Intergenerational equity as tax devolution criterion
Source: The Hindu
Prelims: Current events of national importance
Federalism, Finance Commission, Cess and Surcharges, NITI Aayog, etc.
Mains: GS Paper II & III
Functions and responsibilities of the union and the states, issues and challenges pertaining to the federal structure
ARTICLE HIGHLIGHTS
- The Finance Commission (FC) decides the horizontal distribution formula for tax devolution to states once every five years.
- There's a need to balance intragenerational equity (redistribution among states) with intergenerational equity (not burdening future generations with debt).
- High-income states are facing challenges due to lower Union financial transfers despite higher own tax revenues.
- The current system may be creating fiscal imbalances and potentially violating state Fiscal Responsibility Acts.
Context
Amid concerns over freebies doled out by the state, having a revenue deficit of Rs 23,198 crore, bleeding the exchequer dry, Punjab Chief Minister Bhagwant Mann Monday met with 16th Finance Commission Chairman Arvind Panagariya in New Delhi pressing the state’s case for a grant
UPSC EXAM NOTES ANALYSIS
1. Finance Commission and its Contribution
(a). Horizontal contributions refer to the distribution of resources among the States. The Finance Commission's role in this regard includes:
- The Finance Commission decides how the central tax revenues are distributed among the States. This is done using a formula that considers various factors like population, income distance, area, and fiscal capacity
- The goal is to reduce disparities among States by ensuring that financially weaker States receive a larger share of central resources to provide comparable levels of public services.
- The Fourteenth Finance Commission, for example, raised the share of States in the divisible pool of central taxes to 42%, though this was later revised to 41% when the number of States was reduced
- While equity is a priority, the Finance Commission also considers efficiency indicators such as tax effort and fiscal discipline, though these often carry less weight in the distribution formula
- By distributing resources based on needs and capacities, the Finance Commission aims to ensure that all States have the financial ability to provide necessary public services to their residents
(b).Vertical contributions pertain to the distribution of resources between the Union and the States. The Finance Commission's role here includes:
- The Finance Commission recommends the proportion of the net proceeds of central taxes that should be shared with the States. This is a critical aspect of ensuring that States have adequate resources to meet their expenditures.
- The effective share of States in the Centre’s gross tax revenues averaged close to 31% during 2020-21 to 2023-24 (BE), lower than the nearly 35% share during 2015-16 to 2019-20.
- The Commission ensures that there is a balance between the financial resources of the Union and the States. This involves not only tax devolution but also grants-in-aid to States.
- By assessing the revenue and expenditure needs of both the Union and the States, the Commission aims to distribute resources in a manner that supports both national and sub-national priorities.
2. Statistics of Devolution in States
- The FC decides the horizontal distribution formula every five years.
- The combined government debt-GDP ratio rose close to 90% at the end of 2020-21.
- States exhibit significant fiscal imbalances
- The Fourteenth FC increased the share of States in the divisible pool of central taxes from 32% to 42%, later adjusted to 41% when the number of States reduced to 28.
- From 2020-21 to 2023-24 (BE), the States' effective share in the Centre’s gross tax revenues (GTR) averaged around 31%, lower than nearly 35% during 2015-16 to 2019-20.
- The share of cesses and surcharges in the Centre’s GTR increased from 12.8% during 2015-16 to 2019-20 to 18.5% during 2020-21 to 2023-24 (BE)
3. States Data who gets what (High to Low)
- High-income States: Tamil Nadu, Kerala, Karnataka, Maharashtra, Gujarat, Haryana.
- Low-income States: Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan, Odisha, Jharkhand.
- During the 14th FC period (2015-20), high-income States financed 59.3% of revenue expenditure through own tax revenue, while low-income States financed only 35.9%.
- High-income States had a lower Revenue Expenditure to GSDP ratio (10.9%) compared to low-income States (18.3%)
- Low-income States rely more on Union financial transfers, while high-income States rely more on their own tax revenue but receive less in transfers.
- High-income States had a deficit of 13.1%, while low-income States had a deficit of 6.4%.
4. Addressing Conflicting Equities
- Finance Commissions typically utilize indicators like per capita income, population, and area in their distribution formulas. These indicators are designed to account for the varying demands for public services (population and area) and the available public revenue (per capita income) among States.
- They carry significant weight to ensure equitable distribution of Union financial transfers. In contrast, factors such as tax effort and fiscal discipline have less influence in the formula, serving to reward States' fiscal efficiency.
- Equity variables act as proxies and may not accurately represent the fiscal realities within States. Efficiency indicators, derived from State budgets, are crucial as Union financial transfers affect only the Budget and modify States' fiscal behavior. Thus, incorporating more fiscal variables into the tax devolution criteria is essential to guide States' fiscal behavior in the desired direction.
- Every State enforces a Fiscal Responsibility Act to limit deficits and public debt. However, decreased Union financial transfers can force some States to exceed these limits.
- Therefore, the Finance Commission should place greater emphasis on fiscal indicators and promote tax effort and expenditure efficiency through increased Union financial transfers. This approach will inherently support intergenerational fiscal equity and sustainable debt management by States
5. Way Forward
- FCs typically use per capita income, population, and area as indicators in the distribution formula to reflect public service demand and revenue size.
- Efficiency indicators like tax effort and fiscal discipline should have more weight to incentivize States' fiscal efficiency.
- Greater emphasis on fiscal indicators can ensure intergenerational fiscal equity and sustainable debt management.
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Mains Practice Questions
1.Discuss the role of the Finance Commission in ensuring equitable distribution of resources among States in India. How do the indicators used in the distribution formula reflect the fiscal capacities and needs of different States?
2.Analyze the impact of the Finance Commission's distribution formula on intergenerational fiscal equity. How does the balance between equity and efficiency in resource distribution affect the fiscal behavior of States?
3.Evaluate the effectiveness of the indicators such as per capita income, population, and area used by the Finance Commission in the tax devolution process. Should more fiscal variables be included in the distribution criteria? Justify your answer.
4.Examine the challenges faced by high-income and low-income States in terms of fiscal deficits and Union financial transfers. How can the Finance Commission address these challenges to promote sustainable debt management and fiscal responsibility?
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