Our introductory article examined the origin, functions, composition, and core principles of the Finance Commission (FC), including the concepts of the divisible pool and grants-in-aid. Building on this foundation, this article explores a key aspect of fiscal federalism that has been in the news in recent years—the formula for sharing tax revenues between the Centre and the states.
As discussed earlier, state governments, being closer to the people, are better positioned to understand and address regional needs effectively. However, their expenditures often exceed their revenues, creating a fiscal gap that must be bridged. To support the states in partially filling this gap and creating a balance between resourceful and laggard states, the Centre transfers a portion of its tax collections to the states through the constitutionally mandated mechanism of tax devolution.
Tax devolution, repeatedly mentioned in FC documents, is considered the primary route for transferring resources to states since it is formula-based and thus conducive to sound fiscal federalism.
The FC, responsible for undertaking tax devolution between the Centre and the states, has two key tasks:
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- Vertical Devolution – Determining the percentage of the Centre’s total tax revenue that should be transferred to the states.
- Horizontal Devolution – Allocating each state’s share from the divisible pool based on specific criteria.
The 10th FC (1995–2000) recommended a major shift by proposing that all central taxes—except surcharges and cesses—be included in the divisible pool, replacing the earlier system of devolving only Personal Income Tax and Central/Union Excise Duty. It also recommended that 29% of the aggregate central tax revenues be shared with the states, moving away from the previous system of tax-by-tax sharing.
This led to the 80th Constitutional Amendment, effective June 9, 2000, which restructured tax devolution. From the 11th FC onward, all Union List taxes (except those under Articles 268, 269, and 269A, along with surcharges and specific-purpose cesses) became shareable with states, ensuring a broader revenue-sharing framework.
From the 11th FC, tax devolution followed multiple criteria, including tax collection, backwardness, and poverty ratio. Based on these factors, the central government allocated a portion of Personal Income Tax and central/Union Excise Duty to the states.
The following table shows how the States’ share in Union taxes (vertical devolution) has varied across different FCs:
Table 1:
| Finance Commission | States’ Share in Net Proceeds of Income Tax (%) | States’ Share in Net Proceeds of Union Excise Duties (%) | States’ Share in All Shareable Union Taxes (%) |
|---|---|---|---|
| FC-I (1952-57) | 55.00 | 40.00 | 0.00 |
| FC-II (1957-62) | 60.00 | 25.00 | 0.00 |
| FC-III (1962-66) | 66.66 | 20.00 | 0.00 |
| FC-IV (1966-69) | 75.00 | 20.00 | 0.00 |
| FC-V (1969-74) | 75.00 | 20.00 | 0.00 |
| FC-VI (1974-79) | 80.00 | 20.00 | 0.00 |
| FC-VII (1979-84) | 85.00 | 40.00 | 0.00 |
| FC-VIII (1984-89) | 85.00 | 45.00 | 0.00 |
| FC-IX (1989-95) | 85.00 | 45.00 | 0.00 |
| FC-X (1995-00) | 77.50 | 47.50 | 0.00 |
| FC-XI (2000-05) | 0.00 | 0.00 | 29.50 |
| FC-XII (2005-10) | 0.00 | 0.00 | 30.50 |
| FC-XIII (2010-15) | 0.00 | 0.00 | 32.00 |
| FC-XIV (2015-20) | 0.00 | 0.00 | 42.00 |
| FC-XV (2020-21) | 0.00 | 0.00 | 41.00 |
| FC-XV (2021-26) | 0.00 | 0.00 | 41.00 |
Source: Finance Commission Reports
Regarding horizontal distribution, some states have achieved higher growth in recent decades, while others continue to lag. These disparities arise due to differences in historical backgrounds, resource availability, political conditions, and other structural factors. To ensure fair distribution of taxes among all 28 states, the FC determines each state’s share from the total divisible pool based on specific parameters, broadly classified into need-based, equity-based, and performance-based criteria.
Though there is consensus among the states that a higher share of central taxes should be devolved to them, there is a difference in approach regarding the basis on which the devolved taxes should be shared.
Different FCs have considered factors like population, states’ revenue collection, backwardness, state domestic product, the population below the poverty line, and the infrastructure index over the years for horizontal devolution.
I have referred to the horizontal devolution criteria of the 14th and 15th FCs to explain the criteria used and the weightage assigned for the fair distribution of tax revenues among states in recent years.
Table 2:
| CRITERIA | WEIGHTAGE (%) | ||||
| 11th FC | 12th FC | 13th FC | 14th FC | 15th FC | |
| 1971 population | 10 | 25 | 25 | 17.5 | 0 |
| 2011 population | – | – | – | 10 | 15 |
| Demographic performance | – | – | – | – | 12.5 |
| Income distance | 62.5 | 50 | – | 50 | 45 |
| Fiscal Capacity Distance | – | – | 47.5 | – | – |
| Area | 7.5 | 10 | 10 | 15 | 15 |
| Forest cover | – | – | – | 7.5 | 10 |
| Tax & fiscal effort | 5.0 | 7.5 | – | – | 2.5 |
| Fiscal Discipline | 7.5 | 7.5 | 17.5 | – | – |
| Index of Infrastructure | 7.5 | – | – | – | – |
Source: Press Information Bureau
The allocation process has sparked debates due to two key issues. First, southern states argue that the formula disproportionately benefits less developed states, reducing the share of central taxes for those with higher GSDP per capita and better demographic indicators, such as Tamil Nadu, Kerala, Andhra Pradesh, Telangana, and Karnataka. Second, actual tax devolution has been consistently lower than recommended levels in recent years, further reducing these states’ shares.
Politicians from these southern states have consistently raised this issue, particularly during elections. T. M. Thomas Isaac, the former Finance Minister of Kerala, has been a vocal critic of the decision since its announcement. More recently, in 2024, the Chief Minister of Karnataka, Siddaramaiah, protested in the national capital with the support of the Chief Ministers of Kerala, Telangana, and Tamil Nadu, demanding a fair share of central tax revenues. They challenged the formula used by the 15th FC and accused the central government of inadequate fund allocation, emphasising the need for fair financial rights for their states. Interestingly, in 2018, N. Chandrababu Naidu, the Chief Minister of Andhra Pradesh(AP) and now a partner of the BJP, accused the Narendra Modi government of diverting tax revenues collected from the South to fund development projects in northern states. In the same month, actor-politician Pawan Kalyan, Deputy Chief Minister of AP and chief of the Jana Sena Party and now a partner in the NDA coalition, questioned the population-based formula for sharing tax revenues between states. He asked whether the Centre was going to use the ‘success of South Indian states’ against their own interests.
MK Stalin, the Chief Minister of Tamil Nadu and the supreme leader of Dravida Munnetra Kazhagam, raised concerns that states which have effectively controlled their population are being penalised by the Centre through a reduced share of central funds. He called the Centre’s allocation of funds to states a “travesty of justice” and warned that it would affect the very fabric of equitable and just devolution of central tax revenues.
At the heart of this controversy, and the focus of this article, is the 15th Finance Commission’s tax-sharing formula, which is based on three broad criteria and includes six key parameters: population, forest and ecology, area, demographic performance, tax and fiscal efforts, and income distance.
To fully understand the issue, it is essential to first examine the root causes of this conflict and the FC’s rationale for selecting these six parameters, their significance, and the design. Analysing the 15th FC’s approach provides insight into India’s principles guiding tax devolution.
A. Need-Based Criterion
1. Population
Population is a key indicator of a state’s expenditure needs, serving as a simple, objective, and transparent measure that ensures stability. It directly reflects resource allocation requirements for public services, making it crucial for equity. Since the 1st FC, population has been the most significant and heavily weighted indicator. From the 6th FC (1974-79) onward, population data from the 1971 Census were used for allocations. While the 14th FC (2015-20) recognised this data as outdated, it still followed the Terms of Reference by using the 1971 Census for tax distribution.
The 15th FC (2020-21, 2021-26) adopted the 2011 Census data to better reflect current needs, assigning it a 15% weightage. This change had notable effects, as states with high population growth gained relatively more, while those with stabilised populations—mainly southern states—saw their shares reduced. In response, several states, particularly the South, demanded that the 1971 population data be used. They argued that relying on the latest Census would unfairly penalise them for successfully implementing population control measures. It is important to note that the population parameter also influences other factors in the formula, such as demographic performance and tax & fiscal efforts, making it a crucial element in resource allocation.
Formula:
• Inter se share of iᵗʰ State = POPᵢ,₂₀₁₁/ Σ²⁸ⱼ₌₁ POPⱼ,₂₀₁₁
Where:
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POPᵢ,₂₀₁₁ = Population of the iᵗʰ state as per the 2011 Census
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Σ²⁸ⱼ₌₁ POPⱼ,₂₀₁₁ = Total population of all 28 states (2011 Census)
2. Forest and Ecology (Forest Cover)
The 14th FC introduced forest cover as a criterion to acknowledge its ecological value. While forests preserve biodiversity and regulate climate, they also limit land availability for development, creating opportunity costs for states. Restricted land for economic activities due to ecological resources like forests is considered an indicator of fiscal disability.
To compensate states for this fiscal disability, they are allocated funds based on their share of dense forest cover relative to the national total. The 15th FC assigned a 10% weightage to this criterion, ensuring that states contributing to ecological sustainability receive appropriate financial support.
Formula:
• Inter se share of iᵗʰ State: FCᵢ = Fᵢ/ Σ²⁸ⱼ₌₁ Fⱼ
Where:
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FCᵢ = Forest and Cover of the iᵗʰ state
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Fᵢ = Forest area (in sq. km) of the iᵗʰ state
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Σ²⁸ⱼ₌₁ Fⱼ = Total forest area of all 28 states (as per the Forest Survey of India)
3. Area
The area criterion considers the administrative costs of running larger states. While bigger states need more funds, the cost of services doesn’t rise at the same rate as their size. To balance this, the 15th FC assigned a moderate weight of 15%.
Additionally, states with less than 2% of India’s total area receive a minimum share of 2% to ensure fairness. This adjustment ensures that small states are not disadvantaged in the devolution process.
Formula:
• Inter se share of iᵗʰ State = Aᵢ/ Σ²⁸ⱼ₌₁ Aⱼ
Where:
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Aᵢ = Geographical area of the iᵗʰ state
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Σ²⁸ⱼ₌₁ Aⱼ = Total geographical area of all 28 states
Note: For states with an actual area share of less than 2 percent, a floor share of 2 percent is fixed in the final shares, and the remaining states’ shares are adjusted so that the total adds up to 100.
B. Performance-Based Criterion
4. Demographic Performance
To address concerns about penalising states that controlled their population, the 15th FC introduced the “demographic performance” criterion after using 2011 Census data for tax distribution. States with lower Total Fertility Rates (TFR) are rewarded, acknowledging their efforts in population control.
For example, a state’s share under this parameter is calculated by multiplying its 1971 population by the inverse of its TFR. States with lower TFRs get a higher weight due to their higher inverse values and vice versa. It has been observed that regions with lower Total Fertility Rates (TFRs) tend to have better health, education, and human capital development outcomes. This criterion accounts for 12.5% of the devolution formula, ensuring states are fairly rewarded for stabilising their populations.
Formula:
• From Census 2011, the total fertility rate of iᵗʰ State (TFRᵢ) is calculated from Age-Specific Fertility Rates (ASFRᵢ,ₖ) where ASFRᵢ,ₖ is the kᵗʰ age-specific fertility rate in the iᵗʰ State.
Number of live births last year in the kᵗʰ age group of females in the iᵗʰ state/Mid-year female population in the kᵗʰ age group in the iᵗʰ state
# The female population as registered in the age group by Census 2011 is taken as the mid-year female population.
• Total Fertility Rate (TFR) of the iᵗʰ State: TFRᵢ = 5 × Σ₍ₖ₌₁₅₋₄₉₎ ASFRᵢ,ₖ
Where k = 15–19, 20–24, 25–29, 30–34, 35–39, 40–44, 45–49.
• DPᵢ = Demographic performance of the iᵗʰ State is given by: DPᵢ = (1 / TFRᵢ) × POPᵢ,₁₉₇₁
• Inter se share of iᵗʰ State = DPᵢ / Σ²⁸ⱼ₌₁ DPⱼ
5. Tax & Fiscal Efforts
The inclusion of the “tax effort” parameter incentivises states to improve tax collection efficiency, reduce revenue leakage, and minimise evasion. This ensures that states generate sufficient funds for essential services, such as healthcare, education, and infrastructure, while also reducing their reliance on borrowing.
This parameter is measured in two steps. First, the Per Capita Own Tax Revenue (OTR) of a state is divided by its Gross State Domestic Product Per Capita (GSDPPC) for three years (2016-17 to 2018-19). Then, this ratio is multiplied by the state’s population (as per the 2011 Census) to determine the final value. OTR means money collected by the state through taxes like SGST, excise duty, property tax, and stamp duty, while GSDP represents the state’s total economic output. States with high tax efficiency are rewarded to encourage fiscal responsibility, with a nominal weightage of 2.5%.
Formula:
• Tᵢ = Three-year (2016–17 to 2018–19) average of per capita own tax revenue of the iᵗʰ State.
• 𝐺SDDP𝐶ᵢ̄ = Three-year average (2016–17 to 2018–19) of GSDPPCᵢ.
• Tax ratio (tᵢ) = tᵢ = Tᵢ / GSDPPCᵢ̄
• Tax effort of iᵗʰ State (TEᵢ) = TEᵢ = tᵢ × POPᵢ
• Inter se share of iᵗʰ State = TEᵢ / Σ²⁸ⱼ₌₁ TEⱼ
Equity-based Criterion
6. Income Distance
This parameter has the highest weightage of 45%, ensuring that states with lower per capita income (average income per person in a region) and weaker tax capacity receive more funds. It uses per capita GSDP to measure the gap in economic output between states, identifying those needing greater support.
Historically, different versions of this principle have been used. The Planning Commission’s Gadgil formula (later known as the Gadgil–Mukherjee formula) applied a deviation method, where states with per capita income above the national average were excluded from receiving funds under this criterion. The 9th FC used a combination of the inverse income formula and the income distance formula. From the 10th FC onward, only the income distance formula was retained, as it demonstrated desirable properties that made it a suitable proxy for fiscal capacity equalisation—a principle used in federal countries like Canada and Australia to reduce regional disparities. Since then, all subsequent Finance Commissions up to the 14th FC have continued using a version of the income distance criterion, consistently assigning it the highest weight among all devolution parameters.
The calculation of income distance follows a similar approach used by the 14th FC. First, a three-year average (2016-17 to 2018-19) per capita GSDP is taken for all states. To determine income distance, each state’s per capita GSDP is compared to that of the highest-income state. In this case, Goa has the highest per capita GSDP, followed by Sikkim. However, since both are small states and considered outliers, they are excluded to avoid distortions. Instead, Haryana, which has the third-highest per capita GSDP, is chosen as the benchmark state for comparison.
The income distance for each state is then calculated as the difference between its per capita GSDP and that of Haryana. However, to ensure fairness, Goa, Sikkim, and Haryana are assigned the income distance of Kerala, which has the fourth-highest per capita GSDP. For fairer distribution, the income distance of each state is scaled by its population (as per the 2011 Census).
This adjustment is done to ensure that states with larger populations, which often have lower per capita incomes, receive a greater share of resources. Since many lower-income states also have larger populations, this method makes the distribution more progressive, ensuring that tax devolution benefits those states that need it most. Also, this parameter addresses disparities and allocates resources to poorer states that face higher costs in delivering essential services.
Formula:
• Three-year (2016-17 to 2018-19) average of per capita GSDP of iᵗʰ State (GSDPPCᵢ)
dᵢ is distance (difference) of iᵗʰ state’s GSDPPCᵢ from third highest state’s, namely Haryana’s, GSDPPC
• Top three GSDPPC States — Goa, Sikkim and Haryana — are assigned notional distance of the fourth highest state, namely Kerala
• Dᵢ = dᵢ * POPᵢ₂₀₁₁
• Inter se share of iᵗʰ state = Dᵢ / Σ²⁸ⱼ₌₁ Dⱼ
End Note:
The inter se share of the iᵗʰ State in the tax-sharing formula (Sᵢ) is determined as the weighted sum of State shares by six parameters or criteria — population, area, forest and ecology, income distance, fiscal and tax performance, and demographic performance.
• Sᵢ = Σ⁶ₘ₌₁ (Sᵢᵐ × ωₘ)
Where:
• ωₘ = Weight of the mᵗʰ parameter
• Sᵢᵐ = Inter se share of the iᵗʰ State as per the mᵗʰ parameter
The overall inter-se share of each State is then expressed as:
• Inter se share of iᵗʰ State = Dᵢ / Σ²⁸ⱼ₌₁ Dⱼ
In conclusion, the 15th FC attempted to capture multiple dimensions of equity and efficiency by considering diverse parameters for resource distribution. However, population emerges as a recurring and significant variable in determining the allocation of resources. In the next article, I will discuss the various grievances, especially concerning the population parameter, and the specific demands of each of the five southern states, along with trends in their share of total resources over the past decade.
Ishant Deshmukh, Research Assistant, JP-SSSC
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