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Informist, Wednesday, Dec. 24, 2025

 

By Priyasmita Dutta

 

NEW DELHI – The 16th Finance Commission is likely to have recommended ways to state governments in which they can reduce their debt to align their fiscal management with the Centre's debt-to-GDP ratio targeting, helping restructure the overall debt of the economy, a senior government official familiar with the recommendations said. The commission, which submitted its report to the President on Nov. 17, is likely to have laid down rolling targets for states that correspond with the Centre's new fiscal consolidation roadmap, the official said. 

 

The official refused to divulge details about the recommendations, including the level of debt or the reductions the states should target.

 

"Fiscal consolidation through targeting fiscal deficit level has broadly served the purpose of anchoring the ballooning fiscal deficit of both states and Centre, especially after the COVID-19 pandemic, but high outstanding debt remains an area that needs to be addressed," the official told Informist. "Shifting entirely away from targeting a particular fiscal deficit level – especially for states – may not be ideal but their debt stock needs greater attention," the official added. 

 

As per the terms of reference, the 16th Finance Commission was mandated to determine the formula for states' share of central taxes and grants-in-aid for five years starting 2026-27 (Apr-Mar). According to the official, determining vertical and horizontal tax devolution without laying down a fiscal consolidation path does not make sense as the eventual arrangement between the Centre and states should take into account their fiscal position and debt vulnerabilities. 

 

Vertical and horizontal devolution are two components of the distribution of tax revenues. Vertical devolution refers to tax revenue sharing by the central government with state governments, while horizontal devolution refers to the distribution of states' share of revenue among individual states.

 

The government has projected its fiscal deficit for FY26 at 4.4% of GDP, marking the last leg of the fiscal consolidation roadmap in line with the 15th Finance Commission's recommendation. For FY27, the Centre has announced its intent to shift its fiscal consolidation benchmarking to metrics favoured by international rating agencies such as the debt-to-GDP ratio and interest expenses.

 

According to the Budget document for FY26, the government aims to keep the fiscal deficit at a level each year such that the central government debt will be on a declining path as a percentage of GDP. Its target for fiscal consolidation is that the Centre's debt is 50% of GDP, plus or minus 1%, by FY31. The government debt is projected to reach 56.1% of GDP at the end of FY26.

 

According to the official, if states adhere to the commission's latest roadmap, their debt will come down materially over the next two-three years, bringing down the combined debt of the Centre and states. "With this, debt burden and off-budget borrowing should not be a concern for the next commission (17th Finance Commission) at all," the official said.

 

The 15th Finance Commission had recommended that the Centre lower its fiscal deficit to 4% by FY26 and states lower their fiscal deficit to 3% of gross state domestic product. For the current fiscal year, states' aggregate fiscal deficit is expected to be 3.2% of GSDP, with seven states expected to have a fiscal deficit higher than the recommended level. These include Madhya Pradesh and Sikkim projecting their fiscal deficit at 4% of their respective GSDP, Andhra Pradesh and Punjab projecting their fiscal gap at 3.8% of their respective GSDP, Himachal Pradesh at 3.6%, followed by Rajasthan at 3.5%, and West Bengal at 3.2%.

 

The panel had also recommended a debt ceiling of 20% of GSDP for states and 40% of India's GDP for the Centre by 2023, although the roadmap became a relic in the wake of the COVID-19 pandemic. While the Centre and states have broadly anchored their fiscal deficit to a figure around the commission's recommendation, the gross debt has stayed at a much higher level.

 

As of March 2025, the total outstanding combined debt of states accounted for 27.5% of the combined GSDP, while the Centre's outstanding debt was 56% of GDP. States with higher outstanding debt-to-GSDP ratios included Punjab at 46%, Himachal Pradesh at 44%, and Arunachal Pradesh at 42%. Only three states had debt within the 20% target by March 2025 – Odisha at 15%, Gujarat at 17%, and Maharashtra at 18%.

 

A rise in debt implies a growing interest payment burden and a higher debt servicing burden reduces states' flexibility to spend on revenue and capital expenditure. According to a report by PRS Legislative Research, between FY17 and FY25, states' interest payments as a percentage of revenue receipts increased to 11.8% from 10.9%.

 

According to the official, the 16th Finance Commission report likely suggested that states restructure their debt by repaying some of the loans the moment they have adequate cash balance to bring down the debt stock. "Managing interest payments is key for states to improve their overall health," the official said.

 

To further nudge states, the commission is likely to favour giving more weightage to a state's fiscal performance while deciding its horizontal devolution share. This will enhance attention on revenue mobilisation and instil discipline in spending, the official said. "The commission reckons the importance of fiscal responsibilities of states and their incremental contribution to overall economy," the official said.  

 

The 15th Finance Commission, headed by N.K. Singh, had given 45% weightage to income distance, 15% to population, 15% to area, 12.5% to demographic performance, 10% to forest cover and ecology, and 2.5% to tax and fiscal efforts while determining states' share of common pool taxes. It had recommended that 41% of the divisible pool be devolved to states.

 

The share of states was cut by one percentage point from the ratio mandated by the 14th Finance Commission to adjust for the reorganisation of Jammu & Kashmir and Ladakh into Union territories. The Budget for FY26 estimates that the Centre will transfer INR 14.22 trillion to states as their share in taxes from the projected collection of INR 42.70 trillion. This is only a 33?volution of taxes and is much lower than the 41% recommended by the 15th Finance Commission. This is because the Centre collects a host of cesses and surcharges that are not part of the divisible pool and are, hence, not shared with states.

 

Informist had reported in June that the 16th Finance Commission is likely to "broadly" stick to the current 41% vertical tax devolution ratio to balance political considerations and fiscal imperatives. Besides revenue deficit grants and state-specific grants, finance commissions also recommend social sector grants to improve states' education and health services, grants to local bodies for administrative and governance reforms, and grants tied to infrastructure maintenance.

 

According to the official, the 16th Finance Commission has probably also recommended that a portion of the finance commission grant be tied to states' fiscal management. "Incentives may push states to be more prudent in their expenditure management," the official said.  End

 

Edited by Avishek Dutta

 

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