Intergenerational Equity and Taxation

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

This editorial covers about the Intergenerational equity should be a factor in India’s horizontal distribution formula for tax devolution.

Table of Contents

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 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.

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.

Analysis and data from 14th FC period (2015-20)

High-income States: Tamil Nadu, Kerala, Karnataka, Maharashtra, Gujarat, Haryana.
Low-income States: Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan, Odisha, Jharkhand.
14th FC period (2015-20):
- High-income States financed 59.3% of revenue expenditure through their own tax revenue; low-income States financed only 35.9%.
Revenue Expenditure to GSDP ratio: 10.9% for high-income States, 18.3% for low-income States.
- 57.7% of revenue expenditure in low-income States was financed by Union financial transfers; 27.6% in high-income States.
- High-income States had a deficit of 13.1%, while low-income States had a deficit of 6.4%.

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.

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.