Context:

• State governments are crucial stakeholders in the Union Budget, as their fiscal health is significantly influenced by tax devolution, grants from the Centre, and interest-free loans for capital spending.
• These components form a substantial part of state revenues and shape their expenditure and deficit levels.

Tax Devolution Trends:

• Overview: Over 40% of several states' revenues come from tax devolution and grants. The actual tax devolution has fluctuated over the past five years, varying from initial budget estimates.
• 2024-25: Tax devolution was revised upwards to Rs 12.9 trillion from Rs 12.5 trillion, reflecting adjustments for previous payments and an increase in states' share of income tax revenues.
• 2025-26: Tax devolution is projected at Rs 14.2 trillion, an 11% increase over the previous year.
• Future projections: The impact of personal income tax modifications may lead to an optimistic revenue growth forecast, potentially affecting tax devolution.

Grants to States - Declining and Volatile Trends:

• Overview: Grants from the Centre have shown an uneven trajectory, influenced by factors such as:
  • End of GST compensation grants (2022-23).
  • Decline in Finance Commission-recommended grants, leading to a 13% drop in total grants (Rs 7.8 trillion in 2023-24).
• 2024-25: Further reduction of Rs 1 trillion in 2024-25 revised estimates due to lower allocations for centrally sponsored schemes and GST compensation.
• 2025-26 projections: Total grants set at Rs 8.9 trillion, marking a 14% growth, surpassing the increase in tax devolution.

Capital Expenditure Loans to States:

• Overview:
  • Interest-free loans for capital expenditure have emerged as a critical funding source since 2020-21.
  • To boost the resources of state governments, the Centre has been stepping up allocation under the special assistance scheme as loans to states for capital expenditure.
• 2024-25 revised estimates:
  • Allocation for the capex loan scheme was reduced to Rs 1.25 trillion from Rs 1.5 trillion.
  • By January-end 2025, actual disbursements reached Rs 1.1 trillion, indicating robust utilization.
  • All 28 states availed funds under this scheme, with major recipients including Bihar, MP, UP, and West Bengal (40% share).
• 2025-26 allocation: Rs 1.5 trillion, with disbursement influenced by the mix of tied and untied loans.

Conditional Borrowing and Power Sector Reforms:

• The Centre extended the 0.5% of gross state domestic product (GSDP) conditional borrowing linked to power sector reforms for 2025-26. In FY 2023-24, States borrowed Rs 1.2 trillion under this framework.
• Initially set to end as per the 15th Finance Commission's recommendations, this extension aims to drive critical reforms in the power sector.
• This move is expected to strengthen state finances and support economic growth.

Implications for State Capital Expenditure:

• Key provisions in the Union Budget positively impact state capex:
  • Higher tax devolution: Provides untied funds, offering fiscal flexibility.
  • Enhanced capex loan outlay: Encourages infrastructure development.
  • Extension of power sector reform-linked borrowing: Incentivizes critical sectoral reforms.

Future Outlook - 16th Finance Commission Recommendations:

• State governments will closely monitor the recommendations of the 16th Finance Commission (FY 2027-31).
• Key expectations include:
  • Deficit and debt targets for states.
  • Continuation of the capex loan scheme beyond the 16th FC award period.
  • Potential exclusion of capex loans from the net borrowing limit.
• The recommendations are expected before the Union Budget 2026-27 and will significantly shape state finances.

Conclusion:

• The Union Budget significantly influences state finances through tax devolution, grants, and loans.
• While tax devolution has seen an upward revision, the volatility in grants remains a concern.
• The capex loan scheme and conditional borrowing linked to power sector reforms play a crucial role in shaping state fiscal health.
• The upcoming 16th Finance Commission recommendations will be critical in determining future fiscal frameworks for states.