Research Article

An Econometric South Asia Economic Journal

24(1) 41­–63, 2023
Analysis of Revenue © 2023 Research and Information System
for Developing Countries & Institute of
Diversification Among Policy Studies of Sri Lanka
https://doi.org/10.1177_13915614231158438
Article reuse guidelines:
Selected Indian States in.sagepub.com/journals-permissions-india
DOI: 10.1177/13915614231158438
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J.S. Darshini1 and K. Gayithri2

Abstract
The key objective of this article is to empirically examine the trends and
determinants of revenue diversification with respect to 14 major Indian states.
The findings highlight a gradual decrease in the level of revenue diversification,
which has become more visible in recent years. This indicates an erratic pattern
of growth in tax and non-tax revenue sources. The panel cross-sectional–
autoregressive distributed lag model test results reveal a positive contribution of
economic and institutional factors, as compared to political factors, toward the
process of revenue diversification. Overall, it is evident that cyclical fluctuations in
the major tax revenue sources, coupled with a lessened emphasis on rationalising
the structure of non-tax revenue sources, seem to have had an adverse impact
on the process of revenue diversification on the part of states.

JEL Classifications: H0, H1, H2, H7

Keywords
Fiscal policy, revenue structure, revenue diversification, CS-ARDL

Introduction
Revenue adequacy refers to the availability of a sufficient level of revenue
required to ensure uninterrupted public service delivery. For adequate revenue
generation, proper management of the revenue structure with a diverse set of
revenue sources is essential. In this direction, changes in tax policy and reform
measures and differences in tax bases help diversify their revenue portfolios.

1Faculty, Department of Economics, GFGC, K R Puram, Bengaluru, Karnataka, India

2Fiscal Policy Institute, Bengaluru, Government of Karnataka, India

Corresponding author:
J.S. Darshini, Faculty, Department of Economics, GFGC, K R Puram, Bengaluru, Karnataka 560072,
India.
E-mail: darshini.darshinijs@gmail.com
42 South Asia Economic Journal 24(1)

Diversification is the process of changing the level of diversity of revenue

mobilisation as part of mitigating the uncertainty associated with reliance on a
single or a few revenue sources. Following the existing literature, diversification
of revenue helps expand the tax base, reduce the fiscal stress (Shamsub & Akoto,
2004), reduce the extent of variability associated with revenue mobilisation,
improve fiscal stability (Oates, 1985), besides improving the overall fiscal
performance. Even to insulate sub-national governments against any external
shocks, mobilizing sufficient revenue through internal sources is desirable, as it
helps ensure autonomy, flexibility and accountability with respect to revenue
management. Thus, tax collection from multiple sources may make governments
less vulnerable to the risk associated with increased dependency on any one single
source of revenue during a phase of sluggish economic activity.
In the Indian context, it becomes evident that a larger part of the states’ revenue
continues to be derived from their own revenue sources. Of the total own tax
revenue, more than half flows from sales tax, followed by excise, stamp and taxes
on vehicles. Revenues from sales and stamps and from registration fees are
relatively more elastic as compared to motor vehicle tax and excise duty, whereas
revenues from state excise and motor vehicle taxes have remained relatively
inelastic, even showing a consistent increase during the period of economic
slowdown (MTFP, 2011, various issues).
The process of fiscal decentralization (own financial compulsion) has forced
the states to improve their own source revenue mobilisation through diversifying
their revenue structure and introducing fiscal reforms over time. The medium
term fiscal plan (MTFP) is used for incentivising states to undertake some fiscal
restructuring and institutional reforms at the subnational level. Overall, the
reforms at the state level, mainly the fiscal adjustment measures, undertaken in
the last decade to improve their fiscal position have helped the states improve
their own-tax revenue mobilization, but they have failed to maintain consistency
for a longer period (MTFP, various issues). For instance, the increasing revenue
gap is a major concern haunting the Indian states (Kurian & Sushmita, 2004), as
reflected by a long-term decline in the states’ own revenues from 69% in 1955–
1956 to 52% in 2002–2003 (Singh, 2006). Some studies have even observed an
increase in the coefficient of variation with regard to per capita own revenues over
the years, resulting in a growing divergence between per capita own revenue and
per capita expenditure (Chakraborty, 2014). In view of these revenue- and
expenditure-led fiscal correction measures and tax reform measures undertaken at
the sub-national level, it is necessary to examine the extent of reliance on different
sources of revenue over time.
An analysis of the pattern and extent of revenue diversification helps analyze
the variations in the changing revenue structures of states. However, because of
the lesser emphasis laid on the importance of revenue diversification in the fiscal
policy at the national and sub-national levels, this kind of analysis has not been
attempted before in the Indian context. Therefore, the present analysis aims to
explore the changes in the revenue composition, the extent and the changing
trends in the revenue diversification across 14 major Indian states for the period
of 1981–2017.
Darshini and Gayithri 43

The structure of the article is as follows: The present study aims to assess the
trends in revenue diversification across 14 major Indian states. For this purpose,
the study critically assesses the changing trends in the extent of revenue
diversification across the states. The study also examines the determinants of
revenue diversification followed by theoretical background to revenue
diversification and a brief overview of empirical studies that have examined the
aspects of revenue diversification.

An Overview of Total Revenue Sources

In the total revenue structure, states’ own revenue sources are broadly classified
into tax and non-tax revenue sources. Tax revenue sources can be further classified
into direct and indirect taxes. The revenue categories used in this analysis include
taxes on income, taxes on property and capital transactions, taxes on commodities
and services, and states’ own non-tax revenue. Taxes on income comprise
agricultural income tax and taxes on professions, taxes on property and capital
transactions comprise land revenue, stamps and registration fees and urban
immovable property tax, taxes on commodities and services comprise sales tax,
state excise, taxes on vehicles, taxes on goods and passengers, taxes and duties on
electricity, entertainment tax and other taxes and duties.
It is evident from Table 1 that in the changing revenue structure, the contribution
of sales tax accounts for more than half of own source revenue. Although sales tax
predominates the period under analysis as a whole, from the first half of the 1990s,
stamp duty, registration fee, entertainment tax and taxes on vehicles show an
increase in their relative share over the period under their respective categories.
The real estate boom, growing urbanization and increasing number of registered
motor vehicles have also contributed towards revenue collection over the years.
The revenue from four major state taxes, such as stamps and registration fees,
sales tax, excise duty and motor vehicle tax, comprising taxes on vehicles and
taxes on goods and passengers, accounts for a larger portion of the aggregate own-
source revenue of the states, while receipts from interest, dividends and profits
from state PSUs and income from royalties constitute a relatively larger share of
the non-tax revenue. Overall, the own source revenue kitty tells a dismal story,
though the states have managed to improve the ratio of own tax revenue-GSDP
from 1990–1991 to 2016–2017. It is also important to notice that several low-
income states have become fiscally prudent through improving their own-tax
revenue, besides having a larger share in the divisible pool as compared to middle-
and high-income states (Rathin Roy, 2022).
Changed fiscal scenarios and fiscal correction measures undertaken in the last
decade (FRBM, 2004) have helped the states improve their revenue mobilisation
capacity in the post-reform, to a larger extent (MTFP, various issues), but there is
no long-term consistency observed in this respect. It is even observed that the
coefficient of variation with regard to per capita own revenues continues to persist
over the years.
44 South Asia Economic Journal 24(1)

Table 1. States’ Own Tax and Non-Tax Revenue Shares.

Revenue
Components-14
States (As % of Total Own Source of Revenue)
1981– 1985– 1990– 1995– 2000– 2005– 2010–
Sub-Periods 1985 1990 1995 2000 2005 2010 2017
Agricultural Income 0.24 0.18 0.13 0.10 0.01 0.01 0.01
Tax
Taxes on Professions, 0.64 0.80 0.90 1.01 1.28 0.86 0.63
Trades, Callings and
Employment
Land Revenue 1.61 1.78 1.31 1.09 1.08 1.13 1.10
Stamps and 4.47 4.94 5.96 6.95 7.92 9.95 9.92
Registration Fees
Urban Immovable 0.05 0.05 0.06 0.07 0.04 0.55 1.34
Property Tax
Sales Tax 39.34 43.40 44.25 45.93 48.87 48.84 53.07
State Excise 12.58 11.11 11.40 10.51 10.24 9.10 10.24
Taxes on Vehicles 4.77 4.39 4.08 4.60 4.87 4.27 4.55
Taxes on Goods and 2.93 2.64 2.27 1.74 2.06 2.08 1.95
Passengers
Taxes and Duties on 2.40 3.31 3.15 3.18 3.16 2.68 2.83
Electricity
Entertainment Tax 2.79 1.51 0.83 0.63 0.49 0.27 0.23
Other Taxes and 0.67 0.80 0.66 1.51 0.71 0.53 0.55
Duties
State’s Own
Non-Tax Revenue 27.50 25.10 24.99 22.69 19.25 18.86 13.58
Source: The authors’ compilation is based on RBI (2004, 2010 and 2018) documents.

As part of continued tax reform, the Goods and Services Tax (GST), introduced
on 1 July 2017, encompasses various taxes coming under the Union and state
government’s indirect tax bases (Mukherjee, 2019). Considering that excise and
stamp duties happen to be the major revenue-yielding sources in the period of
transition, with more uncertainty surrounding the initial stages of implementation
of the GST as a major indirect tax reform, states need to focus on other existing
taxes to improve their own revenue collection. Thus, it becomes evident that state
governments must mobilize additional resources, as their reliance on non-sales
taxes and non-tax revenue is inevitable.
With the onset of the COVID-19 pandemic, a shortfall in states overall revenue
receipts has become more evident in recent years. A larger shortfall in revenue led
to the curtailment of total expenditure and even an increase in borrowing. Such a
growing tendency toward excessive borrowing among states may lead to the
Darshini and Gayithri 45

accumulation of unsustainable debt, which further restricts the space available for
fiscal expansion. To tackle this problem, improvement in tax effort is the key to
fiscal prudence at the subnational level (Rajaraman, 2004).

Method of Measuring Revenue Diversification

Revenue diversification is measured by the Hirschman–Herfindahl Index (HHI).
HHI is the most widely used method to measure revenue diversification
(Suyderhoud, 1994). The revenue diversification index (RDI) value ranges from
0 to 1, where 0 means no diversification and 1 means maximum possible
diversification. An RDI value closer to 1 is an indication of reliance on multiple
sources of revenue categories and vice versa (Carroll & Johnson, 2010; Hendrik,
2002; Suyderhoud, 1994; Yan, 2008). To assess the extent of dependency on
different sources of revenue, this study employs RDI score, which is based on
the Herfindahl–Hirschman Index of concentration. The derivation of HHI
follows:

HHI =
( 1−∑ N
i= 1
pi2 )
1
1−
N

HHI is computed first by taking the sum of the squares of the proportion of each
category of revenue to the total revenue sources in percentage terms. Since HHI
is an index of concentration, subtracting the summed percentages of revenue from
 N 2
one (1 − HHI) = 1 −∑ pi  value near to one is interpreted as a move towards
 i= 1 
increased diversification. Here, N represents the total number of revenue
categories, and pi is the proportion of ith revenue to the total revenue categories. In
the second stage, the value derived in the first stage is scaled by the number of
revenue categories, with 0 as the lower limit of concentration.

Revenue Diversification Trends Across the States

To construct an HHI Index, the total own source revenue (18 taxes) is broadly
classified into four categories, that is, taxes on income; taxes on property and
capital transactions; taxes on commodities and services; and states’ own non-tax
revenue. Based on an inter-temporal analysis of the changing fiscal scenario and
implementation of new economic policies and considering the path of fiscal
adjustment, the period of the study has been sub-divided into three phases
(Table 2).
Phase I: From 1981–1982 to 1991–1992 (period with lesser fluctuations in the
macroeconomic variables in the economy).
46 South Asia Economic Journal 24(1)

Table 2. RDI Values of the States.

States 1981–2017 1981–1992 1992–2003 2003–2017
Andhra Pradesh 0.60 0.63 0.61 0.57
Bihar 0.66 0.71 0.67 0.60
Gujarat 0.59 0.60 0.62 0.56
Haryana 0.73 0.77 0.74 0.68
Karnataka 0.55 0.61 0.55 0.49
Kerala 0.49 0.57 0.44 0.47
Madhya Pradesh 0.67 0.71 0.68 0.62
Maharashtra 0.64 0.64 0.67 0.63
Odisha 0.72 0.80 0.72 0.65
Punjab 0.70 0.65 0.76 0.70
Rajasthan 0.70 0.78 0.71 0.63
Tamil Nadu 0.46 0.49 0.43 0.45
Uttar Pradesh 0.67 0.72 0.64 0.65
West Bengal 0.60 0.63 0.60 0.57

Phase II: From 1992–1993 to 2002–2003 (period marked by fiscal imbalance,

fiscal deterioration, characterised by increase in revenue deficit, fiscal deficit and
off-budget borrowings).
Phase III: From 2003–2004 to 2016–2017 (period of fiscal improvement, fiscal
soundness, characterised by decrease in revenue deficit and increase in tax
collection).
For each of the 14 major states of India, Table 2 illustrates the change in the
levels of diversification within and across the states over different sub-periods. As
per the observation, one of the prominent fiscal trends in the state finances is the
gradual decrease in the level of revenue diversification, more so in the recent
decades as compared to the 1980s. In the 1980s, the level of diversification was
relatively higher across states such as Odisha, Rajasthan, Haryana, Bihar, Madhya
Pradesh and Uttar Pradesh. During the first and third sub-periods, a greater
number of states fall within 60–80 RDI range and exhibit a higher level of
diversification. In the 1990s, due to fiscal deterioration in the state finances,
mainly from the mid-1990s, followed by a constant fall of non-tax revenue,
besides fluctuations in several major taxes and the preponderance of sales tax in
the total taxes, the level of diversification further decreased.
During the post-FRBM period, the extent of diversification showed a
progressive trend, but due to several constraints associated with reform measures,
revenue collection was not much more progressive and not even consistent during
the period of accelerated economic growth (2004–2008). In the late 2000s,
followed by an economic recession, lack of consistency in the growth of non-sales
tax and more fluctuations in the various components of non-tax revenue further
contributed to a lower level of diversification.
Darshini and Gayithri 47

Even after the enactment of fiscal reform measures, the states’ attempt to
enhance their own revenue generation was not progressive in the long run. As
depicted in Table 2, among the 14 states, Haryana, Punjab, Madhya Pradesh and
Uttar Pradesh come under a relatively more diversified category. In contrast,
Tamil Nadu, Kerala and Karnataka are less diversified states with a greater
reliance on sales tax and a continuous fall in non-tax revenue. In terms of state-
wise ranking, Haryana recorded consistent progress in RDI ranking, while Punjab,
since the 1990s, has witnessed a notable improvement in its RDI ranking. On the
contrary, Bihar, Odisha and Rajasthan experienced a constant fall in their RDI
rankings, despite being relatively highly diversified states, until the mid-1990s.
Finally, no such variability in the HHI values and RDI rankings is noticed in
respect of Maharashtra, Andhra Pradesh, Gujarat and West Bengal. In the 1980s,
more fiscally stressed states like Odisha, Rajasthan, Bihar, Uttar Pradesh and
Madhya Pradesh, excluding Haryana, experienced a more diversified revenue
structure. The change in the pattern of diversification, over time, implies that
high- and some middle-income states like Punjab, Uttar Pradesh, Karnataka,
Kerala and Haryana experienced a relatively progressive trend during the period
of fiscal improvement followed by revenue-led reform initiatives in the aftermath
of post-reform period. But, in the recent years, mainly in post-recession, a fall in
the level of diversification remained much more visible than ever before, in all the
states. However, Odisha and Uttar Pradesh are exceptions with a progressive
revenue diversification.
Overall, the above analysis reveals that very few states have significantly
improved their rankings in RDI, while comparatively many more states have
experienced stagnant levels of diversification and some more states have
experienced a drastic fall in their RDI rankings.

Theoretical Underpinnings
In the public finance and public choice literature, there are two distinct views with
respect to the effect of revenue diversification on the size of government: one is
fiscal illusion (revenue complexity) and the other is fiscal stress hypothesis. As
per the fiscal illusion hypothesis, there is a systematic misperception of the cost of
government on the part of tax payers, and this illusion induces an underestimation
of tax prices for public expenditure. Scholars such as Buchanan (1967), Wagner
(1976) and Baker (1983) argued that diversifying revenue streams often leads to
a ‘fiscal illusion due to increased complexity of tax structure and it leads to a
bigger government by increasing public expenditure or tax burden’.
On the contrary, fiscal stress hypothesis propagates that revenue
diversification ensures continuity of public service by reducing the cost
associated with revenue variability, as variability in revenue has an adverse
impact on the size of government (Misiolek & Elder, 1988; White, 1983). So,
both the approaches use revenue diversification as a mechanism for estimating
the extent of fiscal illusion and also as a protective instrument in terms of
bearing the cost of revenue volatility (variability), as per White’s argument
48 South Asia Economic Journal 24(1)

(1982). Both approaches find a direct relationship between tax diversification

and the size of government. This dichotomy creates some problems when it
comes to interpreting revenue diversification used in measuring tax complexity
as well as revenue stability (Misiolek & Elder, 1988). Oates (1991) also
viewed the revenue complexity and revenue diversification as two competing
hypotheses. Based on these views, Carroll observes that revenue complexity
does not directly lead to revenue diversification, but revenue diversification
results in revenue complexity. While revenue diversification is considered
from the point of view of revenue variability or volatility, diversified revenue
structures are used as a protective mechanism to control variability in the
generation of revenue.

Review of Empirical Studies

The empirical studies provide an overview of different aspects of revenue
diversification. Some of the empirical studies discussed below dwell on the
different aspects of revenue diversification, considering the economic relationship
between revenue diversification and revenue volatility. Until the 1980s, a
relatively less attention was placed on the role of revenue diversification in
the revenue portfolio. Later, with the initial works of Suyderhoud (1994), the
diversification index came to be widely employed in the analysis of revenue
structure. As Yan (2008) observed, revenue diversification is a highly desirable
goal for the governments due to two reasons. First, it minimizes the loss of
revenues during times of severe fiscal crisis and secondly, it even helps
governments raise revenue through multiple tax sources during periods of
recession. In 2004, Shamsub and Akoto (2004) investigated how state and local
governments’ fiscal structures influenced their fiscal performance. Employing a
pooled panel approach to the 49 US states-local data for the period of 1982–1997,
researchers concluded that local revenue diversification lowered fiscal stress and
enhanced their fiscal performance. While examining the role of revenue
diversification in reducing revenue instability (volatility), several studies, such as
Yan (2008), Carroll and Johnson (2010) and Schunk and Porca (2005), found a
negative relationship, in that a diversified revenue structure helped reduce revenue
instability with a stable economic base. Likewise, Jimenez and Afonso (2022)
assessed the role of tax and non-tax revenue diversification on budgetary solvency
with reference to 500 cities in the United States from 2006 to 2011. As per the
research outcome, cities that had broadened their revenue structure by tapping
non-tax revenue sources were able to handle higher current operational spending
with bigger reserves. Revenue-stabilization effects of home rule was examined by
Zhang and Nguyen-Hoang (2021). As per the study, increased reliance of home
rule cities on property tax to raise more revenue was the major factor behind
revenue stability. In contrast, Shi and Jie (2018) found that a diversified revenue
structure had an adverse impact on the tax burden, mainly during the economic
downturn. The findings suggest that non-tax revenue may help reduce such a
Darshini and Gayithri 49

burden on taxation. But, Seeun (2013) found a positive association between

revenue growth and revenue diversification while noticing the failure of a
diversified revenue structure in smoothing revenue volatility. Way back in 1997,
Dye and McGuire (1997) had also noticed an adverse impact of revenue
diversification on the tax growth rates among the US states.
Some studies have even tried to examine the role of select indirect taxes in
reducing revenue variability. While examining the role of a diversified tax
structure in the stabilisation of revenue structure, Ebeke and Ehrhart (2011)
observed how the implementation of VAT had enhanced tax stability, using
panel data of 103 developing countries for the period of 1980–2008. As per
the outcome, VAT worked as an instrument of risk diversification besides
being less sensitive to economic shocks as compared to the countries that had
not implemented it. In contrast, a study by Whitney (2013), for the period of
1983–2004, found how the increased reliance of 35 US states on local option
sales tax, with a reduced dependency on property tax, had contributed to
revenue volatility.
Going by the existing literature, revenue diversification helps reduce the fiscal
stress. However, there is a view that a diversified revenue structure may fail to
achieve tax policy goals like efficiency, equity and adequacy (Ladd & Dana,
1987), and in addition, it may lead to expenditure inefficiency and a higher tax
burden (Wagner, 1976) on the part of governments.
On this backdrop, it is essential to empirically test the determinants of revenue
diversification in the following section.

Determinants of Revenue Diversification

After having observed the pattern and extent of revenue diversification, it is
important to study the factors determining such diversification. Regarding the
choice of variables, this study has adopted the methodology approach of Purohit
and Purohit (2009). The variables and their data sources considered in the model
are presented in Table A1 in Appendix A.
As tax and non-tax revenue sources are accounted for in the process of
constructing a diversification index, the sub-categories of GSDP, such as the
respective shares of service, construction and real estate, mining, and the area
under food grains in the total cropped area (the contribution of agriculture), are
used as the base for tax revenue. In order to account for the contribution of non-
tax revenue, the major contributors of non-tax revenue sources such as education,
health, road, water supply and sanitation and major and minor irrigation are
used. Following the literature, urbanisation, schools, teachers (education),
irrigated area, urban density (water supply and sanitation) and agriculture GSDP
(major and minor irrigation) are used as proxies for the above five services. To
account for the influence of non-economic factors (political and structural
dummies), the study has further employed step and pulse dummies in the
analysis.
50 South Asia Economic Journal 24(1)

Empirical Framework and Results

The methodology used in the present analysis is the dynamic panel model. The
CD-test (Pesaran, 2004, 2015) is used to test the cross-sectional dependence
(CSD) of the variables, which is robust to non-stationarity, parameter heterogeneity
and structural breaks.

CSD Pesaran =
2T
N ( N − 1)
(∑ N −1
i =1 ∑
N
j = i +1

)
ρ lj N(0,1).

Since CSD exists (Table 3), second generational unit root tests have been employed
as they assume the existence of CSD errors. While working on the large panel,
following the results of the CSD, testing the unit root is common to finding the
existence of a spurious correlation and to detect the order of integration of each
variable. The second generational unit root test CADF is described as follows:

∆yi , t = α i + β i yi , t − 1 + γ i yt − 1 + δ i ∆ yt + ϕ∆yt − 1 + ui , t , uit = λi f t + ε i ,t .

N N

where y = N −1
∑ y jt, Δ yt=N
−1
∑ ∆ yjt.
j �= 1
j=1

The above equation is augmented with the CSA of the lagged levels and the
first differences of the variable. y t-1 is the mean of lagged levels, Δ y t is the mean
of the first differences, and Δy t-1 is used to remove time series dependence with a
larger T. They are used as proxies for unobserved single common factors ft.
Tables 4 and 5 provide the results of panel unit root tests. The results are found
to be mixed in respect of a few variables at level. As per the CADF panel unit root
test, except for revenue diversification, the remaining variables are non-stationary
at level. But as per Hadri and Berting test statistics, all the variables are non-
stationary at level. Overall, as per the results, all the variables are stationary at the
first difference, and no variable is integrated with order two, I(2).
Based on the above results, among the dynamic models, the auto-regressive
distributed lag model and CS-ARDL (Pesaran et al., 1999, 2015) are a more
preferable approach when the variables are integrated with mixed order I(1) &
I(0), and no variable is integrated with order two, I(2).
The CS-ARDL model is as follows:
p q z
Yi,t = ∑ ϕ i,k yi,t−k + ∑ β ' i,l xi,t−l + ∑ ψ ' il Z t−l + ui,t.
k =1 l =0 l =0

where φi = − (1 − ρil) is the speed of adjustment parameter and is expected

to be negative and significant. β1X1it is the vector of all explanatory variables, and
z t = ( y t, x , t) is the cross-section average of variables.
Before moving on to the CS-ARDL model, to check whether the non-stationary
I(1) economic variables are co-integrated, the Pedroni and Westerlund (Westerlund,
Darshini and Gayithri 51

Table 3. Pesaran CD-Test.

Variables CD P value
Log per capita GSDP 52.5 0.000***
Revenue diversification 14.51 0.000***
SST GSDP – Share of service GSDP\total GSDP 44.76 0.000***
STT GSDP – Share of transport GSDP\total GSDP 51.68 0.000***
SMT GSDP – Share of mining GSDP\total GSDP 3.007 0.000**
SPS GSDP – Share of primary sector\total GSDP 15.59 0.000***
SCT GSDP &UD – Share of construction and real estate GSDP in 39.18 0.000***
the total gross state domestic product and urban density
Irrigation – percentage of gross cropped area irrigated 30.72 0.000***
Foodgrains – Share of area under food grains in the gross cropped 24.98 0.000***
area
Number of schools 33.71 0.000***
Log of urban density 3.905 0.000***
STT GSDP – Share of construction and real estate GSDP\total 15.54 0.000***
GSDP
Note: *** Denotes significant at 1% level.

Table 4. Pesaran CADF and Hadri Panel Unit Root Test Statistics.
Pesaran CADF Hadri
Deterministic Level Lag Level
Form Form
Variables t-bar Z[t-bar] P Statistic P
Value Value
Log per Constant + trend –2.098 1.028 (0.848) 1 41.1356 0.00
capita GSDP
Revenue Constant + trend –2.95 –2.592 1 9.7877 0.00
diversifica- (0.005)
tion
SST GSDP – Constant + trend –2.095 1.041 (0.851) 1 21.6693 0.00
Service
STT GSDP – Constant + trend –2.222 0.5(0.692) 1 34.2801 0.00
Transport
SMT GSDP – Constant + trend –1.856 1.347 (0.911) 1 21.6225 0.00
Mining
Gross irri- Constant + trend –1.687 2.776 (0.997) 1 19.703 0.00
gated area
Foodgrains Constant + trend –2.532 –0.818(0.207) 1 6.0669 0.00
Schools Constant + trend –1.899 1.877 (0.970) 1 23.7668 0.00
(Table 4 continued)
52 South Asia Economic Journal 24(1)

(Table 4 continued)

Pesaran CADF Hadri

Deterministic Level Lag Level
Form Form
Variables t-bar Z[t-bar] P Statistic P
Value Value
Urban Constant + trend –1.874 1.982 (0.976) 1 23.1671 0.00
density
SCT GSDP Constant + trend –1.912 1.820 6 1 35.6565 0.00
– Construc- (0.966)
tion and real
estate GSDP
SPS GSDP – Constant + trend –2.731 –1.664(0.048) 1 18.8195 0.00
Primary
SCT GSDP & Constant + trend –2.318 0.092(0.537) 1 28.2732 0.00
UD – Con-
struction and
real estate &
urban density
Note: The Pesaran CADF test of H0 of non-stationary and Hadri Unit Root test of Ho of
stationary. The optimum number of augmenting lag is selected based on Schwarz Criterion and
 T   1 
Pesaran et al. (2013), set lag order, ρ = 4     .
  100   4  

Table 5. Pesaran CADF and Hadri Panel Unit Root Test Statistics.
Pesaran CADF Hadri
Deterministic First Difference Lag First Difference
Z[t-bar]
Variables t-bar P Value Statistic P Value
Log P K Constant + trend –4.717 –10.105 (0.00) 1 0.2159 0.4145
GSDP
Revenue Constant + trend –4.993 –11.279 (0.00) 1 –2.9313 0.9983
diversifica-
tion
SST GSDP – Constant + trend –4.304 –8.353 (0.00) 1 –2.0317 0.9789
Service
STT GSDP Constant + trend –4.255 –8.143(0.00) 1 –0.184 0.573
– Transport
SMT GSDP Constant + trend –4.028 –7.178 (0.00) 1 0.3598 0.3595
– Mining
Gross irri- Constant + trend –4.125 –7.588 (0.00) 1 –2.2441 0.9876
gated area
Foodgrains Constant + trend –4.568 –9.475 29(0.00) 1 –3.9119 1.000
Schools Constant + trend –4.231 –8.042 (0.00) 1 –1.095 0.8632
(Table 5 continued)
Darshini and Gayithri 53

(Table 5 continued)
Pesaran CADF Hadri
Deterministic First Difference Lag First Difference
Z[t-bar]
Variables t-bar P Value Statistic P Value
Urban Constant + trend –4.230 –8.037 (0.00) 1 –0.7004 0.7581
density
SCT GSDP Constant + trend –4.348 –8.536 (0.00) 1 –0.4941 0.6894
– Construc-
tion and
real estate
GSDP
SPS GSDP – Constant + trend –4.208 –7.941 (0.00) 1 –1.4597 0.9278
Primary
SCT GSDP Constant + trend –3.863 –6.476(0.00) 1 0.7993 0.2121
& UD –
Construc-
tion and
real estate
& urban
density
Note: The Pesaran CADF test of H0 of non-stationary and Hadri unit root test of H0 of
stationarity.

2007) co-integration methods are employed to test the null hypothesis of no

co-integration (several quantitative variables are stationary at first difference).
Pedroni’s (1995, 1999, 2004) residual-based test statistics are based on the
assumption that all the variables are integrated at I(1), which assumes both
intercept and slope heterogeneity. Out of seven statistics, four are based on pooling
data in the within-dimension (panel co-integration), and the remaining three are
averaging values for each unit in the between-dimension (group mean
co-integration). Residuals extracted from the level and differenced regressions are
used in autoregression form to estimate the variance and long-run covariance and
to use those to estimate each test statistic (Barbieri, 2009; Pedroni, 1999, 2004).
The test results of both the panel and group statistics presented in Table 6 prove
the cointegration between the variables. Model 1 includes mining, Model 2
includes the primary sector, and Model 3 includes schools (Table 6). Excluding
these three variables, construction and real estate, service, transport, urban density
and food grains have been retained in all three models. The test results of Pedroni,
supported by the Westerlund co-integration method presented in Table 7, reject
the null hypothesis of no co-integration between the variables. Model 1 includes
teachers and Model 2 includes area under food grains in the total cropped area
(Table 7). Excluding these two variables, construction and real estate, service,
transport and irrigation have been retained in the two models.
54 South Asia Economic Journal 24(1)

Table 6. Pedroni Error Correction-based Panel Co-integration Tests.

Pedroni Co-integration Model 1 Model 2 Model 3
Model With Individual Intercept and Trend
Panel Statistics
V Statistics –1.342 –1.252 –1.348
Rho Statistics 0.209 0.2492 0.165
pp Statistics –6.48*** –6.742*** –7.053***
ADF Statistics –3.757*** –5.236*** –4.146***
Group Statistics
Rho Statistics 1.507 1.439 1.327
Pp Statistics –6.509*** –7.012*** –7.315***
ADF Statistics –4.276*** –5.874*** –3.806***
Note: *** Implies rejection of no co-integration at 1% levels.

Table 7. Westerlund Error Correction-based Panel Co-integration Tests.

Westerlund Co-integration lags
(0 1) leads (0 1) Model 1 – Value Z Value P Value
Model with individual intercept and trend
Gt –3.786*** –3.133 0.001
Ga –7.961 4.588 1.000
Pt –12.723** –2.309 0.011
Pa –13.896 0.741 0.771
Westerlund Co-integration lags Model 2 – Value Z Value P Value
(0 1) leads (0 1)
Gt –3.374* –1.461 0.072
Ga –5.920 5.417 1.000
Pt –13.479*** –3.068 0.001
Pa –13.674 0.833 0.797
Note: *, **, *** Imply the rejections of no co-integration at 10%, 5% and 1% levels.

Following the Pedroni and Westerlund co-integration test results, in order to

consider the short- and long-run relationship between variables and also the
influence of time-specific dummies that represent the policy as well as non-
economic factors in influencing the level of revenue diversification and some of
the economic variables that are stationary at level, the ARDL model is employed.
ARDL is more preferable, when the variables are integrated with mixed order I(1)
and I(0) and no variable is integrated with order two, I(2). The ARDL model
assumes heterogeneous slopes in the short run. It helps in analysing the
Darshini and Gayithri 55

contemporaneous impacts and speed of adjustment to equilibrium and long-run

coefficients (slops) are homogeneous, which is more preferable for moderate T
compared to the dynamic fixed effect and mean group model. Since N is small,
this analysis employs PMG-adjusted for cross-section dependence (PMG is quite
robust to outliers and the choice of lag orders; Pesaran & Smith, 1995).
The CS-ARDL model is augmented with the lagged cross-section mean of the
variable and its lags. The ARDL methodology assumes that errors are independently
distributed across t and i. If the unobserved common factor in the error term is
correlated with the regressors and the failure to account for dependency, it results
in inappropriate standard errors and biases the coefficients (Pesaran, 2006).

Estimation methods: The ARDL model is written as follows:

Yj, t = δ ∑ k = 1 ϕi , k yi , t , − k + ∑ l = 0 β i′,1 xi ,t − 1 + ui , t
p q

Its cointegration form would be

Y j ,t = θi , xi ,t + α I′ (L) ∆xit + ui , t , t , ui , t . = γ i′ Ft + ε i ,t

where φi = − (1 − ρil) is the speed of adjustment parameter and it must be non-zero,

expected to be negative and significant. It represents bringing the variable back to
a long-run equilibrium. The short-run coefficients and the speed of adjustment to
the long-run from short-run deviation and error variances differ across units,
whereas in the long-run, coefficients are assumed to be homogeneous across
units. θi = θ,I, i = 1,2…..,N. θi is estimated to find out whether the variables are
exogenous or endogenous and are I(0) or I(1) in nature (Pesaran et al., 1999).

∑ β
q
l = 0 i ,1
θi =
1− ∑ ϕ
p
l =1 i ,1

where p is the lag of the dependent variable and q is the lag of the independent variable.
To overcome the problem of unobserved common factors, following the
seminal work of Chudik et al., (2013), CS-ARDL approach was employed,
following the CCE methodology of Pesaran (2006). When the feedback effects
from the lagged values of the dependent variable to the independent variables
exist, u it is correlated with xit, then the distributed lag model would be inconsistent.
The CS-ARDL model is

Yi , t = ∑ k = 1 ϕi , k yi , t − k + ∑ l = 0 β i′,1 xi , t − 1 + ∑ l = 0 ψ il′ Z t − 1 + ui , t
p q z

 1
where z t = ( y t, x′ t)’ & z = T  cross-section averages of current and lags of
 3
dependent and independent variables. The selection of lag length is crucial. The
56 South Asia Economic Journal 24(1)

Table 8. Dependent Variable: RDI (CS-ARDL Model).

Explanatory Variables Model I
Dependent Variable Revenue D iversification
ECT –0.2908 (–3.08)***
Long Run
SST GSDP – Service –0.603 (–5.19)***
STT GSDP – Transport 2.696 (5.40)***
Irrigation 6.233 (5.10)***
Schools 2.966 (6.41)***
PM GSDP – Primary 0.438 (5.17)***
Log Urban Density 0.00222 (0.24)
SCT GSDP-C and Real estate –1.486 (–4.63)***
VAT –0.0600 (–2.96)***
FRL 0.0134 (0.67)
BLEY –0.0115 (–2.43)**
LEY –0.0699 (–6.64)***
Regional parties –0.0220 (–3.15)***
Coalition governments –0.0220 (–1.91)*
Incumbency 0.0940 (7.78)***
Short Run
ΔSST GSDP – Service 0.266 (0.65)
ΔSTT GSDP – Transport 0.910 (1.13)
ΔSCT GSDP & UD – Construction and real –0.207 (–0.37)
estate & urban density
Δlog of Urban Density –0.0588 (–1.23)
Δ Gross Irrigated Area 5.144 (0.16)
ΔSchools 3.911 (0.03)
ΔFRL 0.00806 (0.38)
ΔRD(-1) –0.0733 (–0.88)
ΔSTT GSDP – Transport (–1) –2.625 (–3.00)***
ΔPMGSDP – Primary (–1) –0.0979 (–0.45)
Constant 0.0536 (2.43)**
N 460
CD-test (p value), corr –0.63 (0.537), –0.013
Note: ***p < .01, **p < .05, *p < .1 levels of significance, respectively. T-statistics are shown in
parentheses. Δ represents first difference. Period (1981–2015).

lag order of 1 is chosen considering the time period and number of explanatory
variables used in this analysis.
The test results of the CS-ARDL panel regression models are reported in
Table 8. Each table contains different models with different sets of control
variables. The empirical analyses, with the inclusion of cross-section averages,
Darshini and Gayithri 57

successfully account for the presence of common factors across units. The
CS-ARDL model helps take care of the potential endogeneity of political variables.
Focusing on the long-term coefficients, most of the variables are found to be
statistically significant and the EC [yt − 1] refers to the Error-Correction term
(speed of adjustment parameter), which is statistically significant at 1% and
confirms co-integration in the long run.
In the CS-ARDL model, column 2 of Table 8 indicates that most of the
economic variables are significant. Different components of GSDP are the core
independent variables used in this model. Among the long-run coefficients, the
share of transport GSDP, primary GSDP, the school proxy for education and
irrigation are significant and positively associated with revenue diversification,
whereas service, construction, and real estate GSDPare are negatively associated
with it.
The primary sector of the economy includes agriculture, forestry, fishing,
mining and quarrying. As per the regression outcomes, irrigation, which is used as
a proxy for agriculture GSDP, is positive and relatively more significant despite
overall primary sector GSDP significantly contributing to revenue diversification.
This shows the importance of the agricultural sector in widening the tax base in
India.
In own tax portfolio, sales tax, excise duties, stamp and registration fees, and
motor vehicle taxes have progressively contributed to a higher tax revenue
buoyancy. However, among the major tax sources, only sales and excise duties
accounted for a larger share of the total own tax revenue till 1997, while a gradual
improvement in stamp duties and electricity duties thereafter has contributed
positively towards a diversified revenue structure since the mid-2000s but failed
to maintain sustained growth for a longer duration in the period of
post-recession.
The nature and structure of a revenue portfolio are very much crucial to a
diversified revenue structure. Taxes, which are relatively more elastic in
nature, show fluctuations with economic ups and downs. Among the major
taxes, stamps and registration, and commercial taxes (sales tax) are relatively
more elastic as compared to motor vehicle and excise duties. Revenue from
sales, a major revenue source, being relatively elastic, shows fluctuations with
an economic slowdown. Even revenue from motor vehicle and excise duties
shows a decrease with the economic downturn due to a lack of demand-led
growth, and several stimulus measures undertaken by the respective state
governments and the central governments towards stimulating demand may
have further reduced revenue collection in the post-recession period (MTFP,
various issues).
In own tax portfolio, only sales tax has been the most buoyant and elastic
among all the other taxes for a longer period, negatively contributing to a
diversified revenue structure. Furthermore, the implementation of VAT as a step
towards tax reform has had an adverse impact on the process of revenue
diversification. It is probably because of the greater emphasis placed on sales tax
reforms since the last decade on generating more revenue with the implementation
of VAT.
58 South Asia Economic Journal 24(1)

In non-tax category, education, health, roads, water supply, sanitation and

major and minor irrigation have contributed significantly towards a diversified
revenue structure, though it has failed to maintain consistency over a longer
period. For instance, in the 1990s, the dismal performance of non-merit services
such as irrigation, co-operation and uneconomic transport fares, the poor
performance of the state PSUs, huge losses incurred by state electricity boards,
and lower recovery rates were evedent fluctuations in general and economic
services was evident. The trend got reversed with the states’ constant effort to
mobilise additional resources through tax and non-tax sources towards improving
the state of the fiscal situation from crisis to stability over the period of 2001–
2011. A better recovery of user charges with respect to irrigation in the early
2000s and a relatively progressive contribution of economic, irrigation and
mineral resources to non-tax revenue altogether contributed positively to the level
of revenue diversification. Although, due to several constraints associated with
reform initiatives, diversified revenue collection has not remained much
progressive since 2008, following an economic recession, due to a lack of a
strategic policy to cope with such economic ups and downs. With such an erratic
growth pattern displaced by major non-tax revenue sources, annual growth rates
of various components of non-tax revenue have remained more volatile with year-
to-year fluctuations across states and time.
Among the components of tax and non-tax revenue, despite progressive
growth, sluggishness and wide fluctuations in the growth pattern are more evident.
As per the above outcomes, stamps and registration fees, taxes on vehicles, the
real estate boom, agricultural taxation and reforms in motor vehicle taxes have
contributed positively towards mobilisation of revenue from non-sales taxes (state
finances 2008–2009). In addition, the contribution of social and economic services
from non-tax revenue, such as major and minor irrigation, education and roads, is
positive and significant with respect to the level of revenue diversification. The
real estate boom and ongoing urbanization, together representing real estate
activities and reforms, mainly in the urban area, are responsible for such an
outcome. Nevertheless, a huge unevenness in the amount of revenue collection
across the states and over time has had an adverse impact on the level of
diversification of the revenue structure.
Among political variables, as per the empirical outcome, excluding
‘incumbency’, election dummies, regional parties and coalition government are
negatively significant. This implies that when the arena of politics is competitive
and a coalition is in place, governments tend to focus more on pre-poll uneconomic
populist programmes/decisions to win elections by showcasing the temporary
relief benefits rather than undertaking long-term revenue mobilization initiatives
as part of widening the tax base.
The rise of coalition governments and regional parties since 1989 has reduced
the dominance of a single party while increasing the trend of political uncertainty.
At the same time, regional parties have started to follow their own respective
development models to retain power over a longer period. However, political
coalitions, with an increase in the number of affiliated political parties coming
together with different pre-election agendas and political ideologies, have often
Darshini and Gayithri 59

failed to mobilize sufficient revenue from a diverse set of sources. As citizens are
generally reluctant to pay taxes, ruling parties have failed to prioritise more
revenue mobilization from a diverse set of sources.
As people generally dislike paying taxes and the most often political parties
show an inclination to move towards a massive reduction in tax rates, unlimited,
unscientific ways of tax exemptions and concessions may lead to a massive
erosion in tax revenue collection. If the parties in power focus more on identity
politics, a lack in the timing of fiscal reforms and long-term strategies towards
mobilising resources may further increase the states’ capacity and policy to cope
with economic ups and downs, further increasing their continued dependence on
a very few revenue sources. The states’ reluctance to raise revenue from a diverse
set of sources is also one of the reasons for poor tax buoyancy.
On the contrary, ‘incumbency dummy’ is positive and significant. This implies
that when the same party/government is re-elected in the coming elections, it may
focus on mobilizing revenue from additional sources. Once re-elected, the ruling
party more often faces increased pressure to mobilize sufficient revenue to
continue or undertake expenditure obligations, and that may force the government
to take initiatives towards widening the tax base.
Overall, it is evident from the analysis that both economic and non-economic
variables play a crucial role in the process of revenue structure diversification.
States seem to be less enthusiastic about diversified revenue generation from non-
tax revenue sources.

Conclusions and Policy Suggestions

The study has explored the extent and changing trends in the level of revenue
diversification and subsequently focused on the determinants of such
diversification among selected Indian states. A proper diversification of revenue
basket serves as an important cushion against any internal or external fiscal shocks
associated with the slowdown of economic activities. The present analysis has
thrown up some interesting findings as well. Cyclical fluctuations in the major tax
sources with a lesser emphasis on non-tax revenue because of non-revision of user
charges, non-recovery of user charges, and even poor monitoring of the collection
of user charges have had an adverse impact on the process of revenue diversification
on the part of states. Overall, the states have failed in their planning in the due
course of proper fiscal management initiatives to mobilize adequate revenues.
Over the decades, a lack of macroeconomic vision has been observed on the part
of states towards diversified revenue generation from different sectors with an
overreliance on a few revenue sources.
Governments have to choose between healthy revenue generation and
providing a stimulus to the economy through lower prices. Since public services
are largely in the nature of economic and social services with a high socio-
economic importance attached, there is a need for rationalising the existing user
charges in a way that will not affect the demand for public goods such as education
60 South Asia Economic Journal 24(1)

and health. This is a matter of concern that needs policymakers’ due attention. If
states could diversify their revenue baskets with more non-sales taxes as well as
non-tax revenue sources, it is an indication of a higher level of diversification.

Appendix A

Table A1. Variable Specifications and Data Sources.

Variables Definition and Data Sources
RDI (Revenue Diversification) HHI Values
Share of Service GSDP\Total GSDP National Accounts Statistics
Share of Transport GSDP\Total GSDP –
Share of Construction and Real Estate GSDP in –
the Total GSDP and Urban Density
Share of Primary Sector GSDP/Total GSDP –
Share of Mining/Total GSDP –
Irrigation, measured as a percentage of gross Directorate of Economics and
cropped area irrigated Statistics, MOA
Number of schools Selected Educational Statistics
VAT (value-added tax) – One of the institutional State Finance Documents
reforms introduced by state governments in
2005. It is used as a dummy variable to capture its
impact on revenue diversification, as it is a major
policy change.
FRBM (Fiscal Responsibility and Budget Manage- –
ment Act) – One of the institutional reforms initi-
ated by state governments enacted in 2003
Form of government-coalition or single party is in Election Commission of India
power at the state level (takes value 1 if the coali-
tion government is in power, 0 otherwise).
Political incumbency takes value 1 if there is –
change in the ruling party in the next state legisla-
tive assembly, 0 otherwise.
Regional party takes value 1 if the regional party is –
in power, 0 otherwise.
Electoral cycle dummies (ELA) – election year of –
state legislative assembly; BELA – 1 year prior to
election.
Urban Density Census of India

Declaration of Conflicting Interests

The authors declared no potential conflicts of interest with respect to the research,
authorship and/or publication of this article.
Darshini and Gayithri 61

Funding
The authors received no financial support for the research, authorship and/or publication of
this article.

ORCID iD
J.S. Darshini  https://orcid.org/0000-0003-4032-327X

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