Note4Students: 

Prelims: Powers and Functions of Finance Commission;

Mains: Challenges to Fiscal Federalism; 

Mentor comments: Fiscal devolution (Horizontal and Vertical), the transfer of fiscal powers and resources from the central government to state/local governments, is a crucial aspect of fiscal federalism. Fiscal devolution increases the financial resources and decision-making powers of state governments, allowing them to better address local needs and priorities. This strengthens fiscal federalism by empowering states to be more fiscally responsible and accountable to their citizens. It also helps in fostering competition among states to attract investments and provide better public services, driving overall economic development. This eventually contributes to macroeconomic stability. Further, the Fiscal devolution to local bodies (Municipalities and Panchayats) by State FC empowers them to undertake development activities and provide public services more efficiently.  Hence it is a key pillar of cooperative and competitive fiscal federalism, promoting fiscal autonomy, equitable development, and overall macroeconomic stability in a federal polity like India.

Let’s learn!

Why in the News? 

The fiscal devolution between the Union and States, as well as the distribution formula among states, is an ongoing debate with concerns about maintaining the balance of fiscal federalism and equitable development across generations within states.

Intergenerational fiscal equity

• It refers to a situation where every generation pays for the public services it receives and does not burden the future generation through borrowings. It is also the principle of providing equal opportunities and outcomes to every generation.
• There are only two ways for any government to raise its revenue:
  • Tax: 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.
  • Borrowing: If the government finances the current expenditure through borrowing, 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.

• Presently, the current generations worldwide pay taxes less than the value of the current public services they receive, and thus it saves too. Whereas in our Indian present federal situation, this is not the case.
  • Condition of Developed States: The 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 expenditures.
  • Condition of Developing States: The 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.

Issues with Intragenerational Equity:

• Low-income States (Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan, Odisha, and Jharkhand) finance a smaller portion of their revenue expenditure with their own tax revenue and also receive larger amounts of Union financial transfers.
  • The own tax revenue (collection from GST, VAT Excise, Stamp Duty, and Motor Vehicle Tax) financed up to 59.3% of revenue expenditure in high-income States, while in low-income States, their own tax revenue was financed only 35.9%.
• High-income States (Tamil Nadu, Kerala, Karnataka, Maharashtra, Gujarat, Haryana) finance a substantial portion of their revenue expenditure with their own tax revenue but receive too few Union financial transfers.
  • The Revenue Expenditure to GSDP (Gross State Domestic Product) ratio for high-income States was 10.9%, which is lower than the similar ratio of 18.3% for low-income States.
  • 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.
• Government 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 tax revenue and curtail their revenue expenditure, yet incur higher deficits because of lower Union financial transfers compared to low-income States.

Address the Impacts and Conflicting Equities

• Issue with Indicators Used by FC: The indicators presently used by the FC are per capita income, population, and area to reflect differences in demand for public services and revenue availability among states which carries a larger weight to assure equitable distribution of Union transfers.
  • Efficiency indicators like tax effort and fiscal discipline have smaller weightage to reward the fiscal efficiency of states.
• Impact of Lower Transfers: States have Fiscal Responsibility Acts restricting deficit and debt but the reduced Union transfers compel some states to breach these legal limits.
  • Larger weight to fiscal indicators and incentivizing tax effort and expenditure efficiency through higher transfers can ensure intergenerational fiscal equity and sustainable debt management by states

Way Forward:

• Balancing intragenerational and intergenerational equity is crucial to balancing equity and efficiency in the tax devolution formula.
  • Incentivize tax effort and expenditure efficiency through higher Union transfers
• The Finance Commission (FC) should assign larger weight to fiscal indicators.