The devolution of Union tax revenue to States is a topic that has been in discussion in the political sphere in recent times. However, it is an evergreen subject of discussion for economists. One of the points in this discussion 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 prioritized 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.
Intergenerational fiscal equity 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. From a public finance point of view, it refers to a situation where every generation pays for the public services it receives and does not burden the future generation through borrowings. 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. There is an argument in fiscal economics called Ricardian Equivalence Theory that 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.
Versus intragenerational equity To give the broader picture, let us divide some of the major States into high-income and low-income — Tamil Nadu, Kerala, Karnataka, Maharashtra, Gujarat, and Haryana as high-income States and Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan, Odisha and Jharkhand as low-income States. Let us analyse only the 14th FC period (2015-20). The own tax revenue financed up to 59.3% of revenue expenditure in high-income States, while in low-income States, their own tax revenue was financing only 35.9%. The Revenue Expenditure to GSDP ratio for high-income States was 10.9%, which is lower than the similar ratio of 18.3% for low-income States. Thus, while high-income States curtailed their revenue expenditure and began financing a substantial part of it through their own tax revenues, the low-income States not only had higher Revenue Expenditure to GSDP but also financed only a smaller portion of it through their own tax revenues. Nearly 57.7% of revenue expenditure in low-income States was financed by Union financial transfers, and only 27.6% of revenue expenditure was financed by Union financial transfers in high-income States. We can see three aspects of federal finances. First, low-income States finance a smaller portion of their revenue expenditure with their own tax revenue and also receive larger amounts of Union financial transfers. Second, high-income States finance a substantial portion of their revenue expenditure with their own tax revenue but receive too little Union financial transfers. Third, we can also deduce that the high-income States had to incur a deficit of 13.1%, and the low-income States ended up with a deficit of only 6.4% of revenue expenditure. Thus, the high-income States raise higher amounts of their own tax revenue and curtail their own revenue expenditure, yet incur higher deficits because of lower Union financial transfers compared to low-income States. People of a State know the level of direct and indirect taxes they pay and expect an equivalent value of services from the government. So, the public services provided to the people of a State by both the State and the Union government should match this expectation. Any other fiscal behaviour would only result in burdening the high-income States with higher tax payments for both present and future generations. We understand the need for intragenerational equity across States in a federal system as it provides a larger unified market for everyone. Balancing both intragenerational and intergenerational equity is important, and it reiterates the need to balance equity and efficiency in the distribution formula for tax devolution to States. This squarely falls under the purview of the FC to have a fair mechanism to address the conflicting equity issues.
Address conflicting equities 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. You may find that 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. 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 incentivize tax effort and expenditure efficiency through larger Union financial transfers. This will automatically ensure intergenerational fiscal equity and sustainable debt management by States.
S. Raja Sethu Durai is Professor of Economics, University of Hyderabad. R. Srinivasan is Member, Tamil Nadu State Planning Commission
