Original Article

Estimating Relative Tax Millennial Asia

1–27

Efficiency for Selected © 2023 Association of

Asia Scholars

States in India: An Error Article reuse guidelines:

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Correction Approach DOI: 10.1177/09763996231157048

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Dinesh Kumar Srivastava1,2, Muralikrishna Bharadwaj1 ,

Tarrung Kapur1 and Ragini Trehan1

Abstract
We estimate state-level tax efficiency in India using an error correction frame-
work, making a distinction between a long-term cointegrating relationship and a
short-term dynamics around it. We use a stochastic frontier approach in a panel
data framework considering 17 medium and large (ML) states for the period
2004–2005 to 2019–2020. We find that the FC14’s initiative to sharply increase
the states’ share in the divisible pool of central taxes had an adverse impact on
states’ own tax revenues. The short-term relationship converges to the long-
term relationship in 2.6 years. In terms of relative tax effort, the most efficient
state was Tamil Nadu, while the least efficient was Bihar. Results from this study
would be useful in averting the problem of adverse incentives, while determining
the intergovernmental transfers. In the post-GST scenario, operating at their tax
efficiency frontier would be critical for states especially in the light of discontinu-
ation of the GST compensation cess.

Keywords
Tax efficiency, own tax revenues, cointegrating relationship, error correction
process, stochastic frontier analysis, fiscal transfers

I. Introduction
As per the Indian Constitution, the differential distribution of tax assignments
between centre and states makes for an effective federal structure. Among all
revenue sources, taxation serves as a primary tool to finance the expenditure

Ernst & Young India, Gurugram, Haryana, India

1 

Formerly at Madras School of Economics, Chennai, Tamil Nadu, India

2 

Corresponding author:
Muralikrishna Bharadwaj, Ernst & Young India, Golf View Corporate Tower B, Sector 42, Sector
Road, Gurugram, Haryana 122002, India.
E-mails: Muralikrishna.b@outlook.com; muralikrishna.B@in.ey.com
2 Millennial Asia

responsibilities. However, at the sub-national level, there are large variations in

the expenditure levels of publicly provided goods and services. This may be
attributable to differences in fiscal capacity, varying cost and need disabilities,
and differences in tax effort. Although the first two factors are beyond the control
of the state and must be compensated for in the scheme of fiscal transfers, the
third factor viz. tax effort is within its control. In this context, it is important to
analyse state-level tax efficiency for identifying those states that perform close to
their frontier, that is, they collect tax revenues close to their capacity and those
that are far below their capacity and need to move up to the frontier.
The objective of this study is to construct a tax frontier at the sub-national level
for distinguishing between states operating at the frontier and those below it.
Based on these estimates, states are ranked from low to high tax effort, wherein
low tax effort indicates that a state has not exploited its tax capacity relative to
other states. In the Indian context, with the introduction of GST in 2017, most of
the state-level taxes have been subsumed under GST resulting in a significant
erosion of their tax autonomy. In this backdrop, it is all the more important for
state governments to operate on their tax efficiency frontier with respect to own
tax revenues (OTR) for exploiting their revenue potential. This will have a critical
role to play especially after the cushion of GST compensation cess ceases to exist.
One of the key theoretical/empirical questions that is often cited in the litera-
ture refers to whether low tax-GDP ratio among countries, particularly the devel-
oping countries, is an outcome of low tax base, or whether it is to do with lack of
tax effort, implying tax inefficiency leading to revenue erosion. The empirical
literature on estimating tax efficiency (a term that is often used interchangeably
as ‘tax effort’) is quite vast. Studies have attempted to estimate tax efficiency at
the national level, where a selected group of countries (e.g., developed vis-à-vis
developing countries) have been considered. Some of these include Piancastelli
(2001), Eltony (2002), Gupta (2007), Lotz and Morss (1967), Martinez-Vazquez
(2001), and Brun et al. (2014). Similarly, there are studies that have estimated tax
efficiency at the sub-national level. These include Chelliah (1971), Saini et al.
(2015), Jha et al. (1999), among others. We discuss some of these in detail in
Section III.
In this article, a stochastic frontier approach (SFA) is used to estimate relative tax
efficiency across a set of 17 medium and large (ML) states in India with a view to
determining their own tax revenues (OTR) in per-capita terms if these states were to
operate at maximum or benchmark efficiency. In estimating this model, we have
made a distinction between a long-term relationship among variables determining
state-level OTR and a short-term relationship in an error correction framework. This
exercise is undertaken for the period 2003–2004 to 2019–2020. Estimating per-
capita OTR at selected benchmark levels is a useful exercise for following a norma-
tive approach in determining fiscal transfers from the centre to the states. This is
consistent with a fiscal capacity equalization approach, where assessment of states’
entitlements is undertaken on the basis of normative or benchmark revenues rather
than actual revenues. In such a context, a panel data error correction model has not
yet been used in the Indian context although there is an extensive literature relating
to a stochastic frontier production function approach.
Srivastava et al. 3

This study contributes to the fiscal transfers literature as it demonstrates how a

stochastic frontier tax function may be specified and estimated for measuring tax
potential and efficiency and how a benchmark level of public service (equity) may
be chosen in developing an appropriate formula for designing fiscal transfers.
Although we use the Indian data to demonstrate our newly designed fiscal transfer
system, the model is also relevant for other fiscal transfer systems.
This article contains six sections including the introductory section. Section II
provides a theoretical and empirical review of literature on this subject while
emphasizing the contribution of this study to the existing literature. Section III
discusses the key dimensions of the methodological framework. Section IV pro-
vides details regarding the data and sample period including the descriptive statis-
tics of relevant variables used in the model. Section V provides estimation results
for the long-term and short-term models and discusses the main findings. Section
VI provides concluding observations based on model findings as well as relevant
policy messages.

II. Review of Literature

There is a large body of empirical literature focused on tax efficiency estimates,
which is used interchangeably with the term ‘tax effort’. Studies have attempted
to estimate tax efficiency at the national level, which serves as an important input
in formulation of the relevant policies. Some studies that have estimated country
level tax efficiency include Piancastelli (2001), Eltony (2002), and Gupta (2007).
Lotz and Morss (1967) estimated tax efficiency for developed and developing
countries separately. Martinez-Vazquez (2001) used the fixed effect model to esti-
mate tax efficiency for 32 developing countries over the period 1990 to 1996.
Similarly, Brun et al. (2014) used the random effect model for 85 developing
countries covering the period from 1980 to 2003.
Tax efficiency has also been estimated at the sub-national level with a view to
identifying states that operate close to their capacity (tax frontier) and those that
operate away from this benchmark. Tax collection differs across state govern-
ments in India depending on their tax base (known as taxable capacity) and tax
efforts (also known as tax efficiency). Even though state governments have
similar tax instruments, the efficiency with which they collect revenues from
these taxes can differ significantly. It has been argued in the literature that, once
tax base or capacity factors have been identified, it is possible to recognize an
efficient state, which would be able to collect higher revenues as compared to less
efficient one. Chelliah (1971) defines tax capacity as the ability of a government
to raise tax revenues based on various structural factors including the level of
economic development, the number of ‘tax handles’ available, and the ability of
the population to pay taxes. Bahl (1972) defines tax effort as a measure of how
well a country is using its taxable capacity. In other words, tax effort is the ratio
of actual tax revenue to taxable capacity.
Over time, different methodologies have emerged to estimate tax effort and tax
potential of the governments. Broadly, there are four approaches that have been
4 Millennial Asia

used for estimating government’s tax capacity namely, Income Approach,

Representative Tax System (RTS), Aggregate Regression Approach, and the SFA
approach. For a detailed review of methodologies and possible merits and demer-
its, see Cyan et al. (2013), Pitt and Lee (1981), Battese (1992), and Battese and
Coelli (1992). Referring to Pal et al. (2014), in the Income Approach, revenue
capacity is calculated by taking state or national income, as proxy for the tax base
and tax effort is defined as the ratio of actual tax collection to the state/national
income. However, the main limitation is that this measure assumes that the only
factor determining the variations in tax revenues is income. The RTS method
describes tax capacity, as the hypothetical revenue that a sub-national government
could raise, provided all governments imposed identical effective tax rates to their
tax bases. Although initially, the RTS methodology estimated tax capacity and tax
effort at the aggregate level of tax revenue, its scope was increased later by calcu-
lating these measures for individual components of aggregate tax revenue and
also for remaining revenue sources other than OTR of the sub-national govern-
ments. For calculating the tax capacities, close proxies for the tax base for each
type of tax is required. Purohit (2006) used the RTS approach to compare the tax
effort and taxable capacity of the state governments with the average tax effort of
all the states in India for the period 2000 to 2003. The results indicated that Gujarat
ranked first, followed by West Bengal and Andhra Pradesh.
The third approach namely, Aggregate Regression Approach, incorporates a
set of independent variables explaining variation in the inter-regional tax revenue
(for details, see Bahl, 1971 and Gupta, 2007). These independent variables could
be GSDP of various sectors such as primary, secondary, and tertiary. In addition,
demographic, social, geographical, and political variables can also be included in
the analysis. Oommen (1987) measured the relative tax efforts of 16 Indian states
during the period 1970 to 1982 using this approach. Aggregate tax-income ratio
was regressed on the income of agricultural sector, manufacturing sector, and
income from hotels, trade and commerce. A major limitation of this approach is
that the residual error that can contain a random component is taken as the measure
of tax effort (Rao, 1993).
In recent literature, a large number of studies have used the SFA in estimating
tax efficiency. The SFA methodology is an extension of regression approach. SFA
is a statistical method that is based on regression rather than mathematical pro-
gramming. SFA measures the maximum output (revenue) that a state can achieve
given a set of inputs such as tax base and other determinants. Then, it uses the
random errors generated by the estimation process to measure efficiency. The dif-
ference between the actual revenue and the maximum revenue indicates the tech-
nical inefficiency. The standard econometric SFA model is presented by Aigner
et al. (1977). Several variants of this model such as the Battese and Coelli (1995)
have been applied in the literature. The inefficiency term in the Battese and Coelli
model is assumed to be a linear function of a set of explanatory variables.
Saini et al. (2015) use a principal component analysis (PCA) approach to study
the determinants of tax revenue in India using data from 1999–2000 to
2011–2012. Explanatory variables include growth of Gross Domestic Product,
agriculture, industry, and services, inflation rate, unemployment rate, population
Srivastava et al. 5

density, total expenditure (developmental and non-developmental), Gross

National Income per-capita, and exports and imports. These variables were
divided into three sets namely, ‘Core Developmental Indicators’, ‘Growth
Boosters’, and ‘Sustainable Development Indicators’. A multiple regression anal-
ysis was carried out to test the null hypothesis that these indicators had no influ-
ence on the total tax revenue generation in India. The findings of the study
revealed that these three sets of factors positively impact tax revenue generation
in India with the most important role played by ‘Core Developmental Indicators’,
followed by ‘Growth Boosters’ and ‘Sustainable Development Indicators’.
Mukherjee (2020) used a time variant truncated panel SFA approach to esti-
mate the state-level tax capacity and tax efficiency (tax effort) functions jointly
for the period 2012–2013 to 2019–2020 in the context of the GST in India. The
dependent variable was taken as state’s revenues subsumed in GST during the
VAT regime or state’s GST collection including IGST settlement after the intro-
duction of GST in 2017. The study finds that the capacity of GST collection is
significantly determined by scale of economic activity as measured by GSVA and
the structural composition of the economy as measured by ratio of shares of
mining, manufacturing, industry, and services in GSVA vis-à-vis share of agricul-
ture in GSVA. Further, introduction of GST as captured by a dummy variable
reduced states’ GST capacity and the impact is restricted to scale (intercept) only.
The introduction of another dummy capturing the impact of change in data source
of underlying GST data shows that for low GSVA states, GSTN data shows higher
capacity but for high GSVA states, it shows lower capacity. Further, results of
inefficiency function showed that high per-capita income states have lower tax
efficiency as compared to low-income states. Tax efficiency declines with rising
per-capita income, but it rises after a point, implying a non-linear relationship
between per-capita income and tax efficiency. It was found that minor states
(special category states and UTs with legislative assembly) have lower tax effi-
ciency as compared to major states. The results showed that on average, major
states could increase their GST collection by 0.52% of GSVA and minor states by
1.15% if they increased their tax efforts. The two dummies were found insignifi-
cant in the inefficiency function.
More recently, Kawadia and Suryawanshi (2021) used a stochastic frontier
panel data model to estimate the tax capacity and tax effort of 17 major states of
India for the period 2001–2002 to 2016–2017. The study found that per-capita
income, agriculture activity, infrastructure, labour force, and bank credit signifi-
cantly determined the tax capacity of states. Social sector spending and central
transfer to states were significant in determining tax effort. The authors also noted
that since the implementation of GST has reduced the states’ tax autonomy, the
states are highly dependent on their limited legislative taxes for revenue mobiliza-
tion. The results of the study indicated that the selected 17 states have achieved at
least 90% of their tax potential and hence there might be limited scope for aug-
menting their tax revenues.
Jha et al. (1999) measured tax efficiency for 15 major Indian states for the
period 1980–1981 to 1992–1993 in a manner that allowed efficiency to vary both
across time as well as across states. This study adopted a time variant SFA
6 Millennial Asia

approach as developed by Battese and Coelli (1995) and explored some variables
influencing tax effort as well. To assess if the ranks of states by tax efficiency dif-
fered significantly across the years, Kendall’s coefficient of concordance was also
calculated. The authors found that GSDP, proportion of agricultural income to
total state domestic product (SDP) (AGY), and time series trend captured through
year or time variable significantly determined the OTR capacity of states. A posi-
tive relationship between SDP and OTR and a negative relationship between
share of agriculture in GSDP and OTR was found. Inefficiency determinants
included central government grants in total state government expenditure (GTOE),
interaction term of GTOE and SDP, interaction term of GTOE and AGY and
household consumption expenditure. The main results of this study indicate that
the greater the proportion of states’ expenditure financed by central grants, the
lower is their tax efficiency highlighting a moral hazard problem. Further, the less
poor states, ceteris paribus, display greater efficiency in tax collection. In addi-
tion, rankings of states by tax efficiency for various years do not converge. The
index of aggregate tax efficiency calculated by the authors shows a stagnation.
Shanmugam and Srivastava (2009) specified a tax revenue function for esti-
mating the tax revenue potentials of 15 major state governments in India and
applied them along with a benchmark level of public services to derive the fiscal
transfers required so that each state can provide the same amount of services to its
people subject to maintaining state-level tax effort and efficiency. The period of
their analysis was 1993–1994 to 2002–2003. The authors have used the SFA
approach to estimate tax potential and efficiency at the state level. This study has
also attempted to correct endogeneity bias that arises due to the impact of the past
transfers on current transfers. The results show that the per-capita OTR of a state
is significantly determined by per-capita real GSDP, GSDP deflator, and per-
capita transfers. Further, higher the per-capita transfer from the centre, higher is
the per-capita OTR indicating no adverse effect of transfers on the OTR. This is
in contrast with the findings of Jha et al. (1999). The authors found that the overall
mean efficiency score was 0.63, indicating that on an average, the state govern-
ments approximately utilized only 63% of their tax potential during the study
period and, therefore, it could be possible for states to raise their OTR approxi-
mately by 58% with the existing tax bases/resources.

III. Methodology
Traditional literature on this subject have related state-level tax revenues to activ-
ity variables such as SDP in a cross-section equation. As highlighted by Jha et al.
(1999), this method does not give a good measure of tax efficiency by individual
states because states with high values of activity variables will tend to have larger
tax bases and larger tax revenues and will, therefore, end up showing higher tax
efficiency because of this factor alone. Further, he has emphasized that, tax effi-
ciency is more appropriately measured after altering out the effects of the activity
variables. Tax efficiency analysis carried out using the traditional approach does
not allow for a comparison of tax efficiency across states and across time. For this
Srivastava et al. 7

reason, the recent literature has used panel data framework for measuring tax
efficiency because of the distinct advantages of this approach.
The novelty of our approach relates to two aspects. First, we use an error cor-
rection mechanism, making a distinction between a long-term relationship and the
short-term dynamics, which is characteristic of most time series that are non-
stationary. To the best of our knowledge, this distinction has not been made in the
existing literature on the subject of measurement of relative tax efficiency and
therefore our study bridges this methodological gap. Thus, in this article, we have
endeavoured to test for the existence of a cointegrating relationship and in its
presence, estimated an error correction mechanism describing the short-term
dynamics of the relationship. Second, we have estimated state-level own tax
revenue efficiency for a relatively homogenous group of ML states pertaining to
the recent period spanning from 2004–2005 to 2019–2020, for which latest data
were available. Such a study is not available so far in the Indian context. This
study also captures the changes in overall tax efficiency at the state level that may
have taken place in the post-GST period.
In estimating tax efficiency, we have used the standard SFA (Battese & Coelli
1992, 1995). The SFA models were originally proposed by Aigner et al. (1977)
and Meeusen and van den Broeck (1977). Apart from the basic formulation of the
model, several new models have been proposed with different distributional
assumptions from this basic model. The SFA approach estimates the technical
efficiency/(in)efficiency as reflected by the one-sided residual term. We start with
a simple production function corresponding to the tax revenue of the ith state in
time period t (Yit) as:

Yit = a + V'it b + vit – ui      i = 1, 2, …, n; t = 1, 2, …, T

where,
Yit is the OTR of the state government,
Vit is a vector of relevant explanatory variables for state i at time t,
β is a vector of parameters,
vit is random noise variable,
uit (uit ≥0) is a one-sided residual term, representing the tax (in)efficiency of the
state.

This inefficiency is the reason due to which states’ tax effort falls short of tax
capacity. TE is a non-negative random variable. Normality is assumed for vit.
Different distributional assumptions on uit lead to different class of models. This
model assumes statistical independence between vit and uit.
In this article, we have specified the tax revenue frontier function using the
Cobb-Douglas form.
In a recent discussion by Nayak and Hazarika (2022), cross-sectional depend-
ence among groups of Indian states was noted. The authors also argued that in
view of the recent literature on the subject, panel unit root tests may be conducted
under the assumption of existence of cross-sectional dependence. We have also
tested for cross-sectional dependence for the ML states. We find that there is
8 Millennial Asia

Table 1. Panel Unit Root Test Results for Variables in the Long-run Model.

Group/Variable LPE LOTR LNGSDP

ML Non-stationary Non-stationary Non-stationary
Note: LPE, log of primary expenditure; LOTR, log of the own tax revenues of states; LNGSDP, log
of nominal gross state domestic product.

cross-sectional dependence in the ML group of states. The results are given in

Appendix B. In view of this, we have conducted panel unit root tests in the pres-
ence of cross-sectional dependence. The relevant test is the second-generation
Pesaran (2007) test. Summary statistics with reference to stationarity tests are
summarized in Table 1.
All the relevant variables in the long-run model were found to be non-
stationary at levels. Therefore, we have estimated a cointegrating relationship
among these variables in the long run.

IV. Data and Sample Period

The sample for this study pertains to the 17 ML1 states of India namely, Andhra
Pradesh (including Telangana) (APCB), Assam (AS), Bihar (BH), Chhattisgarh
(CH), Gujarat (GJ), Haryana (HR), Jharkhand (JH), Karnataka (KA), Kerala
(KL), Madhya Pradesh (MP), Maharashtra (MH), Odisha (OR), Punjab (PB),
Rajasthan (RJ), Tamil Nadu (TN), Uttar Pradesh (UP), and West Bengal (WB).
The state of Andhra Pradesh was divided into Andhra Pradesh and Telangana in
2014. To keep the sample period homogenous and not introduce a break in data
points, we have considered variables pertaining to the combined entity of Andhra
Pradesh even beyond 2014–2015. This is done by adding together, the magni-
tudes/values for the relevant variables for the new Andhra Pradesh and Telangana.
The sample period for this analysis is from 2004–2005 to 2019–2020. The rele-
vant data pertaining to state finances have been sourced from various issues of the
RBI state finances: A study of budgets. Data on population and GSDP have been
sourced from Ministry of Statistics and Programme Implementation (MoSPI).
For the purpose of this analysis, variables are first converted into per-capita
terms and then transformed into logarithms. State-level OTR is taken as the
dependant variable. Explanatory variables include nominal GSDP and primary
expenditure at the state level. In the short-term model, additionally, a dummy
variable for the Fourteenth Finance Commission (FC 14) has been added along
with the lagged dependant variable and the error correction term. We have used
SFA for estimating relative tax efficiencies. In the long term, a cointegrating rela-
tionship has been estimated among the variables, while in the short term, a
one-way random effects model has been estimated based on the results of the
Hausman test. The key variables used in this analysis are defined in Table 2.
With the implementation of GST since July 2017, major state taxes that were
merged into the GST included: (a) state VAT (except on specified petroleum prod-
ucts), (b) entry tax, (c) entertainment tax (other than those levied by local bodies),
Srivastava et al. 9

Table 2. List of Variables and Definitions.

No. Variable Name (Taken as Logs in the Model) Short Name

1 Own tax revenues of states* LOTR
2 Primary expenditure (total expenditure minus interest LPE
payments)
3 Nominal gross state domestic product LNGSDP
4 Dummy for fourteenth finance commission period DDFC14
(2015–2016 to 2019–2020)
Notes: ZLOTR represents the residual values from the long-term cointegrating equation.
*OTR constitute (a) land revenue, (b) stamp and registration fees, (c) urban immovable property tax,
(d) sales tax/VAT, (e) state excise, (f) taxes on motor vehicles, (g) taxes on goods and passengers, (h)
taxes and duties on electricity, and (i) entertainment tax.

Table 3. Summary Statistics.

No. of
Variable Mean SD Max Min Observations
LOTR 8.33 0.79 9.65 5.92 272
LPE 9.18 0.66 10.34 7.31 272
LNGSDP 11.12 0.71 12.49 9.08 272

(d) hotel and luxury tax, (e) central sales tax except on specified petroleum prod-
ucts, (f) advertisement tax, (g) entry tax, (h) taxes on lottery, betting, and gam-
bling, and (i) state surcharges.
Descriptive statistics for the variables considered for the long-term model are
summarized in Table 3.

V. Estimating Cointegration and Short-term Dynamics

We hypothesize that state-level OTR is a function of fiscal capacity and own tax
effort. Neither fiscal capacity nor tax effort is directly observable. Fiscal capacity
can however be proxied mainly by per-capita GSDP. In addition to per-capita
GSDP, we have used primary expenditures (LPE). All variables are logarithms of
corresponding per-capita magnitudes. Primary expenditures by the state consti-
tute purchases and as such, become part of the tax base of sales taxes/state-level
GST. Government’s own expenditures are affected by transfers that they receive
from the central government in the form of share in central taxes and grants.
These also affect overall purchases in the state economy directly and indirectly.
We have estimated a cointegrating relationship among these three variables
namely, LOTR, LPE, and LNGSDP, as shown in Table 4.
The Kao residual cointegration test confirms the presence of a cointegrating
relationship among the three variables namely, LOTR, LPE, and LNGSDP. The
results of this test are summarized in Table 5.
10 Millennial Asia

Table 4. Long-term (Cointegrating) Relationship.

Dependent variable: LOTR

Method: Panel fully modified least squares (FMOLS)
Sample: 2005 to 2020
Periods included: 16
Cross-sections included: 17
Total panel (balanced) observations: 272
Panel method: Pooled estimation
Cointegrating equation deterministics: C
Coefficient covariance computed using default method
Long-run covariance estimates (Bartlett kernel, Newey-West fixed bandwidth)
Variable Coefficient SE t-Statistic Probability
LPE 0.402 0.070 5.767 0.000
LNGSDP 0.583 0.078 7.483 0.000
R-squared 0.988 Mean dependent variable 8.328
Adjusted R-squared 0.987 SD dependent variable 0.790
SE of regression 0.089 Sum squared residual 1.983
Long-run variance 0.014

Table 5. Kao Residual Cointegration Test.

Series: LOTR, LPE, LNGSDP

Sample: 2005, 2020
Included observations: 272
Null Hypothesis: No cointegration
Trend assumption: No deterministic trend
User-specified lag length: 0
Newey-West automatic bandwidth selection and Bartlett kernel
  Rho Probability t-Statistic Probability
DF –3.93 0.00 –2.57 0.01
DF* –2.36 0.01 –1.86 0.03
Residual variance     0.005  
HAC variance     0.004  
Dickey–Fuller test equation
Dependent variable: D(RESID)
Method: Least squares
Sample (adjusted): 2006, 2020
Included observations: 255 after adjustments
Variable Coefficient SE t-Statistic Probability
RESID(-1) –0.38 0.05 –7.35 0.00
R-squared 0.174 Mean dependent var 0.00
Adjusted R-squared 0.174 SD dependent var 0.07
SE of regression 0.067 Akaike info criterion –2.55
Sum squared resid 1.153 Schwarz criterion –2.54
Log likelihood 326.519 Hannan–Quinn criter. –2.55
Durbin–Watson stat 1.834  
Srivastava et al. 11

This estimation is based on state-specific intercepts, which are given in

Table 6. These state-specific intercepts highlight the difference among states of
the influence on OTR, which is not captured by the two common explanatory
variables namely, LPE and LNGSDP. Thus, these represent state’s differentiated
own tax effort.

Table 6. State-specific Intercepts.

State C
AS -2.203
BH -2.224
CH -1.829
GJ -1.694
HR -1.674
JH -2.204
KA -1.625
KL -1.675
MP -1.816
MH -1.621
OR -1.970
PB -1.704
RJ -1.868
TN -1.609
UP -1.866
WB -1.993
APCB -1.711

Table 7. Relative Tax Efficiency of Selected States.

States Relative Tax Efficiency (%) Rank

TN 100.0 1
MH 98.8 2
KA 98.4 3
HR 93.7 4
KL 93.6 5
GJ 91.9 6
PB 90.9 7
APCB 90.3 8
MP 81.3 9
CH 80.3 10
UP 77.4 11
RJ 77.2 12
OR 69.7 13
WB 68.1 14
AS 55.2 15
JH 55.2 16
BH 54.1 17
12 Millennial Asia

Based on these intercepts, we can determine relative tax efficiency and relative
ranking of states according to their own tax effort. The relative tax efficiency can
be defined as follows:

ti = ec*–ci

where ti is the relative tax efficiency, c* is the tax efficiency estimate of the bench-
mark state (TN) in log terms and ci is the tax efficiency estimate derived from the
state-specific intercept (as given in Table 6) of the ith state in log terms. e is the
exponential constant to convert the log values into natural numbers.
Accordingly, as shown in Table 7, the best performing state in terms of own tax
effort is TN and the least performing state is Bihar. Other states at the lower end
of tax effort are Jharkhand, Assam, and WB. Some of the better performing states
after TN are Maharashtra, Karnataka, Haryana, and Kerala.
There is a short-term dynamics around a long-term relationship. This is cap-
tured by the equation summarized in Table 8. From the cointegrating relationship,
a residual is obtained as the difference between the actual and the estimated OTR,
the lagged term of which defines the error correction process in the short-run
equation. The magnitude of adjustment of the short-term relationship to the long-
term relationship is given by the coefficient of the lagged error term [ZLOTR
(–1)]. It has the expected negative sign with a magnitude of less than 1. From this
magnitude of 0.388, we can work out the periodicity of the convergence of the
short-term relationship to the long-term relationship as 1/0.388 = 2.6 years
approximately.
In the short-run equation, we have estimated change in the log of OTR as the
dependant variable. In the short-term relationship, we find that there is an adverse
impact of the award of the Fourteenth Finance Commission (FC 14) on state’s
OTR, which is statistically significant. FC 14 had recommended uplifting states’
share in the divisible pool of central taxes from 32% to 42% in one step. The
equivalent of this has been continued by the FC 15 also.
Based on the Hausman statistics (Table 9), the preferred short-term model is a
Random Effects model. There is a common intercept for all states in this
specification.
We can use the entire model to estimate the OTR of the states in per-capita
terms for generating two solutions. In one case, we estimate the model-predicted
OTR for the sample period when actual values of the exogenous variables are
used. In the second case, we estimate the model-predicted OTR when states are
benchmarked to operate at the frontier of the tax effort among states. This implies
that we predict their OTR if they were to apply the same tax effort as that of TN.
We have done this by taking the long-term value of TN’s tax effort as the bench-
mark and giving every state, the same level by replacing the state-specific inter-
cept by TN’s intercept in the long-term relationship. The estimated change in
OTR for each year is then added on the long-term relationship by using the short-
term relationship. In the short-term relationship, there is a common intercept
across states, which has been used.
Srivastava et al. 13

Table 8.  Short-term Relationship.

Dependent variable: DLOTR

Method: Panel EGLS (cross-section random effects)
Sample (adjusted): 2006, 20202
Periods included: 15
Cross-sections included: 17
Total panel (balanced) observations: 255
Swamy and Arora estimator of component variances
Variable Coefficient SE t-Statistic Probability
C 0.061 0.016 3.752 0.000
ZLOTR(-1) -0.388 0.052 -7.508 0.000
DLPE 0.135 0.041 3.309 0.001
DLNGSDP 0.268 0.104 2.569 0.011
DLOTR(-1) 0.184 0.064 2.848 0.005
DDFC14 -0.042 0.009 -4.440 0.000
Effects Specification
SD Rho
Cross-section random 0.000 0.000
Idiosyncratic random 0.062 1.000
Weighted Statistics
R-squared 0.343 Mean dependent var 0.112
Adjusted R-squared 0.330 SD dependent var 0.074
SE of regression 0.061 Sum squared residual 0.914
F-statistic 25.996 Durbin–Watson stat 2.068
Prob(F-statistic) 0.000
Unweighted Statistics
R-squared 0.343 Mean dependent variable 0.112
Sum squared residual 0.914 Durbin–Watson statistic 2.068

Table 9.  Hausman Test for Determining the Short-term Model.

Test cross-section random effects

Chi-square Chi-square
Test Summary Statistic df Probability
Cross-section random 0.000000 5 1.0000
Cross-section random effects test comparisons
Variable Fixed Random Var (Diff.) Probability
ZLOTR(-1) -0.378715 -0.387706 0.000046 0.1852
DLPE 0.130222 0.135258 0.000038 0.4156
DLNGSDP 0.274296 0.267757 0.000902 0.8276
DLOTR(-1) 0.169120 0.183536 0.000141 0.2251
DDFC14 -0.042527 -0.041843 0.000002 0.5910
(Table 9 continued)
14 Millennial Asia

(Table 9 continued)
Cross-section random effects test equation:
Dependent variable: DLOTR
Method: Panel least squares
Sample (adjusted): 2006, 2020
Periods included: 15
Cross-sections included: 17
Total panel (balanced) observations: 255
Variable Coefficient SE t-Statistic Probability
C 0.063 0.017 3.711 0.000
ZLOTR(-1) -0.379 0.052 -7.272 0.000
DLPE 0.130 0.041 3.150 0.002
DLNGSDP 0.274 0.108 2.529 0.012
DLOTR(-1) 0.169 0.066 2.580 0.011
DDFC14 -0.043 0.010 -4.472 0.000
Effects Specification
Cross-section fixed (dummy variables)
R-squared 0.350 Mean dependent var 0.112
Adjusted R-squared 0.291 SD dependent var 0.074
SE of regression 0.062 Akaike info criterion -2.632
Sum squared residual 0.904 Schwarz criterion -2.326
Log likelihood 357.570 Hannan–Quinn criterion -2.509
F-statistic 5.973 Durbin–Watson statistic 2.079
Prob(F-statistic) 0.000  

The results are summarized in Appendix A for all the 17 states. A comparison
of the time profile of these model-predicted OTR magnitudes are summarized in
Figures 1 to 17. We have also plotted the actual per-capita OTR for this period to
indicate the goodness of fit of the estimated model.
The years correspond to fiscal years. For example, 2006 refers to 2005–2006
and so on.

VI. Conclusions and Policy Implications

Using a panel data set of 17 ML Indian states, covering the period 2004–2005 to
2019–2020, we have determined state-wise OTR in per-capita terms using an SFA
approach. A distinction has been made between a long-term relationship and a
short-term dynamics around it. We find that per-capita OTR of states is signifi-
cantly determined by primary expenditures and nominal GSDP. In the short-run
equation, apart from the error correction term, other significant explanatory vari-
ables were primary expenditure, nominal GSDP, lagged dependant variable, and a
dummy variable capturing the recommendation period of FC14. A noticeable
finding is that the FC14 initiative to increase the states’ share in the divisible
pool of sharable central taxes by 10% points in one step has had a statistically
Srivastava et al. 15

Figure 1. Per-capita Own Tax Revenues: AS.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Assam. The divergence
between benchmark and fitted curves is high.

Figure 2. Per-capita Own Tax Revenues: BH.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Bihar. The divergence
between benchmark and fitted curves is high.

Figure 3. Per-capita Own Tax Revenues: CH.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Chhattisgarh. The
divergence between benchmark and fitted curves is medium.
16 Millennial Asia

Figure 4. Per-capita Own Tax Revenues: GJ.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Gujarat. The divergence
between benchmark and fitted curves is low.

Figure 5. Per-capita Own Tax Revenues: HR.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Haryana. The divergence
between benchmark and fitted curves is low.

Figure 6. Per-capita Own Tax Revenues: JH.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Jharkhand. The divergence
between benchmark and fitted curves is high.
Srivastava et al. 17

Figure 7. Per-capita Own Tax Revenues: KA.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Karnataka. The divergence
between benchmark and fitted curves is negligible.

Figure 8. Per-capita Own Tax Revenues: KL.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Kerala. The divergence
between benchmark and fitted curves is low.

Figure 9. Per-capita Own Tax Revenues: MP.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Madhya Pradesh. The
divergence between benchmark and fitted curves is medium.
18 Millennial Asia

Figure 10. Per-capita Own Tax Revenues: MH.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Maharashtra. The
divergence between benchmark and fitted curves is negligible.

Figure 11. Per-capita Own Tax Revenues: OR.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Odisha. The divergence
between benchmark and fitted curves is high.

Figure 12. Per-capita Own Tax Revenues: PB.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Punjab. The divergence
between benchmark and fitted curves is low.
Srivastava et al. 19

Figure 13. Per-capita Own Tax Revenues: RJ.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Rajasthan. The divergence
between benchmark and fitted curves is medium.

Figure 14. Per-capita Own Tax Revenues: TN.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Tamil Nadu. Benchmark
and fitted curves coincide.

Figure 15. Per-capita Own Tax Revenues: UP.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for Uttar Pradesh. The
divergence between benchmark and fitted curves is medium.
20 Millennial Asia

Figure 16. Per-capita Own Tax Revenues: WB.

Note: This figure plots Actual, Fitted and Benchmark per-capita OTR for WB. The divergence
between benchmark and fitted curves is high.

Figure 17. Per-capita Own Tax Revenues: AP (including TS).

Notes: This figure plots Actual, Fitted and Benchmark per-capita OTR for Combined Andhra
Pradesh. The divergence between benchmark and fitted curves is low.

significant adverse impact on the OTR at the state level. A second important
finding of this article is that the short-term relationship converges to the long-term
relationship in about 2.6 years.
We have used these estimates for generating an index of relative tax efficiency
among the 17 states under study. We find that the best performing state in terms of
OTR is TN and the least performing state is Bihar. Other states at the lower end of
tax effort are Jharkhand, Assam, and WB. Some of the better performing states
after TN are Maharashtra, Karnataka, Haryana, and Kerala.
An important practical implication of this article is for the Finance Commission
and the Central government ministries that deal with fiscal transfers to sub-
national governments. It provides a framework in which fiscal transfers can take
Srivastava et al. 21

into account the normative level of states’ own tax revenue rather than the actual
level. By this way, the problem of adverse incentives in determining fiscal trans-
fers can be avoided. Further, with the introduction of GST in 2017, most of the
state-level taxes have been subsumed under GST resulting in a significant erosion
of their tax autonomy. In this backdrop, it is critical for state governments to
operate on their tax efficiency frontier with respect to OTR for exploiting their
revenue potential. This will have a critical role to play especially after the cushion
of GST compensation cess ceases to exist.

Acknowledgments
We sincerely thank the anonymous referees for their valuable comments and suggestions.

Declaration of Conflicting Interests

The authors declared no potential conflicts of interest with respect to the research, author-
ship and/or publication of this article.

Funding
The authors received no financial support for the research, authorship and/or publication
of this article.

ORCID iD
Muralikrishna Bharadwaj     https://orcid.org/0000-0001-5179-6828

Appendix A. State-wise Benchmark, Fitted, and Actual Per-capita Tax Revenues.

Per-capita Own Tax Revenues: AS Per-capita Own Tax Revenues: BH

Benchmarked Benchmarked
Year Actual Fitted to TN Actual Fitted to TN
2006 1,130 1,235 2,237 387 466 863
2007 1,198 1,356 2,455 429 577 1,068
2008 1,138 1,480 2,680 529 722 1,336
2009 1,383 1,694 3,067 627 916 1,696
2010 1,636 2,054 3,718 804 1,129 2,088
2011 1,915 2,425 4,391 959 1,376 2,546
2012 2,429 2,796 5,063 1,201 1,640 3,034
2013 2,590 3,083 5,583 1,523 1,894 3,504
2014 2,788 3,352 6,069 1,841 2,088 3,863
2015 2,892 3,711 6,720 1,884 2,197 4,064
2016 3,053 3,947 7,147 2,275 2,216 4,100
2017 3,603 4,386 7,943 2,089 2,238 4,140
2018 4,581 4,892 8,859 2,539 2,277 4,212
2019 4,810 5,177 9,375 2,598 2,350 4,348
2020 4,789 5,378 9,737 2,500 2,356 4,358
(Appendix A cantinued)
22 Millennial Asia

(Appendix A cantinued)
Per-capita Own Tax Revenues: CH Per-capita Own Tax Revenues: GJ
Benchmarked Benchmarked
Year Actual Fitted to TN Actual Fitted to TN
2006 1,774 1,688 2,103 2,862 2,950 3,212
2007 2,165 1,957 2,438 3,307 3,427 3,731
2008 2,362 2,240 2,791 3,851 3,901 4,247
2009 2,716 2,594 3,231 4,073 4,399 4,788
2010 2,875 2,937 3,659 4,543 5,048 5,495
2011 3,561 3,392 4,226 6,065 5,986 6,516
2012 4,154 3,965 4,939 7,266 6,811 7,415
2013 4,975 4,531 5,644 8,733 7,565 8,236
2014 5,387 5,113 6,370 9,015 8,077 8,793
2015 5,806 5,669 7,063 9,681 8,653 9,420
2016 6,211 5,935 7,394 9,759 8,998 9,795
2017 6,782 6,362 7,926 9,907 9,515 10,358
2018 7,747 6,801 8,473 11,174 10,479 11,408
2019 7,589 7,238 9,017 12,064 11,689 12,724
2020 7,547 7,746 9,650 11,676 12,798 13,932
Per-capita Own Tax Revenues: HR Per-capita Own Tax Revenues: JH
Benchmarked Benchmarked
Year Actual Fitted to TN Actual Fitted to TN
2006 3,957 2,953 3,152 979 1,218 2,208
2007 4,677 3,210 3,425 1,039 1,452 2,632
2008 4,883 3,438 3,668 1,155 1,767 3,204
2009 4,811 3,778 4,031 1,621 2,106 3,819
2010 5,358 4,444 4,742 1,737 2,395 4,341
2011 6,683 5,313 5,670 1,827 2,714 4,920
2012 7,981 6,212 6,629 2,088 3,002 5,442
2013 9,088 7,096 7,572 2,430 3,369 6,107
2014 9,725 7,894 8,423 2,727 3,617 6,556
2015 10,365 8,734 9,320 2,960 3,965 7,187
2016 11,438 9,827 10,486 3,230 4,108 7,446
2017 12,408 11,011 11,750 3,682 4,328 7,846
2018 15,043 12,393 13,224 3,953 4,562 8,270
2019 15,154 13,486 14,390 3,968 4,719 8,554
2020 14,971 14,617 15,598 4,447 4,860 8,809
Per-capita Own Tax Revenues: KA Per-capita Own Tax Revenues: KL
Benchmarked Benchmarked
Year Actual Fitted to TN Actual Fitted to TN
2006 3,303 3,316 3,370 3,005 3,110 3,321
2007 4,071 3,833 3,895 3,653 3,546 3,786
2008 4,475 4,371 4,441 4,161 4,081 4,357
2009 4,692 4,908 4,987 4,844 4,663 4,979
2010 5,115 5,551 5,640 5,314 5,267 5,624
2011 6,343 6,524 6,629 6,518 5,955 6,358
(Appendix A cantinued)
Srivastava et al. 23

(Appendix A cantinued)
Per-capita Own Tax Revenues: KA Per-capita Own Tax Revenues: KL
Benchmarked Benchmarked
Year Actual Fitted to TN Actual Fitted to TN
2012 7,559 7,533 7,654 7,677 6,887 7,354
2013 8,649 8,466 8,602 8,934 7,810 8,340
2014 9,964 9,467 9,619 9,461 8,701 9,291
2015 11,050 10,461 10,629 10,367 9,706 10,364
2016 11,768 11,061 11,238 11,418 10,481 11,192
2017 12,782 11,945 12,137 12,288 11,506 12,287
2018 13,886 13,000 13,209 13,962 12,602 13,457
2019 14,873 14,287 14,516 14,718 13,781 14,716
2020 15,485 15,620 15,871 14,444 14,633 15,626
Per-capita Own Tax Revenues: MP Per-capita Own Tax Revenues: MH
Benchmarked Benchmarked
Year Actual Fitted to TN Actual Fitted to TN
2006 1,390 1,519 1,868 3,238 3,694 3,740
2007 1,567 1,721 2,117 3,815 4,339 4,394
2008 1,766 1,932 2,376 4,455 5,047 5,110
2009 1,963 2,210 2,718 4,805 5,789 5,861
2010 2,445 2,566 3,155 5,378 6,699 6,783
2011 2,977 2,958 3,637 6,726 7,938 8,038
2012 3,677 3,386 4,163 7,745 9,114 9,228
2013 4,100 3,757 4,621 9,044 10,187 10,314
2014 4,425 4,057 4,989 9,390 11,197 11,337
2015 4,746 4,417 5,431 9,841 12,218 12,371
2016 5,136 4,676 5,751 10,712 12,992 13,155
2017 5,561 5,178 6,368 11,441 14,042 14,219
2018 6,195 5,730 7,046 14,244 15,111 15,301
2019 6,376 6,288 7,733 15,479 15,955 16,155
2020 6,734 6,963 8,563 15,384 16,488 16,695
Per-capita Own Tax Revenues: OR Per-capita Own Tax Revenues: PB
Benchmarked Benchmarked
Year Actual Fitted to TN Actual Fitted to TN
2006 1,281 1,265 1,814 3,480 3,157 3,471
2007 1,533 1,452 2,082 3,446 3,515 3,865
2008 1,710 1,698 2,436 3,734 3,990 4,387
2009 1,968 1,990 2,854 4,152 4,638 5,100
2010 2,183 2,310 3,314 4,425 5,392 5,929
2011 2,684 2,743 3,934 6,105 6,405 7,042
2012 3,192 3,208 4,602 6,740 7,187 7,902
2013 3,551 3,647 5,231 7,976 7,793 8,568
2014 3,968 4,158 5,964 8,392 8,256 9,077
2015 4,633 4,704 6,747 8,797 8,615 9,473
2016 5,235 5,030 7,214 9,064 8,848 9,729
(Appendix A cantinued)
24 Millennial Asia

(Appendix A cantinued)
Per-capita Own Tax Revenues: OR Per-capita Own Tax Revenues: PB
Benchmarked Benchmarked
Year Actual Fitted to TN Actual Fitted to TN
2017 5,286 5,418 7,771 9,301 9,891 10,875
2018 7,157 5,925 8,498 10,421 10,424 11,461
2019 7,114 6,384 9,158 10,389 11,031 12,129
2020 7,382 6,745 9,675 9,669 11,873 13,054
Per-capita Own Tax Revenues: RJ Per-capita Own Tax Revenues: TN
Benchmarked Benchmarked
Year Actual Fitted to TN Actual Fitted to TN
2006 1,603 1,486 1,925 3,502 3,084 3,084
2007 1,847 1,663 2,154 4,109 3,468 3,468
2008 2,072 1,853 2,400 4,319 3,807 3,807
2009 2,288 2,077 2,690 4,841 4,277 4,277
2010 2,465 2,333 3,021 5,177 4,892 4,892
2011 3,057 2,710 3,509 6,671 5,809 5,809
2012 3,671 3,186 4,127 8,216 6,826 6,826
2013 4,350 3,671 4,754 9,770 7,661 7,661
2014 4,706 4,139 5,360 10,039 8,316 8,316
2015 5,359 4,693 6,078 10,639 9,073 9,073
2016 5,835 5,295 6,858 10,813 9,613 9,613
2017 5,975 5,824 7,543 11,483 10,573 10,573
2018 7,166 6,381 8,264 12,830 11,701 11,701
2019 7,574 6,957 9,010 14,049 13,074 13,074
2020 7,610 7,383 9,562 14,158 14,467 14,467
Per-capita Own Tax Revenues: UP Per-capita Own Tax Revenues: WB
Benchmarked Benchmarked
Year Actual Fitted to TN Actual Fitted to TN
2006 1,044 1,110 1,435 1,222 1,295 1,900
2007 1,250 1,308 1,691 1,358 1,464 2,149
2008 1,332 1,518 1,962 1,505 1,688 2,478
2009 1,502 1,783 2,304 1,632 2,019 2,963
2010 1,743 2,137 2,762 1,888 2,456 3,605
2011 2,089 2,531 3,271 2,330 2,977 4,370
2012 2,610 2,934 3,792 2,716 3,521 5,169
2013 2,839 3,281 4,241 3,538 4,070 5,975
2014 3,204 3,638 4,703 3,826 4,535 6,657
2015 3,515 4,011 5,185 4,167 4,886 7,171
2016 3,786 4,318 5,581 4,448 5,126 7,524
2017 3,952 4,676 6,044 4,712 5,401 7,928
2018 4,963 5,010 6,477 5,921 5,765 8,462
2019 5,478 5,327 6,886 6,397 6,124 8,989
2020 5,395 5,352 6,918 6,238 6,239 9,158
(Appendix A cantinued)
Srivastava et al. 25

(Appendix A cantinued)
Per-capita Own Tax Revenues: AP+TS
Benchmarked
Year Actual Fitted to TN
2006 2,405 2,438 2,700
2007 2,965 2,847 3,152
2008 3,531 3,381 3,744
2009 4,048 3,917 4,337
2010 4,224 4,380 4,850
2011 5,365 5,083 5,628
2012 6,272 5,861 6,490
2013 6,994 6,493 7,190
2014 7,434 7,077 7,837
2015 8,273 8,076 8,943
2016 9,121 8,976 9,940
2017 10,492 10,124 11,211
2018 12,437 11,244 12,452
2019 13,990 12,252 13,568
2020 14,069 12,975 14,368

Appendix B. Cross-sectional Dependence Test.

Residual cross-section dependence test
Null hypothesis: No cross-section dependence (correlation) in residuals
Total panel observations: 272
Test Statistic df Probability
Breusch–Pagan LM 1577.53 136 0.0000
Pesaran scaled LM 87.41 0.0000
Pesaran CD 39.32 0.0000
Notes: Non-zero cross-section means detected in data.
Cross-section means were removed during computation of correlations.

Notes
1. States have been categorized as medium and large based on their area and GSDP
parameters.
2. The sample period is adjusted due to the use of lagged dependent variable as an explan-
atory variable.

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