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Sharing of Tax Revenues - A Reality Check

Feb 21, 2024

K. Vaitheeswaran
Advocate

Media is agog with news about statements from various leaders / ministers from the Southern States that
there is a general dissatisfaction with the revenue that is shared with the States. Stepmotherly treatment
has also been alleged on the premise that there is a bias by the Centre in favour of the Northern States
whereby these states receive a greater share of Central Tax Revenue as compared to southern States.

Constitution – Union List and State List

The Seventh Schedule of the Constitution of India comprises of the Union List, State List and Concurrent
List and the Constitution has clearly divided the subjects for taxation between the Centre and the States.
It is interesting to note that the Seventh Schedule of the Constitution had simply adopted the lists from
the Government of India Act, 1935, except for few additions in the State list such as tax on electricity etc.

States’ Own Tax Revenues

Every State has its own tax revenues. Entry 46 provides for taxes on agricultural income. Entry 47
provides for duties in respect of succession to agricultural land. Entry 48 provides for estate duty in
respect of agricultural land. Entry 49 provides for taxes on lands and building. Entry 50 provides for taxes
on minerals rights subject to any limitation imposed by Parliament by law relating to mineral
developments. Entry 51 provides for duties of excise on alcoholic liquor for human consumption; opium;
Indian hemp and other narcotic drugs and narcotics but not including medicinal and toilet preparation
containing alcohol, etc. Entry 53 provides for taxes on consumption or sale of electricity. Entry 54
provides for taxes on petroleum products including alcoholic liquor for human consumption. Entry 56
provides for taxes on goods and passengers carried on by road or in inland water ways. Entry 57 provides
for taxes on vehicles whether mechanically propelled or not suitable for use on roads including tramcars
subject to the provisions of Entry 35, List III. Entry 58 provides for taxes on animals and boats. Entry 59
provides for tolls. Entry 60 provides for taxes on profession, trade, calling an employment. Entry 61
provides for capitation tax. Entry 62 provides for taxes on entertainment and amusements to the extent
levied and collected by Panchayat or a municipality or a regional council or a district council and Entry 63
provides for rates of stamp duties in respect of documents other than those specified in List I. All these
taxes and duties are levied, collected and retained by the State in their own right.

The 101st Constitution Amendment paved the way for GST and in terms of Article 246A(1), Parliament
and the Legislature are both empowered to make laws for GST. Accordingly, State Legislatures have
enacted laws for levy of SGST and contrary to popular belief as well as the world of memes which assume
that Centre is holding back State’s GST revenues, SGST is in fact levied, collected, retained by the State
in their own right.

Central Taxes

Central Taxes are taxes levied by the Central Government under Parliament Laws enacted in respect of
subjects falling in the Union List. The main and significant Central Taxes are taxes on income other than
agricultural income under Entry 82; Customs duty under Entry 83; excise duty on 6 items including

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tobacco under Entry 84 apart from other levies which are minor in nature. Entry 87 provides for estate
duty but estate duty has been abolished. Similarly, wealth tax and gift tax which were levied by the
Centre under the residuary powers conferred under Entry 97 is no longer in vogue.

Distribution of Central Revenues

Article 270 deals with taxes levied and distributed between the Union and the States. Originally, Article
270 dealt with sharing of income-tax between the Union and the States. Accordingly, based on the
recommendations of the Finance Commission, such percentage of the net proceeds of taxes shall be
distributed among states in the manner prescribed. The Constitution (80th Amendment Act) substituted
Article 270 with retrospective effect from 01.04.1996.

In terms of Article 270, the taxes and duties referred to in the Union List shall be levied and collected by
the Government of India. A percentage of such taxes shall be distributed among those states in the
manner prescribed by the President after considering the recommendations of the Finance Commission.

The 101st Constitution Amendment Act paved the way for GST and Article 270 was also amended.
Accordingly, the tax collected by the Union under Article 246A shall also be distributed between the
Union and the States. In simpler terms, the CGST collected by the Union as well as the IGST used for
payment of CGST and IGST portion that is appropriated to the Union are also subject to the distribution
mechanism envisaged by Article 270. Unlike SGST which is completely retained by the State, the Centre
cannot retain the entire CGST and its portion of IGST and the same is subject to the distribution
mechanism envisaged by the Constitution. This is but natural since CGST subsumed various central
indirect tax levies.

The Finance Commission

The Finance Commission is a constitutional body established under Article 280 of the Constitution. Article
280(3) mandates the Commission to make recommendations regarding "the distribution between the
Union and the States of the net proceeds of taxes, which are to be, or may be, divided between them
under this Chapter and the allocation between the States of the respective shares of such proceeds." The
Finance Commission is constituted by the President and generally has a term of five years. It is an
independent body that consults the Union and the States in matters relating to the devolution of central
tax revenue, attempts to reconcile their views, and subsequently incorporates them into the devolution
formula for the division of tax revenue.

History of Distribution

It can be seen that from the recommendations of the 11th Finance Commission (2000-2005) to the latest
Report of the 15th Finance Commission (2021-2026), the states’ share in the divisible pool of central tax
revenue has increased from 29.5% to 41%. Notably, the Report of the 14th Finance Commission
(2015-2020) radically enhanced the share offered to the states in the central tax pool from an erstwhile
32% to 42%. This move was based on the Commission’s finding that tax devolution must be the primary
route of transfer of resources to the state owing to its empirical and formulaic nature, which in turn
secures its objectivity. The subsequent 15th Finance Commission Report reduced the share of the states
from 42% to 41%, citing the requirement of adjusting the resources of the Centre to finance the newly
formed territories of Jammu and Kashmir and Ladakh.

The horizontal devolution for allocation of taxes between various states is driven by considerations of
propelling horizontal equity by providing a greater share to poorer States, equalizing the fiscal capacities
of various States, ensuring that States are adequately mobilised to generate their own revenue, etc. The
formula for horizontal devolution takes into account criteria such as need, equity, and performance,
which are to be adequately balanced in order to create an effective formula for devolution.

The criteria factor for devolution takes into account the following factors

Area – 15%

Population – 15%

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Demographic Performance 12.5%

Forest and Ecology 10%

Tax and fiscal efforts 2.5%

Income distance* 45%

*Income distance is the distance of a state’s income from the State which has the highest income.

The 15th Finance Commission report also specifies that a State with lower per-capita income will have a
higher share to maintain equity among states.

The following table gives a list of sample states and their individual share of tax devolved by the Centre
(out of 100) – 15th Finance Commission (2021-26)

State
Andhra Pradesh 4.047
Tamil Nadu 4.079
Telengana 2.102
Kerala 1.925
Karnataka 3.647
Bihar 10.058
Gujarat 3.478
Uttarakhand 1.118
Madhya Pradesh 7.850
Uttar Pradesh 17.939
Punjab 1.807
Rajasthan 6.026
Maharashtra 6.317
Assam 3.128
West Bengal 7.523

The Population Factor

One of the most contentious issues raised by some States involve the incorporation of the 2011 census
into the horizontal devolution formula by the Finance Commission. All the previous Commissions, from
the 6th Finance Commission to the 14th Finance Commission, used the 1971 data. However, the 15th
Commission was of the view that in order to align with the objective of fiscal equalisation, the present
needs of the States can only be appropriately met by taking into consideration the latest population data.
The concern of the states that opposed the use of this data flows from the reasoning that States which
have managed to control their populations would be placed at a disadvantage in such a situation.
Nevertheless, both the 14th and the 15th Finance Commissions opined that it would be appropriate to
consider the 2011 data. The 14th Commission, bound by its Terms of Reference, was unable to
incorporate the 2011 data in its entirety and assigned a weightage of 10% to the 2011 population data
and a 17.5% weightage to the 1971 data. However, with the updated Terms of Reference for the 15th
Commission, a 15% weightage was dedicated to population, and this was to be wholly derived from the
2011 census data. In effect, the percentage difference on account of population as a factor has moved
from 17.5% (1971 census) to 15% (2011 census).

Arguments have been raised that although the Commission is to consult the Centre and the States and
produce unbiased recommendations, the Terms of Reference for the Commission are approved by the
Union Cabinet and the Commission is bound by these Terms. Therefore, the Central Government, by
prescribing the use of the 2011 data in the Terms of Reference of the 15th Finance Commission, has
indirectly influenced the decision-making of the Commission in this regard, thereby fuelling the supposed
bias against the southern States.

It is interesting to note that regardless of the year specified in the Terms of Reference, both the 14th and
the 15th Finance Commissions specifically remarked that they believed in the use of the most recent

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population statistics in order to ensure sound fiscal federalism. In fact, the 14th Report went as far as to
comment that although it found it appropriate to use the 2011 population data, it was bound by the
Terms of Reference and was unable to discontinue the use of the 1971 data, despite believing it to be
unfair to use such outdated statistics. Thus, it is evident that the argument that the Commission had
been unfairly influenced into using the 2011 data is not sound, as it is also of the Commission’s opinion
that such data would be most fitting in this exercise. Clearly, outdated population figures can lead to
inequitable distribution of funds, misrepresentation of demographic realities, and ineffective planning for
the future.

Demographic Performance and Tax Efforts

The Terms of Reference of the 15th Finance Commission proposed the use of measurable performance-
based incentives for States. Resultantly, the Commission, taking into account the concerns raised
regarding the use of the latest population data, stated that in order to alleviate any unfair disadvantage
that may arise from the sudden change of underlying data after four decades, performance-based criteria
such as demographic performance and tax efforts would be factored into the devolution formula. The
demographic performance was calculated using the Total Fertility Rate data for all States, in order to
reward States which have managed to control population. This indicates that the concern of the southern
States has been directly addressed by the Commission.

The Paisa Story

Media reports indicate political leaders and ministers and senior officials lamenting on the actual
devolution to their respective States based on certain media reports. These reports suggest that for
every rupee contributed by Karnataka, it got back 15 paisa, Tamil Nadu received 29 paisa, Telangana and
Andhra Pradesh received 43 and 49 paisa respectively, and Kerala received 57 paisa. To the contrary,
states like Bihar received 7.06 rupees in return for every rupee contributed, Uttar Pradesh received 2.73
rupees, Assam received 2.63 rupees, and Madhya Pradesh got back 2.42 rupees. Going by the same
media report, it can be seen that States like Maharashtra, Haryana, and Gujarat, which supposedly
received 8 paisa, 18 paisa, and 28 paisa respectively as compared to every rupee contributed, have not
expressed such sentiments.

This paisa per Rupee calculation is apparently based on a media analysis of data pertaining to direct tax
and GST collections from the respective States and the money they got back. This analysis itself is flawed
since that is not what is envisaged under Article 270 or by the Finance Commission. If State A has got the
maximum number of Income-Tax assessees and generates highest income tax collection, does it mean
that State A should get more? If State B has the lowest Income-tax collections or CGST collections
emanating from that State, should it get lower share? Customs duty collections would be based on
location of port. There are no ports in land locked States. Does it mean that Customs duty should not be
shared amongst such States? The Finance Commission criteria for distribution is transparent and well laid
out and clearly does not take into account contributions State-wise. Applying this criterion will also have
other consequences since States which are not well developed or economically ahead would suffer more
due to lower devolution.

Further, if contribution by a State to the Income-Tax collections should be the criteria, then there is no
meaning in tax on income being the domain of the Centre as per the Constitution. The Constitution has
envisaged distribution between Centre and States and further distribution among states of the share of
States and the Finance Commission is the Constitutional Body for this purpose created under Article 280.
The Finance Commission has identified the parameters and the weightage in terms of percentage for
each factor. Collections from a particular State has never been a factor since inception. Therefore,
comparing the collections from a particular State based on Tax collection Statistics and comparing it with
devolution is an exercise not envisaged by The Finance Commission or Article 270 or 280. It is only the
imagination of the media which has unfortunately built a very different narrative.

Interestingly, although population is given a weightage of 15%, a significantly higher weightage is placed
on the equity factor of income-distance, which currently stands at 45% and consequently plays a greater
role in influencing the outcome of the share of tax received by the states. This factor has been given a
weightage of up to 62.5% in previous reports of the Commission, wherein the Centre during that period
was not saddled with the allegations of bias. Further, a significant weightage of 12.5% has also been

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given to demographic performance to offset any adverse effects of changes in structural population data,
as has previously been addressed. This principle of devolution, involving the factoring of considerations
rooted in equity, has been observed for decades by various Finance Commissions and it cannot be called
a novel move enacted to disfavour certain States.

One will have to see as to what is the real issue in these debates. Is it the claim of some States that the
central share from central taxes should be reduced from 59%? Or, is it that out of 41% representing the
share of the States, the percentage allocation to performing States should be higher? If it is the case of
the former, then one should also answer the question as to whether the States will share the expenditure
which the Centre is currently incurring for infrastructure, defence, health, welfare, social security and all
other Central Expenditure.

If the question is of the latter, where higher distribution is sought based on economic criteria, then it
would be at the deprivation of populous and semi-backward and backward States and would be against
the principle of equity amongst States.

Conclusion

It is clear that the16th Finance Commission will have its task cut out given the debate around devolution
and the press mileage that it has generated. It is also interesting to note that there is very little
discussion on State’s own tax revenues (SOTR). Tamil Nadu’s Own Tax Revenue has been estimated
at Rs.1,95,173/- crores in the Budget Estimates 2024-25, which is a growth of 14.71 per cent over the
Revised Estimates 2023-24. Similarly, SOTR of various States are on the rise. This clearly indicates
significant economic development as well as buoyancy in own tax revenues.

It is also not a far cry where States may re-look at powers available for levy of own taxes as per the State
list and expand their levies. If the debate around income tax collections and sharing gains traction,
maybe a decade from now, there would be another Constitutional Amendment in the lines of GST
whereby both Centre and State would simultaneously levy income-tax and retain their respective levies.

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