[Answered] Critically examine the role of the Finance Commission (FC) in ensuring both equity and efficiency in the distribution of Union tax revenue among states.

The Finance Commission (FC) plays a crucial role in India’s federal fiscal framework. It is tasked with ensuring both equity and efficiency in the distribution of Union tax revenue among states.

Ensuring Equity

• Redistributive Mechanism: The FC prioritizes equity by redistributing resources among states based on criteria such as population, area, and income distance. This approach aims to address regional disparities by providing more resources to lower-income states.
• Support for Low-Income States: During the 14th FC period (2015-20), low-income states like Bihar and Uttar Pradesh received substantial Union financial transfers, that helped these states provide essential public services despite their limited tax revenues.
• Fiscal Responsibility: The FC’s role extends to ensuring that current fiscal policies do not burden future generations. This principle means that states should not rely excessively on borrowings to finance current expenditures, thereby avoiding transferring debt burdens to future generations.
• Tax and Borrowing Balance: The FC’s recommendations encourage states to balance their revenues and expenditures through responsible tax policies and limited borrowings.

Ensuring Efficiency

• Tax Effort and Fiscal Discipline: The FC allocates some resources based on states’ fiscal performance indicators, such as tax effort and expenditure efficiency. However, these indicators often carry smaller weights compared to equity indicators.
• Encouraging Reforms: The FC incentivizes states to improve their tax collection mechanisms and manage their finances more efficiently, thereby enhancing overall fiscal discipline.

Challenges and Recommendations:

• Equity vs. Efficiency Balance: The current formula heavily prioritizes equity, potentially discouraging fiscal efficiency. High-income states like Tamil Nadu and Maharashtra receive fewer transfers despite higher tax efforts and better fiscal management, leading to higher deficits.
• Need for Recalibration: The FC should consider increasing the weight of fiscal performance indicators in the distribution formula. This change would incentivize states to enhance their tax efforts and manage expenditures more efficiently, aligning with the goal of intergenerational equity.
• Sustainable Debt Management: By promoting efficient fiscal practices, the FC can help states manage their debt sustainably, ensuring that future generations are not unduly burdened by current fiscal policies.

Conclusion

The Finance Commission plays a crucial role in balancing equity and efficiency in the distribution of Union tax revenue. While it has successfully addressed intragenerational equity, there is a need to recalibrate its approach to enhance fiscal efficiency and ensure intergenerational equity. By assigning greater weight to fiscal performance indicators, the FC can promote responsible financial management and sustainable development across states.