One of the points in the discussion of devolution of Union tax revenue to States is the factors in the horizontal distribution of States’ share in Union tax revenue among States.
The Finance Commission (FC) decides the horizontal distribution formula once every five years.
Despite repeated quinquennial revisits to this distribution formula, conceptually, it is predictable that equity is prioritised over efficiency.
Equity in the distribution formula is about intragenerational equity, that is, to redistribute tax revenue among States.
The undesirable consequence of this is the accentuation of intergenerational inequity within States.
The argument is that intergenerational equity should be a factor in India’s horizontal distribution formula for tax devolution.
In general, intergenerational equity is the principle of providing equal opportunities and outcomes to every generation.
Intergenerational equity ensures that the decisions or actions of current generations should not burden the future generation.
For any government, there are only two ways to raise its revenue: tax or borrowing.
If, in a period, the tax revenue equals the current expenditure of the government, then the current taxpayers pay for the public services they receive.
If the government finances the current expenditure through borrowings, it means the future generation is going to pay higher taxes to repay this borrowing and interest.
In other words, borrowing to meet the current expenditure of the government amounts to intergenerational inequity
Ricardian Equivalence Theory - whenever the government resorts to borrowing to finance current expenditure, households react through higher savings and thus enable the future generation to pay higher taxes as well as keep aggregate demand in the economy constant over different periods.
This theory assumes that the current generation pays tax less than the value of the current public services it receives, and thus saves.
Whereas in our present federal situation this is not the case.
Households in developed States pay taxes that are not entirely used within the specific States, thus compelling such States to borrow more or curtail current expenditure.
On the contrary, households in developing States pay taxes much less than the value of current expenditure and fill the gap by receiving higher financial transfers from the Union government.
Usually, FCs use indicators such as per capita income, population, and area in the distribution formula.
These indicators reflect the differences between States in terms of demand for public services (population and area) and the size of public revenue available (per capita income).
These indicators carry a larger weight and assure equity in the distribution of Union financial transfers among States.
Variables such as tax effort and fiscal discipline carry smaller weight in the distribution formula to reward the fiscal efficiency of States.
The equity variables are proxy variables, and that they do not reflect the actual fiscal situations in States.
The efficiency indicators are fiscal variables from the State budget.
Way forward
The Union financial transfers make an impact only on the Budget and alter the fiscal behaviour of States.
Therefore, it is appropriate to include more fiscal variables in the tax devolution criterion such that the Union financial transfers change the fiscal behaviour of the States in the desired direction.
Every State has a Fiscal Responsibility Act restricting the quantum of deficit and public debt.
However, reduced Union financial transfers to some States compel them to breach this legal limit.
Therefore, the FC should assign a larger weight to fiscal indicators and incentivise tax effort and expenditure efficiency through larger Union financial transfers.
This will automatically ensure intergenerational fiscal equity and sustainable debt management by States.
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