Syllabus
GS Paper 3 – Indian Economy – Issues relating to mobilisation of resources.
Context
The Finance Commission needs to have a relook at the indicators in rewarding State fiscal efficiency.
Source
The Hindu| Editorial dated 18th July 2024
Intergenerational equity as tax devolution criterion
The devolution of Union tax revenue to States has been a long-standing topic of discussion in both political and economic spheres. The Finance Commission (FC) revisits the horizontal distribution formula every five years, aiming to balance equity and efficiency. While equity, focusing on the redistribution of tax revenue among States, is prioritized, it often leads to intergenerational inequity within States.
Finance Commission
The Finance Commission (FC) recommends the distribution of net tax proceeds between the Union and the States every five years:
- A Constitutional body under Article 280 of the Constitution of India
- Constituted by – President of India (every 5th year or at such earlier time as he considers necessary)
- A quasi-judicial body.
- Recommendations made are only advisory (not binding).
- Composition – Chairman + 4 members
- Qualifications – 4 members should be or have been qualified as High Court judges, or be knowledgeable in finance or experienced in financial matters and are in administration, or possess knowledge in economics.
- The 15th FC suggested that States receive a 41% share of central taxes, a decrease from the 42% share recommended by the 14th FC.
Intergenerational fiscal equity
Intergenerational fiscal equity ensures that each generation bears the cost of public services it consumes, without burdening future generations through debt.
This principle also aims to provide equal opportunities and outcomes across generations.
- Governments primarily raise revenue through two means:
- Taxation: When current tax revenue matches current government expenditure, it ensures that present taxpayers directly fund the services they receive.
- Borrowing: Using borrowing to cover current expenditure shifts the financial burden to future generations, who will face higher taxes to repay the borrowed funds and interest.
- This practice constitutes intergenerational inequity by passing on financial obligations without corresponding benefits.
Ricardian Equivalence Theory
The Ricardian Equivalence Theory, proposed by economist David Ricardo, suggests that individuals anticipate future tax liabilities due to government borrowing to finance current expenditures. Therefore, households adjust their behaviour by saving more to offset expected future tax increases, resulting in no real impact on aggregate demand.
In essence, under this theory, households view government borrowing as equivalent to future taxes and adjust their savings accordingly.
Application in India
Developed States
- Tax Burden: Developed states in India typically contribute more in taxes compared to the benefits they receive from the Union government.
- Borrowing: To meet their expenditure needs, these states might resort to borrowing, assuming they have fiscal space to do so within legal limits.
- Household Behavior: According to Ricardian Equivalence, households in these states might increase savings, anticipating higher future taxes to repay debt incurred by the state government.
Developing States
- Tax Contribution: Developing states generally contribute less in taxes relative to their expenditure needs.
- Union Transfers: These states rely significantly on Union transfers to bridge the gap between their revenue and expenditure requirements.
- Impact on Household Savings: Households in developing states may not adjust savings in response to state borrowing as significantly as in developed states, assuming a lesser direct impact on future tax liabilities due to lower current tax burdens.
Conflicting Intergenerational Equities in Fiscal Distribution
- State Disparities:
- Low-Income States: Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan, Odisha, Jharkhand
- Revenue Financing: Relies more on Union financial transfers than own tax revenue (35.9%).
- Expenditure Coverage: Union transfers finance about 57.7% of revenue expenditure.
- Deficit: Incurs a deficit of 6.4% of revenue expenditure.
- High-Income States: Tamil Nadu, Kerala, Karnataka, Maharashtra, Gujarat, Haryana
- Revenue Financing: Funds a significant portion of revenue expenditure through own tax revenue (59.3%).
- Expenditure Coverage: Relies less on Union transfers (27.6% of revenue expenditure).
- Deficit: Faces a deficit of 13.1% of revenue expenditure despite higher tax revenue.
- Low-Income States: Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan, Odisha, Jharkhand
- Issue with Current Indicators
- FC uses per capita income, population, and area to distribute Union transfers, prioritizing equitable distribution.
- Tax effort and fiscal discipline have lesser weight, which may not fully reflect fiscal efficiency across states.
- Impact of Reduced Transfers
- States have legal limits on deficits and public debt under Fiscal Responsibility Acts.
- Reduced Union transfers sometimes force states to exceed these limits, compromising fiscal discipline.
Way Ahead
- Importance of Equity and Efficiency
- Critical Balance: Achieving equity and efficiency in the tax devolution formula is crucial for fair distribution among states.
- Intragenerational Equity: Ensuring fairness within current generations by equitably distributing resources based on needs and fiscal capacities.
- Intergenerational Equity: Preventing future burdens through sustainable fiscal practices that do not pass excessive debt to future generations.
- Incentivizing Fiscal Responsibility
- Higher Union Transfers: Linking increased transfers to states that demonstrate higher tax effort and efficient expenditure.
- Promoting Efficiency: Encouraging states to improve fiscal discipline and performance through financial incentives.
- Role of the Finance Commission
- Weightage to Fiscal Indicators: Assigning greater importance to fiscal indicators (e.g., tax effort, expenditure efficiency) in the distribution formula.
- Equity Enhancement: Ensuring that states are rewarded appropriately for fiscal responsibility, thereby promoting both intragenerational and intergenerational equity.
Conclusion
Balancing equity and efficiency in the devolution of Union tax revenue to States is crucial for ensuring fiscal sustainability and fairness across generations. The Finance Commission must consider both intragenerational and intergenerational equity, incentivizing States to improve their fiscal discipline while addressing the needs of both high-income and low-income States.
Related PYQ
How have the recommendations of the 14th Finance Commission of India enabled the States to improve their fiscal position? [ UPSC Civil Services Exam – Mains 2021]
Practice Question
How can the Finance Commission ensure a balance between intragenerational and intergenerational equity while addressing the fiscal needs of both high-income and low-income States? [250 words]