How RDG cut leaves hill states vulnerable
Each finance commission has had the authority to evolve its own principles for determining RDG under Article 275
THE Sixteenth Finance Commission's decision not to recommend revenue deficit grant (RDG) to any state marks a significant break from constitutional convention — and for the hill states, it may prove deeply destabilising.
Clause (ii) of the Terms of Reference, dated November 29, 2023, mandates the 16th Commission that it shall determine the principles governing the allocation of grants-in-aid to states from the Consolidated Fund of India under Article 275 of the Constitution.
Earlier finance commissions have consistently discharged this responsibility by recommending post-devolution RDG to states whose revenues, even after tax devolution, were insufficient to meet the assessed expenditure needs. All hill states, including Himachal Pradesh, have regularly received RDG based on such recommendations.
However, the 16th Finance Commission, in its report published on February 1, did not recommend RDG to any state. The commission observed that "State finances in general, and tax revenues, committed expenditure and discretionary expenditure in particular, show that there is significant scope for increasing revenues and rationalising expenditure." On this basis, it chose not to recommend RDG.
Yet, the commission did not specify which states possess such untapped revenue potential or where precisely expenditure rationalisation is feasible. By discontinuing RDG without articulating a clear and state-specific rationale, the commission appears to have abdicated its constitutional duty to determine principles governing such grants under Article 275.
The background to the creation of the finance commission lies in the inherent vertical fiscal imbalance in India. The Union Government commands substantially greater taxation powers relative to its expenditure responsibilities, whereas states bear larger expenditure obligations with comparatively limited revenue-raising authority. This necessitates vertical devolution — the transfer of a share of union tax proceeds to states.
The commission has recommended that 41% of the net proceeds of Union taxes be devolved to the states — the same share as recommended by the Fifteenth Finance Commission. This aspect of the recommendation is not in dispute.
The more complex issue lies in horizontal devolution — the distribution of this 41% among states. The commission has adopted such criteria as population, area, forest cover, per capita income distance and contribution to GDP for inter se distribution.
However, macro indicators used for horizontal devolution do not fully capture the revenue-raising capacity and expenditure disabilities of all states. For example, the revenue potential of Maharashtra cannot be equated with that of Himachal Pradesh or Nagaland. The tax-to-GSDP ratio of most hill states is lower than that of large plain states like Haryana or Uttar Pradesh due to limited industrialisation and geographical constraints.
On the expenditure side, hill states face structural cost disabilities. The cost of constructing a road in Himachal is significantly higher than in Punjab or Haryana.
Similarly, due to dispersed and remote populations, hill states must maintain a larger number of schools, hospitals and administrative units per capita. These cost disabilities are not adequately captured in the horizontal devolution formula.
As a result, even after tax devolution, many hill states face post-devolution revenue deficits. This reality has been recognised by every finance commission since the formation of these states. Not a single commission in the past has denied RDG to hill states, acknowledging that while these states were created to fulfil political and democratic aspirations, they were not necessarily economically self-sustaining at inception.
Each commission has had the authority to evolve its own principles for determining RDG under Article 275. For instance, the Thirteenth Finance Commission capped salary and pension expenditure (net of interest) at 35% of the total expenditure while assessing revenue deficits.
During my tenure as Principal Secretary (Finance), Himachal Pradesh, I represented before the Fourteenth Finance Commission that this condition was unrealistic, given the state's structural constraints.
The commission considered the plea and removed the condition, resulting in RDG of Rs 40,624 crore for Himachal Pradesh, compared to Rs 7,889 crore recommended by the Thirteenth Commission. Thus, while principles may evolve, the responsibility to determine and recommend grants has always been upheld.
In contrast, the Sixteenth Finance Commission has withdrawn from recommending RDG altogether. Its recommendations are applicable from 2026-27 to 2030-31. The financial repercussions for hill states during this period would be severe.
Nagaland, which received Rs 2,750 crore as RDG in 2025-26, and Tripura, which received Rs 2,428 crore, will find it extremely difficult to sustain normal governmental functions without similar support.
The situation demands urgent corrective action. First, all hill States should collectively approach the PM and the Union Finance Minister, seeking the constitution of a high-level committee with representation from these states to reassess the issue of grants under Article 275. Such a committee should be mandated to recommend appropriate compensatory grants in light of structural fiscal disabilities.
Second, pending such recommendations, the Government of India should consider providing ad hoc grants for 2026-27 and relaxing borrowing limits to mitigate immediate fiscal stress.
At the state level, efforts to augment revenue must continue, though the scope is limited in the post-GST regime. For example, Himachal’s per capita tax revenue already exceeds the national average. Nevertheless, the state could explore enhanced revenues through long-term mineral auctions and reforms in hydropower allotment policies to attract investment and secure higher upfront premiums.
On the expenditure side, rationalisation is possible but gradual. With the expansion of private educational institutions, the state needs to reduce government institutions. However, meaningful fiscal correction is a long-term process and cannot substitute for constitutionally mandated support.
A timely response from the Union Government is essential. Without corrective intervention, hill states may face prolonged fiscal distress, adversely affecting governance, infrastructure development and public welfare. For the hill states — guardians of fragile ecosystems, border regions and hydrological resources — fiscal stability is a national imperative.
The debate, therefore, is not about grants versus no grants. It is about whether fiscal federalism can remain responsive to diversity — geographical, economic, and demographic — while upholding constitutional balance.
