Landmark Finance Commission, Prudent Budget, And Key Trade Deals Reshape India’s Economic Outlook

The last fortnight witnessed a rare confluence of events that may have a significant impact on our economic prospects.

First, the Sixteenth Finance Commission submitted its report in the backdrop of several Southern and Western states demanding a higher share in devolution in keeping with their contribution to the nation's GDP. The report is important in three respects: a) The Commission retained the 41% share of union tax revenues to the states as fiscal devolution. In addition, the Commission proposed Rs 8 lakh crore as local body grants, with 45% allocated to urban areas. Both are salutary proposals. If we include grants, centrally sponsored schemes, and interest-free loans for capex, the union transfers to states account for 51.7% of the gross non-debt revenue, or 56.5% of total tax and non-tax revenues, excluding capital receipts, or 59.6% of gross tax revenues.

The states are spending 60% of the total public expenditure in the country, the highest share in a federal country. The union is spending only 37% of the total public expenditure, and there is a structural deficit after non-discretionary expenditure on transfers to states, wages, pensions, and interest payments. There is no fiscal room for additional resources. The real challenge of fiscal federalism is the weak third tier of local governments. The local governments only spend 3% of the total public expenditure, the lowest share among all G-20 countries! And local governments are emasculated in all states except Kerala. States need to follow fiscal discipline and devolve more resources and powers to local governments; that is the real unfinished agenda of federalism.

b) The Finance Commission rightly paved the way for more balanced horizontal devolution. For the first time, the contribution of states to the GDP is given 10% weightage. The result is that the share of the Western and Southern states increased, and that of other states marginally decreased. While there is no radical departure from past allocations, a road map is now in place to address the grievances of the faster-growing states. Also, incentive is created for all states to foster growth. We are in an era of competitive federalism in respect of building infrastructure, attracting investments and promoting growth. Therefore, this gradual shift in emphasis is necessary and welcome.

c) The Finance Commission aptly focused on the need to improve the fiscal health of the states. Some states are doing an impressive job of managing public finances and balancing the needs of welfare with growth. Gujarat, Odisha, Maharashtra, and Uttar Pradesh are doing a creditable job in this respect. Some states, like Andhra Pradesh, Punjab, Himachal Pradesh, West Bengal, Kerala, and Telangana, are getting deeper into debt. The union is the guarantor of financial stability and credit of India. The Constitution provided effective instruments to ensure that the states are fiscally prudent, but the union, over the years, has dropped the ball. It is high time that fiscal rules are tightened under Article 293 and compliance monitored and enforced in a credible, transparent, and non-partisan manner. In this respect, the Finance Commission’s discontinuation of revenue deficit grants to states is a necessary move. If the union replenishes the revenue deficit even after a generous devolution, then there is no incentive for states to be fiscally responsible. Such unearned generosity would be unfair to the other states which practise fiscal discipline.

The second major development is the remarkable fiscal restraint exercised in the union budget, continuing the healthy practices of reducing fiscal deficit and debt-GDP ratio and record allocations for capital expenditure. The budget for FY 2026-27 is predictable and prudent, devoid of drama and resisting the temptations of short-term populism. There could have been greater emphasis on small-town development as hubs of labour-intensive employment and disinvestment. But otherwise, the accent on infrastructure, long-term growth, and building resilience in the face of global uncertainties is welcome. More reforms are needed to unleash our growth potential; perhaps they will be rolled out separately. The budget and the extremely persuasive Economic Survey for 2025-26 give us a sound roadmap for promoting prosperity by building on our strengths and overcoming the weaknesses.

The third development is the announcement of the Free Trade Agreement (FTA) with the European Union. While the FTA will come into effect only after a few months once it crosses all the hurdles, it is a very positive development that signals our willingness to be a serious player in manufacturing and exports in a difficult but vast market. And it is quite a feat to finalise the agreement after intense and protracted negotiations when any one of the 27 member states of the European Union can exercise a veto. In the medium and long term, if we work hard to enhance our productivity and competitiveness, this FTA provides us a great opportunity.

Finally, the announcement of a trade deal with the United States is a significant development in the short, medium, and long terms. The 18% tariff on Indian goods is lower than that imposed on our competitors. A tariff is a tax imposed on importers and consumers. The only thing that matters to us is whether we suffer a higher tariff than our competitors. Low or nil tariffs on American goods in India may not make a significant difference because most US merchandise goods are generally costly and uncompetitive in the Indian market. The US is the world’s largest economy and the biggest market, and no large country that aspires to rapid growth can afford to be excluded from the US market. Immediately the rupee slide will be arrested, FII and FDI will improve, and corporates will be eager to invest in the future.

All in all, all these four developments in quick succession improve our economic outlook in the medium term. There could still be global shocks resulting from US monetary and trade policies or irrational exuberance in AI investments creating a bubble. But thanks to the admirable fiscal prudence of the union over the years, the high capex and strong signals of pro-growth policies, we are in a reasonable position to face the future risks calmly.

The author is the founder of Lok Satta movement and Foundation for Democratic Reforms. Email: drjploksatta@gmail.com / Twitter@jp_loksatta