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Unit 25: Government Finance: Union and States

had raised the States’ share in income tax to the level of 85 per cent (Seventh, Eighth and Ninth Notes
Finance Commissions). However, the Tenth Finance Commission in its report for the period
1995-2000 recommended that 77.5 per cent of the net proceeds of taxes on income should be
assigned to states.
Horizontal division of income tax proceeds
As regards the basis for the distribution of the States’ pool of income tax proceeds among the
States, the first few commissions had used the double criteria of population and tax collection.
The First Finance Commission, for instance, recommended the allocation of income tax proceeds
on the basis of 80 per cent and 20 per cent for population and collection. This criterion benefited
populous states as well as those richer states which contributed more income tax revenue. The
Second Finance Commission regarded population of a State as a more important basis for
distribution and, accordingly, awarded that 90 per cent of the States’ divisible pool of income
tax should be distributed on the basis of population. This criterion naturally favoured populous
states like Uttar Pradesh and Bihar which were the poorest states in India. This was reversed by
the Third and Fourth Finance Commissions which raised the share of collection to 20 per cent
and thus gave greater share to States like Maharashtra and West Bengal which contributed
most of the collection of income tax (because of the location of metropolitan cities like Bombay
and Calcutta). From the Fifth Commission onwards, population had again become the major
criterion for distribution of income tax proceeds among the States.
For the first time, the Eighth Finance Commission presided over by Y.B. Chavan, introduced a
new formula for distribution of the income tax proceeds among the States :
(a) 10 per cent would continue to be distributed among the States on the basis of collection of
income tax;
(b) 90 per cent of the proceeds of the income tax would be distributed among the States on the
following criteria :
25 per cent on the basis of population;
25 per cent on the basis of inverse of the per capita income of the state multiplied by population;
and 50 per cent on the basis of the distance of the per capita income of a state from the highest
per capita income state (i.e., Punjab) and multiplied by the population of the State.
The basic objective of this three-factor formula was to bring about a high degree of equity
among the States. The Ninth Finance Commission (NFC) basically followed the above formula
with minor modifications.
The Tenth Finance Commission (TFC) evaluated the formula of both Eighth and Ninth Finance
Commissions and introduced the following formula/criteria to determine the shares of the
different States in the shareable proceeds of income tax :
(a) 20 per cent on the basis of population of 1971;
(b) 60 per cent on the basis of distance of per capita income of a State from that of the State
having the highest income;
(c) 5 per cent on the basis of area adjusted;
(d) 5 percent on the basis of index of infrastructure; and
(e) 10 per cent on the basis of tax effort.
It would be clear from the above table that (a) the successive finance commissions, except the
Tenth, had increased the share of the States in the income-tax levied and collected by the Centre,
and (b) the proceeds are shared among States mainly on the basis of population, economic
backwardness and other criteria.
(b) Division and Distribution of Excise Duty
Vertical division : The First Finance Commission selected three excise duties—on tobacco,
matches and vegetable products—for division with the States, so as to give them larger revenues.
These commodities are widely consumed and yield a substantial revenue to the Government.

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