Editorial of the Day (18 July): Intergenerational Equity and Taxation

Context: Intergenerational equity should be a factor in India’s horizontal distribution formula for tax devolution.

Introduction

• The Finance Commission (FC) determines the horizontal distribution of Union tax revenue among States every five years.
• This distribution aims to prioritise equity over efficiency, focusing on intragenerational equity, which redistributes tax revenue among States.
• A consequence is the accentuation of intergenerational inequity within States.
• There is an argument for incorporating intergenerational equity into the distribution formula for tax devolution.

Intergenerational Fiscal Equity

• Intergenerational equity ensures equal opportunities and outcomes for every generation.
• In public finance, it means each generation pays for the public services it receives without burdening future generations through borrowing.
• Governments can raise revenue through taxes or borrowing. Using taxes ensures the current generation pays for its services, while borrowing shifts the burden to future generations.
• Ricardian Equivalence Theory posits that households save more when the government borrows, maintaining aggregate demand, but this doesn’t hold true in India’s federal system.
• Developed States often face a mismatch where their tax payments exceed the services they receive, compelling them to borrow more or reduce current expenditures.
• Developing States receive higher financial transfers from the Union government, bridging their revenue-expenditure gap.

Intragenerational Equity vs. Intergenerational Equity

• Low-income States finance less of their revenue expenditure with their own tax revenue and receive more Union financial transfers.
• High-income States finance more of their revenue expenditure with their own tax revenue but receive fewer Union financial transfers.
• High-income States incur higher deficits due to lower Union financial transfers compared to low-income States.

Conflicting Equities

• People expect public services proportional to the taxes they pay.
• High-income States are burdened with higher tax payments and lower Union financial transfers, affecting both present and future generations.
• Balancing intragenerational and intergenerational equity is crucial.
• FCs typically use indicators like per capita income, population, and area to determine distribution, ensuring equity but not efficiency.
• Equity variables (per capita income, population, area) assure equity but don’t reflect actual fiscal situations.
• Efficiency indicators (tax effort, fiscal discipline) carry less weight but should be emphasised to encourage fiscal efficiency.

Addressing Conflicting Equities

• Including more fiscal variables in the tax devolution criterion can better reflect the fiscal behaviour of States.
• States have Fiscal Responsibility Acts limiting deficit and public debt, but reduced Union financial transfers force some States to breach these limits.
• FCs should give more weight to fiscal indicators, incentivizing tax effort and expenditure efficiency to ensure intergenerational fiscal equity and sustainable debt management.

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