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Intergenerational equity as tax devolution criterion
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Context
The discussion on the devolution of Union tax revenue to States has recently gained attention in political and economic spheres. A crucial point in this discussion is the need to balance intragenerational and intergenerational equity within the horizontal distribution formula set by the Finance Commission (FC) every five years.
Intergenerational Fiscal Equity:
- Principle and Importance: Intergenerational equity involves ensuring that current generations do not burden future generations with debt. It emphasizes that every generation should pay for the public services it receives.
- Revenue Raising Methods: Governments can raise revenue through taxes or borrowing. Using borrowings to finance current expenditure leads to future generations bearing the tax burden to repay these borrowings.
- Ricardian Equivalence Theory: This theory suggests that households save more when governments borrow to finance current expenditure, preparing for higher future taxes. However, this does not hold in India's federal structure, where developed states often subsidize less developed ones.
Intragenerational Equity:
- Revenue Expenditure Analysis: During the 14th FC period (2015-20), high-income states financed a larger portion of their revenue expenditure through their own taxes compared to low-income states. High-income states managed 59.3% while low-income states only managed 35.9%.
- Union Financial Transfers: Low-income states received 57.7% of their revenue expenditure from Union transfers, while high-income states received only 27.6%.
- Deficit Implications: High-income states faced higher deficits due to lower Union transfers despite higher own tax revenues and curtailed expenditures.
Balancing Equity in Tax Devolution:
- Current Indicators: The FC uses per capita income, population, and area to distribute Union financial transfers, emphasizing equity. However, these indicators do not fully reflect the fiscal realities of states.
- Fiscal Variables: Incorporating fiscal indicators like tax effort and fiscal discipline in the distribution formula can promote efficient fiscal behavior and ensure a fairer allocation of resources.
- Sustainable Debt Management: Assigning larger weights to fiscal indicators can incentivize states to maintain fiscal discipline, ensuring intergenerational equity and sustainable debt levels.
UPSC Mains Questions:
Q. Discuss the importance of intergenerational equity in the context of fiscal federalism in India. How can the Finance Commission ensure a balance between intergenerational and intragenerational equity?
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