Every time a worker in Bengaluru makes his or her tax payment, some portion of it flows into the coffers of Delhi and is ultimately distributed back to the farmer in UP or Bihar. This hidden exchange, which runs into several thousand crores annually, keeps the fiscal republic of India intact. But it is now becoming one-sided in a way that requires out-of-the-box thinking by the 16th Finance Commission.
The fiscal anomaly
From the chart, you can
see that five states- Maharashtra, Karnataka, Delhi, Tamil Nadu, and Gujarat- alone
contributed 76% of the total direct tax collections in the FY 2024-25. However,
the total population of these states accounts for only around 27%. In other words, around one-fourth of the people contribute
to three-fourths of the revenue collection.
Figure
1 & 2 : "27% of people, 76% of
tax"
Services-Digitalisation corridor
India's
direct tax map is not a demographic cartography; it is cartography for
formalisation & digitalisation. Maharashtra, Karnataka, Delhi, Tamil Nadu,
and Gujarat are five states that generates well over 75 percent of corporate
and personal income tax collections, but house not much more than a quarter of
the population of the country.
What do they have in common? Not size, but infrastructure for formal economy: they have the concentration of committed salaried employment in the organisational sectors, the large corporate head offices, the offices that file taxes for ESOP income (and) capital gains of listed securities, the deepest roots of the gig and platform economy and the digital literacy and adoption.
We can call it the “Services-Digitalisation corridor” - a stretch that runs from Ahmedabad through Mumbai to Delhi and Bengaluru and down to Chennai. In this corridor, the formal wage economy is at its densest, the economy of the digital payment system is richest, and the difference between gross domestic product and the economy of taxable goods and services is at its smallest.
Figure 3: Tax Collection Intensity : (Tax Collected(FY 2024-25) / Total Population(2011 Census) )
On the other extreme, Uttar Pradesh and Bihar, combined, have a little over a fourth of the total population of India, yet they contribute less than three percent to the direct tax corpus -not on account of being poorer by income standards alone, but rather on account of their incomes arising through informal agricultural activity, trading, and small-scale business which are structurally exempted from any sort of self-assessment regime.The policy message is clear: increasing the scope of the direct tax base is not so much a function of rates or compliance, but of formalisation.
Figure 4: Ratio of Tax collection/GSDP
Every extra employment opportunity created in the organized sector, each kirana firm adopting GST invoices, every small-scale contractor paying taxes on income, represents a new taxpayer waiting at the edge of the corridor. And the wider the corridor will become as formalization moves east and north.
From the above, it is clear that direct tax collection follows formalisation and digital visibility, not population or even GDP. The tax map is actually a map of where the formal services economy lives.
A Tale of Two Indias: Emerging Hubs and Persistent
Gaps
Telangana and Haryana as the good-news story - formalisation can travel. Then
the harder picture: why Bihar, UP, MP, and Odisha remain structurally outside
the direct tax perimeter despite economic growth.
The CAGR
of Direct Taxes Collections graph for the period FY19-FY25 is by far the most
optimistic piece of evidence in this whole analysis and should be interpreted
in full detail. The 44% CAGR in
direct taxes in Telangana is not a
mere statistical deviation, but a testament to the state having emerged as a proper technological/pharmaceutical hub
characterized by the presence of large
campuses, salaried workforces and listed companies.
Haryana's 18% CAGR reveals a similar story – the state capital of Gurugram is a center of concentration for corporate registered offices and high salary jobs in India, and this is being picked up now by the tax data. The story of these two states is an optimistic one indeed – formalization can indeed spread beyond its immediate location, and direct taxes follow shortly after, not many years later. However, the story on the right side of this chart is less optimistic. The states of Bihar, Assam, Madhya Pradesh, Uttarakhand, and Andhra Pradesh all exhibit almost 0% or negative CAGRs – that is to say, their base for direct taxation is not only low, but even declining.
Figure 5: CAGR of Direct taxes from FY 2019 -25
This is not about poor states alone since some of them have even seen decent GSDP growth in this period. The issue is more fundamental than that. The growth in such states is being fueled by industries – agricultural, informal building activities, small-scale retail business and subsistence services – which the income tax administration is unable to access because they lie outside the ambit of its functioning.
What this two-India
scenario means is this – whether the growth in the state’s economy is
driven by organised and documented economic activities or the massive informal
sector.
Lorenz
curve of direct tax distribution, FY19 vs FY25
The Lorenz curve
presents a tale of quiet and disturbing changes through just one single number:
the Gini index for direct tax concentration has changed from 0.6342 in FY19 to
0.6506 in FY25.
In other words, over
the past six years, direct taxes collected by the Government in India have
become increasingly concentrated.
The green curve (FY25) is located further away from the line of equality as
compared to the blue curve (FY19), and this implies that the lower 60-70% of
the states account for a smaller portion of direct taxes as compared to the
prior six years; at the same time, the cluster of higher states has outstripped
others.
However, it is
essential to highlight that such inequality is not necessarily a story of the
richer states becoming wealthier from the perspective of the income level; in
fact, it is mostly the story about increasing inequality between formal and
informal states.
As far as implications
for public policy are concerned, here comes the key takeaway: if one aims at
extending the geographic coverage of the direct taxation base, the
path we are currently on does not seem to be the right one.
The collection
mechanisms in the corridor are performing increasingly efficiently - compliance
push factors, expanded TDS regime, reporting capital gains, and even AIS are
doing fine wherever formal incomes are
already present.
None of these
instruments, however, is capable of reaching into the informal economy of
Bihar, eastern Uttar Pradesh, or rural Madhya Pradesh, where the Lorenz gap is
being stealthily expanded each year due to growth without formalisation.
Figure 6: Lorenz curve of direct tax distribution, FY19 vs FY25
(Click on the image to Zoom)
The Fiscal-Digital Alignment Chart is perhaps the single most policy-actionable infographic from this whole series of visual representations since, unlike all others before it, it does away with the “Why is there a gap?” question and focuses on the “What can be done about it?” – and the answer to the latter changes according to the four distinct clusters identified by the chart.
In the top right corner
of this graph, we find the two states which have already become mature fiscal
hubs, characterised by both high levels of digitisation and tax collection
compared to their GDP. Here, the solution is not to try pushing further but to
simply institutionalise: build compliance infrastructure, reduce leakages in
treaties and capital gains, and let it work. Karnataka is just slightly lower
than those two, which means that despite being very digitally advanced, the
state still has some extraction headroom. However, the real excitement of this
visualisation lies in the emerging formalised cluster, including Telangana,
Haryana, and Kerala. This cluster occupies the bottom right corner, which
suggests that even though these states have reached the level of
digitalisation, they still lack tax yield.
The anomaly of the
industrial middle, comprising Gujarat, Tamil Nadu, and Andhra Pradesh, is that
of digitalisation at moderate to high levels but very low tax-GSDP ratios,
implying the existence of an issue of propriety firms and trade enterprises
where there is extensive digital payments but opacity in the accounts.
The toughest
recommendation is for the catch-up development group comprising Uttar Pradesh,
Bihar, Rajasthan, Madhya Pradesh, Odisha, and northeastern states, where both
the level of digitalisation and tax-GDP ratio is low. It would be futile to
expect changes through any form of nudging or oversight here, since the necessary
conditions for direct taxes - employment and organized enterprises - are absent
in these regions.
Unspoken but conveyed
through this image by the Finance Commission is the idea that while devising
equalization payments and devolution schemes, one must take into consideration
the structure of tax administration capabilities, and not just the effort,
since demanding that Bihar matches the tax-to-GSDP ratio of Maharashtra
without first matching its formalisation ratio makes no mathematical sense
whatsoever.
Figure 7: Digitalisation Index Vs Tax-to-GSDP Ratio
Devolution
Paradox
The formula devised by
the Finance Commission for horizontal devolution was specifically designed to
address this sort of bias - more prosperous and more efficient states that
collect more get fewer devolved funds, whereas less prosperous states get more.
There is nothing wrong with the formula itself. What has gone wrong is that the
chasm it needs to fill is growing at an increasing rate beyond what mere
transfers can manage, since transfers take care of fiscal need but do not
tackle fiscal capacity. Increased allocation to Bihar will not necessarily
translate into making the Bihar economy taxable.
The
Missing Instrumentality
This is not about
increased redistribution. This is about investing in different ways, apart from redistribution, in the
preconditions without which direct taxes cannot be levied in the first place.
The
digital payments system in tier-3 cities, assistance in GST compliance for
micro enterprises, formalisation of MSMEs and bringing proprietors into the
formal economy.
These are not social
schemes; they are investments of a supply-side fiscal nature, increasing the
tax base of the country over ten years. They will relieve the burden that rests
largely with the corridor states now. Every
small enterprise that goes beyond the cash economy and into the formal economy
in eastern UP or Odisha is one taxpayer in the making.
The Commission can make
it clear that formalisation should not be considered as a development outlay but as fiscal infrastructure.
An
Equation That Will Determine Where India Is Heading To
The 16th Finance
Commission comes armed with a geography of direct tax collection that is even
more lopsided and digitised to varying degrees than any of its predecessors.
It has also been endowed with a trove of data about the current state of play
in terms of direct tax collection - state-level numbers on formalisation,
number of digital payments using UPI, percentage of companies complying with
the GST, information gathered via AIS on income earned, which have never been
available before, to help create an optimal devolution scheme that helps grow
the tax base for tomorrow. States that are poised on the verge of making the
jump into the formal economy don't require any special dispensations from the
16th Finance Commission. They need the conditions created to get across the
line.
Formula
for India’s Future
In 2035, India’s direct
taxation landscape will be determined by decisions being taken now. While
a Commission that examines the past can give a formula based on the past, a
Commission that sees into the future and pushes forward with it can provide a
formula for the future decade. This is what distinguishes a transfer
formula from a growth formula. The 16th Finance Commission has a unique
opportunity to do both.
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