Tax contribution by States needs to be revisited – Time to Recognize State Efficiency through Tax Contribution | 23 January 2024 | UPSC Daily Editorial Analysis

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What's the article about?

  • It examines the role of tax contribution in the distribution of Union tax revenue to Indian states. It argues that tax contribution, particularly through the Goods and Services Tax (GST) and petroleum consumption, should be included in the distribution formula as an indicator of efficiency, alongside existing equity measures.


  • GS3: Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment
  • Essay: Fiscal Federalism


  • The Finance Commission plays a crucial role in determining the share of each state in Union tax revenue (Horizontal Devolution).
  • Its distribution formula balances equity (addressing needs-based disparities) and efficiency (rewarding tax collection and rational spending).
  • Now, deciding the share of distribution for each state, FC uses some parameters. Historically, the formula has heavily favored equity indicators like population (80-90%), with efficiency indicators like tax contribution receiving lower weights (10-20%).
  • Thus, some states argue that, though they contribute heavily to the collection of taxes, they receive very little share in distribution as per FC's distribution formula.
  • Thus, in this article, the writer argues that some mechanism must be devised to give reasonable weight to tax collections by states while deciding the FC's distribution formula.

Finance Commission

  • The Finance Commission (FC) is a constitutional body, that determines the method and formula for distributing the tax proceeds between the Centre and states, and among the states as per the constitutional arrangement and present requirements.
  • Under Article 280 of the Constitution, the President of India is required to constitute a Finance Commission at an interval of five years or earlier.
  • The 15th Finance Commission was constituted by the President of India in November 2017, under the chairmanship of NK Singh. Its recommendations will cover a period of five years from the year 2021-22 to 2025-26.
  • Now, the Government has established the Sixteenth Finance Commission, appointing Dr. Arvind Panagariya, former Vice-Chairman of NITI Aayog and Professor at Columbia University, as its Chairman.

15th Finance Commission Recommendations:

  • Vertical Devolution (Devolution of Taxes of the Union to States): It has recommended maintaining the vertical devolution at 41% – the same as in its interim report for 2020-21.
  • Horizontal Devolution (Allocation Between the States): For horizontal devolution, it has suggested 12.5% weightage to demographic performance, 45% to income, 15% each to population and area, 10% to forest and ecology and 2.5% to tax and fiscal efforts.
  • Horizontal Devolution Criteria:
    • Population: The population of a State represents the needs of the State to undertake expenditure for providing services to its residents. It is also a simple and transparent indicator that has a significant equalising impact.
    • Area: The larger the area, greater is the expenditure requirement for providing comparable services.
    • Forest and Ecology: By taking into account the share of dense forest of each state in the aggregate dense forest of all the states, the share on this criteria is determined.
    • Income Distance: Income distance is the distance of the Gross State Domestic Product (GSDP) of a particular state from the state with the highest GSDP. To maintain inter state equity, the states with lower per capita income would be given a higher share.
    • Demographic Performance: It rewards efforts made by states in controlling their population.
    • Tax Effort: This criterion has been used to reward states with higher tax collection efficiency. It has been computed as the ratio of the average per capita own tax revenue and the average per capita state GDP during the three-year period between 2016-17 and 2018-19.


  • Historical Considerations:
    • Prior to the 10th Finance Commission, tax contribution, particularly income tax collection, held some weight in the distribution formula.
    • However, the following challenges existed with Tax Contribution as an Indicator:
      • Difficulty in measuring tax contribution: Origin of income tax is complex, making collection a poor indicator of contribution. Lack of proper consumption data hampered similar measures for Union excise duties.
      • Instability of existing efficiency indicators: Tax effort and fiscal discipline fluctuate due to policy changes and external factors.
  • Solution: Tax contribution, especially through GST and petroleum consumption, serves as a strong indicator of efficiency.
  • Why GST and Petroleum Consumption are Ideal Efficiency Indicators?
    • GST:
      • Consumption-based destination tax: Accrual reflects the state's actual tax base, not discretionary policies.
      • Equal sharing between State and Central governments: Accurate estimation of state contribution to the Union exchequer is possible.
      • Stable relative contributions: Variation in absolute GST revenue due to state size and economy doesn't affect relative shares.
    • Petroleum Consumption:
      • Reflects national contribution: Shares of consumption are stable and represent contribution to Union excise duties and customs on petroleum products.
      • Indicates income disparity: Consumption correlates with income, aligning with equity considerations.
    • Thus, both GST and petroleum consumption are stable over time and not influenced by discretionary policies, making them fairer and more accurate measures of contribution. 
    • Including these indicators in the formula aligns with the relative shares of CGST and Union excise duty, contributing about 30% to states' share, and personal and corporate income taxes, contributing 64%.
  • Recommendation for the 16th Finance Commission:
    • Include relative GST contribution and petroleum consumption as efficiency measures: These are fair, accurate, and stable indicators of state contribution.
    • Allocate at least 33% weightage: This recognizes the importance of efficiency while maintaining a balance with equity.

Way Forward:

  • Recognizing state efficiency through tax contribution in the 16th Finance Commission's formula can promote fiscal fairness and incentivize states to contribute more to the national exchequer.
  • This move would require careful consideration and debate to ensure a balanced approach that upholds both equity and efficiency principles.

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