Tax Devolution is a fundamental concept and constitutional mechanism of fiscal federalism in India, defined as the distribution of tax revenues between the Union and State governments. Its origin lies in the need to address the financial imbalance inherent in India's federal structure, where the Union government holds vast financial powers while States require resources for their developmental needs. The formal process of financial decentralization began with the Government of India Act, 1919.
The mechanism is operationalized by the Finance Commission (FC), a constitutional body established by the President every five years under Article 280 of the Constitution of India, which commenced in 1950. The FC's duty, specified in Article 280(3)(a), is to recommend the distribution of the net proceeds of taxes. This process involves two key steps: Vertical Devolution, which determines the percentage of the central taxes to be shared with the States, and Horizontal Devolution, which allocates the respective shares among the States. The taxes to be divided form the "divisible pool," which includes all central taxes except surcharges and cesses levied for specific purposes, as provided for in Article 270.
The 15th Finance Commission recommended the States' share (Vertical Devolution) be 41% of the divisible pool for the 2021-26 period, a reduction from the 42% recommended by the 14th Finance Commission for 2015-20. This 1% adjustment was made to accommodate the newly formed Union Territories of Jammu and Kashmir, and Ladakh. Horizontal Devolution is based on a formula that includes criteria like income distance, population, area, forest and ecology, and tax and fiscal efforts. The exclusion of cesses and surcharges from the divisible pool remains a persistent concern for States.