Finance commissions (FCs) are constitutional bodies, not reform commissions. Under Article 280, they are constitutionally mandated to recommend primarily three things: vertical devolution, horizontal devolution, and grants-in-aid. Over time, their reports have grown thicker and more normative.
Article 275 exemplifies this normative framework, providing grants-in-aid to states considered in need, with amounts drawn annually from Consolidated Fund of India and varying by state. Unlike Article 282 grants, which are conditional and purpose-specific, these grants allow states full discretion, raising sharper concerns about incentives, fiscal discipline and moral hazard.
FCs are asked to reconcile two claims. One, equity - obligation to mitigate structural disadvantage. Two, efficiency - need to preserve incentives for effort, reform and prudence. For long periods, the balance tilted toward equity. The 16th FC has rightly chosen efficiency.
Two points stand out.
Horizontal distribution10% weight is given to a state's GSDP share in national GDP, shifting incentives from entitlement toward economic effort.
Discontinuation of revenue-deficit grants (RDGs)Article 280(3)(b) requires FC to recommend principles for grants. Article 275(1) operationalises them as a charge on Consolidated Fund for States 'in need of assistance', and because Parliament has never legislated under 275(1), this channel has run on FC recommendations throughout.
In practice, the key instrument became RDGs. A 'gap' grants meant to bridge the post-devolution shortfall between a state's revenue receipts and revenue expenditure. Historically, FCs moved from trend-based gap-filling (FC-1 to FC-4) to more 'normative' assessments (explicitly from FC-9 onward), trying to reward tax effort and economy in expenditure rather than writing cheques to the most profligate.
Data 16th FC has shown is blunt. Combined state revenue balance briefly turned surplus. But by 2022-23 and 2023-24, it was back to a revenue deficit of 0.3% and 0.4% of aggregate GSDP, and the number of revenue-deficit states rose from 5 (2011-12) to 12 (2023-24). RDGs themselves became larger, from 1.1% of gross tax receipts under FC-13 to 2.2% under FC-14, and 1.9% under FC-15. This was happening even as FCs kept projecting that deficits would taper to near zero by the terminal year.
Why weren't these grants working? Because FC shows a persistent enforcement failure and a moral-hazard loop.
RDGs created breathing space ex ante but did not induce adjustment ex post. Once states internalise that, GoI will fill revenue gaps, incentives weaken to improve tax administration, curb revenue expenditure, or rationalise subsidies and transfers.
The 'normative' method also became porous because large parts of spending are treated as 'committed' and, so, validated in perpetuity (salaries, pensions), while separating 'acceptable' from 'unacceptable' subsidies becomes arbitrary. Meanwhile, FCs repeatedly assumed buoyancy improvements that did not materialise.
So, RDGs drifted from transitional support into a near-permanent accommodation of weak fiscal effort. Which is why, FC concludes there's scope to raise tax efficiency and rationalise expenditure, and recommends zero RDGs from now on.
These two recommendations are praiseworthy as they bring institutional corrections to incentivise federalism. Economic performance of a state gets embedded within the equalisation framework. States are rewarded for expanding output, investment and employment rather than for fiscal distress alone, introducing a soft but credible discipline against competitive populism and freebie-driven revenue expansion.
Discontinuation of RDGs restores the hard budget constraint at the margin. Gap-filling transfers blurred the link between fiscal effort and outcome. Their removal re-establishes accountability for tax administration, subsidy rationalisation and expenditure prioritisation.
It also reduces structural moral hazard that arises when post-devolution revenue shortfalls are routinely socialised. From GoI's perspective, these reforms reduce pressure for discretionary bailouts and repeated revenue support, strengthening sovereign fiscal credibility and lowering risk premia.
Including GSDP share delivers political-economy benefits. It ensures high- performing states receive fiscal recognition, easing concerns over representation and redistribution. States like Karnataka, Tamil Nadu, Gujarat, Maharashtra, Haryana, Telangana and Kerala see their economic contributions acknowledged, reducing perceptions of purely redistributive extraction.
Instead of permanently compensating revenue weakness, the new framework incentivises states to expand their economic base, deepen formalisation and improve fiscal capacity.
The latest report paves the way for future FCs to lean more towards efficiency. Like in Ayn Rand's Atlas Shrugged, systems decay when effort is detached from reward. Fiscal federalism endures only when efficiency disciplines equity.
The writer is public policy professional
Article 275 exemplifies this normative framework, providing grants-in-aid to states considered in need, with amounts drawn annually from Consolidated Fund of India and varying by state. Unlike Article 282 grants, which are conditional and purpose-specific, these grants allow states full discretion, raising sharper concerns about incentives, fiscal discipline and moral hazard.
FCs are asked to reconcile two claims. One, equity - obligation to mitigate structural disadvantage. Two, efficiency - need to preserve incentives for effort, reform and prudence. For long periods, the balance tilted toward equity. The 16th FC has rightly chosen efficiency.
Two points stand out.
Horizontal distribution10% weight is given to a state's GSDP share in national GDP, shifting incentives from entitlement toward economic effort.
Discontinuation of revenue-deficit grants (RDGs)Article 280(3)(b) requires FC to recommend principles for grants. Article 275(1) operationalises them as a charge on Consolidated Fund for States 'in need of assistance', and because Parliament has never legislated under 275(1), this channel has run on FC recommendations throughout.
In practice, the key instrument became RDGs. A 'gap' grants meant to bridge the post-devolution shortfall between a state's revenue receipts and revenue expenditure. Historically, FCs moved from trend-based gap-filling (FC-1 to FC-4) to more 'normative' assessments (explicitly from FC-9 onward), trying to reward tax effort and economy in expenditure rather than writing cheques to the most profligate.
Data 16th FC has shown is blunt. Combined state revenue balance briefly turned surplus. But by 2022-23 and 2023-24, it was back to a revenue deficit of 0.3% and 0.4% of aggregate GSDP, and the number of revenue-deficit states rose from 5 (2011-12) to 12 (2023-24). RDGs themselves became larger, from 1.1% of gross tax receipts under FC-13 to 2.2% under FC-14, and 1.9% under FC-15. This was happening even as FCs kept projecting that deficits would taper to near zero by the terminal year.
Why weren't these grants working? Because FC shows a persistent enforcement failure and a moral-hazard loop.
RDGs created breathing space ex ante but did not induce adjustment ex post. Once states internalise that, GoI will fill revenue gaps, incentives weaken to improve tax administration, curb revenue expenditure, or rationalise subsidies and transfers.
The 'normative' method also became porous because large parts of spending are treated as 'committed' and, so, validated in perpetuity (salaries, pensions), while separating 'acceptable' from 'unacceptable' subsidies becomes arbitrary. Meanwhile, FCs repeatedly assumed buoyancy improvements that did not materialise.
So, RDGs drifted from transitional support into a near-permanent accommodation of weak fiscal effort. Which is why, FC concludes there's scope to raise tax efficiency and rationalise expenditure, and recommends zero RDGs from now on.
These two recommendations are praiseworthy as they bring institutional corrections to incentivise federalism. Economic performance of a state gets embedded within the equalisation framework. States are rewarded for expanding output, investment and employment rather than for fiscal distress alone, introducing a soft but credible discipline against competitive populism and freebie-driven revenue expansion.
Discontinuation of RDGs restores the hard budget constraint at the margin. Gap-filling transfers blurred the link between fiscal effort and outcome. Their removal re-establishes accountability for tax administration, subsidy rationalisation and expenditure prioritisation.
It also reduces structural moral hazard that arises when post-devolution revenue shortfalls are routinely socialised. From GoI's perspective, these reforms reduce pressure for discretionary bailouts and repeated revenue support, strengthening sovereign fiscal credibility and lowering risk premia.
Including GSDP share delivers political-economy benefits. It ensures high- performing states receive fiscal recognition, easing concerns over representation and redistribution. States like Karnataka, Tamil Nadu, Gujarat, Maharashtra, Haryana, Telangana and Kerala see their economic contributions acknowledged, reducing perceptions of purely redistributive extraction.
Instead of permanently compensating revenue weakness, the new framework incentivises states to expand their economic base, deepen formalisation and improve fiscal capacity.
The latest report paves the way for future FCs to lean more towards efficiency. Like in Ayn Rand's Atlas Shrugged, systems decay when effort is detached from reward. Fiscal federalism endures only when efficiency disciplines equity.
The writer is public policy professional
Aditya Sinha
Assistant consultant, Economic Advisory Council to PM