Context

• The devolution of Union tax revenue to States remains a perennial topic of debate among politicians and economists alike and central to this discussion are the factors influencing the horizontal distribution of States’ shares in Union tax revenue.
• The current focus on intragenerational equity, redistributing tax revenue among States, often exacerbates intergenerational inequity within States.
• Therefore, it is important to examine that intergenerational equity should be integrated into India’s horizontal distribution formula for tax devolution.

The Principles of Intergenerational Fiscal Equity and Mechanisms to Achieve It

• Principles of Intergenerational Fiscal Equity
  • Equal Opportunities and Outcomes
    • Every generation should have access to similar opportunities and should not be disadvantaged by the fiscal policies of previous generations.
    • This includes access to quality public services such as education, healthcare, and infrastructure.
  • Sustainable Public Finance
    • Governments should manage their finances in a way that ensures long-term sustainability.
    • This means avoiding excessive borrowing that future taxpayers will have to repay, thus preventing the accumulation of unsustainable public debt.
• Mechanisms to Achieve Intergenerational Fiscal Equity
  • Taxation
    • Ideally, tax revenues should be sufficient to cover current public expenditures.
    • This ensures that the current generation pays for the services it receives, maintaining a balance between revenues and expenditures.
  • Borrowing
    • While borrowing can be a useful tool for funding large capital projects that benefit multiple generations, it should be used judiciously.
    • Excessive reliance on borrowing for recurrent expenditures shifts the financial burden to future generations, leading to higher taxes or reduced public services in the future.
  • Savings and Investments
    • Governments can establish sovereign wealth funds or other savings mechanisms to accumulate resources during periods of economic surplus.
    • These funds can then be used to finance public expenditures during economic downturns or to invest in long-term projects that benefit future generations.

Case Study to Understand Intergenerational Fiscal Equity: High-Income vs. Low-Income States

• High-Income States
  • Tamil Nadu, Kerala, Karnataka, Maharashtra, Gujarat, and Haryana are categorised as high-income States.
  • These States have robust economies and generate substantial own tax revenues, financing up to 59.3% of their revenue expenditures independently.
  • Despite this, they receive relatively low Union financial transfers, compelling them to either curtail expenditures or resort to borrowing, which can lead to higher fiscal deficits.
• Low-Income States
  • Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan, Odisha, and Jharkhand fall into the low-income category.
  • These States struggle to generate sufficient own tax revenues, covering only 35.9% of their revenue expenditures.
  • Consequently, they rely heavily on Union financial transfers, which finance about 57.7% of their expenditures, enabling them to maintain higher levels of public spending relative to their revenues.

Fiscal Indicators and Equity

• Population and Area
  • These indicators reflect the demand for public services.
  • States with larger populations and areas typically require more resources to provide adequate services, justifying higher financial transfers.
• Per Capita Income
  • This indicator is used to assess the fiscal capacity of States.
  • Lower per capita income States receive more transfers to help them match the service levels of higher-income States.
• Tax Effort and Fiscal Discipline
  • While equity indicators carry significant weight, efficiency indicators such as tax effort and fiscal discipline also influence the distribution formula.
  • States that demonstrate higher tax collection efficiency and prudent fiscal management are rewarded with additional transfers, incentivising better fiscal practices.

Challenges to Intragenerational Equity

• Economic Disparities
  • The significant economic disparities between high-income and low-income States pose a challenge to achieving intragenerational equity.
  • Wealthier States may feel burdened by the redistribution of their tax revenues to less prosperous States, potentially leading to fiscal imbalances.
• Public Expectations
  • Citizens in high-income States expect a level of public services commensurate with their tax contributions.
  • When these expectations are not met due to lower Union financial transfers, it can lead to public dissatisfaction and political pressure.
• Efficiency vs. Equity
  • Balancing the principles of efficiency and equity is a constant challenge. While equity aims to level the playing field, efficiency rewards States for good fiscal practices.
  • The tension between these principles can complicate the design of an optimal distribution formula.

Suggestions to Strengthen Intergenerational Fiscal Equity

• Reforming the Distribution Formula
  • The Finance Commission should consider including more fiscal variables in the tax devolution criteria.
  • This would incentivise States to improve their tax efforts and expenditure efficiency, leading to more sustainable fiscal practices.
• Enhancing Fiscal Discipline
  • Greater emphasis on fiscal discipline and responsible borrowing practices is essential.
  • States should be encouraged to adhere to their FRBM limits and pursue policies that promote long-term fiscal health.
• Promoting Balanced Development
  • Policies aimed at reducing economic disparities between States can contribute to more equitable fiscal outcomes.
  • Investments in infrastructure, education, and healthcare in low-income States can enhance their economic prospects and reduce their reliance on Union transfers.

Conclusion

• Intergenerational fiscal equity is a fundamental principle that ensures the fair distribution of economic opportunities and outcomes across generations.
• In India’s federal system, achieving this equity requires a careful balance between taxation, borrowing, and fiscal discipline.
• By reforming the distribution formula and promoting responsible fiscal practices, policymakers can ensure that current fiscal decisions do not impose undue burdens on future generations, fostering a more sustainable and equitable fiscal environment.