficit grants were a direct instrument to manage this stress. Their removal may be seen by states as another step that narrows their fiscal space. The Union may read resistance as reluctance to undertake hard reforms. That is the road to deeper distrust.
Delhi’s ad hoc fixes may return
There is also a more practical warning embedded in past experience. Former Fifteenth Finance Commission official Arvind Mehta has pointed out that in the 1990s, when an earlier funding formula ended, hill states struggled, after which the government constituted committees, including the Rangarajan Committee, to address structural deficits.
The Union may scrap revenue deficit grants now. But if the same states are pushed into acute stress, Delhi may end up creating a new committee, a new grant window, or a new discretionary mechanism to solve an old problem under a new label. That would defeat the stated purpose of clarity and discipline, while restoring the very dependence the commission wants to end.
The point is not that fiscal discipline does not matter. It does. The point is that a uniform approach does not recognise structural diversity across states.
India’s states do not need a blunt push toward self-reliance. They need differentiated transition paths, with a credible glide path for those facing structural disadvantages. If the Finance Commission framework is seen as indifferent to that diversity, centre-state fiscal relations will get more contentious, not more disciplined.