GST To Farm Laws: The Future Of India’s Fiscal Federalism

As the new fiscal year approaches a contentious discussion between the central government and states will re-open. On goods and services tax compensation cess.

Last year it marked “a breakdown in centre-state trust,” according to Yamini Aiyar, the president and chief executive of Centre for Policy Research. Eventually, states had no option but to accept that instead of compensating them the centre would loan them money. While the loans will be repaid via an extension of the cess period, the manner in which the centre reneged puts it between a rock and a hard place for further negotiations, Aiyar said in an interview with BloombergQuint.

“We are now in a very funny place because the core assumptions of revenue on the basis of which the GST compromise was struck frankly do not exist today and it is in fact an urgent need for the centre and states to come together to renegotiate this.”

The backdrop for that is not picturesque.

The centre-state relationship has been fraught with increasing tension over years now, exacerbated by the Prime Minister Narendra Modi government’s penchant for centralisation of power.

The new farm laws, for instance, prohibit states from levying any taxes or fees outside limited market areas, taking away another source of state revenue. That the laws encroach on a constitutional power many argue lies with states is a matter of separate friction. Aiyar underscores the irony by highlighting the increase in central revenue collection via cesses and surcharges - these do not have to be shared with the states.

“We saw it in this budget when the new agri-infra cess was also introduced, ironically at a time when these farm laws are reducing state access to taxation related to the mandis.”

The strains on fiscal federalism, Aiyar explains, are in a big part due to the desire of central governments to have a larger say in state spending through centrally-sponsored schemes or conditional grants. The bigger problem, she says, is that the low hanging reform fruit has been picked.

The 1991 reforms were about the capital markets and the financial sector, which were squarely within the central government’s purview. The next generation of reforms, factor market reforms, of which the agricultural laws are one example, are firmly state subjects. These are tougher and hence states are reforming at varying speeds, often deemed to be too slow. This, in the eyes of some, has given legitimacy to the centre to muscle its way through.

“So, different states are at different places of their structural transformation. Therefore, they require a very different set of support for taking reforms to the next level. Yet we haven't addressed that fully. We've just got exhausted and there is a general push for the central government to move things...”

Aiyar says any solution to restore fiscal federalism balance must begin here.

Except that the death of the Planning Commission has left an institutional vacuum for such deliberation. Aiyar believes an Interstate Council structure could be suited to finding solutions. “We need an institutionalised, deliberative mechanism which is regular, which is repeated and which remains relevant to the challenges of federalism that India experiences today.”

Watch the full interview with Yamini Aiyar here.

Selected and edited excerpts.

Can you list your concerns regarding the centre-states relationship. This has been a fractious relationship for a long time now and the tensions have only risen over the last several years.

I think fundamentally the Indian constitution envisaged a fiscal federal relationship which many have described as centripetal or more - where the centre had greater revenue collection powers, while the states had greater expenditure powers. It was through mechanisms like the finance commission, specifically the finance commission rather, that the division of resources was to take place on the back of a set of formulae that would enable states to fulfil the expenditure responsibilities allocated to them by virtue of the Constitution.

What happened consistently over decades, it's not a new phenomenon, is that the central government, fueled in no small measure by the dynamics of politics, have tended to overreach by taking on expenditure responsibilities that were traditionally within the ambit of state governments, through, in particular, a mechanism called centrally-sponsored schemes and central sector schemes that sort of directed expenditure to states. Now fundamentally on first principles, this undermines the core of fiscal federalism. There is a clear division of responsibility. There is a mechanism by which resources and the revenue is to be divided between the centre and states - on the basis that states are closer to the ground, there's also the third tier of governance that we don't talk about enough—the local governments, even closer to the ground. Therefore, on first principles alone, they are best capable of identifying needs and priorities and therefore most effective expending. But politics means that the centre wants to take responsibility and take credit and therefore have consistently overridden this core constitutional principle to spend in the name of matters that are traditionally in the name of states. That's the first long-term challenge and states have complained about this consistently from the 1960s onward, if you look at Government of India reports addressing this challenge of centre-state relations.

You see, for decades now, states have asked for more flexibility and more freedom. Yet this trend has only exacerbated rather than resolved itself. In recent times, this has got even more complex by virtue of the fact that the Indian economy has become more sophisticated over time, there is now a pressing need for creating national markets and the GST is a great example—one nation, one tax makes logical and economic sense, but it does create new types of tensions in shaping the dynamic of fiscal federalism. In signing up to the GST, the states certainly gave up a certain degree of autonomy and in giving up that autonomy, there are new tensions that we are seeing. Over time, these are only going to exaggerate because there is also now a national labour market and goods and services are deeply integrated. So, the dynamic of fiscal federalism is increasingly getting more complex, and with it therefore, all tensions exaggerated, and new tensions emerging.

GST, Farm Laws, Cess

Let me try and look at some of these tensions in buckets. Of course the most recent one, would be prompted by the 15th Finance Commission's recommendations. But before I even get to that, there are two other things that I want to bring to you.

First, you spoke of GST - last year we saw a considerable divide between the centre and several states, more so states ruled by opposition parties on the issue of GST compensation cess. We’re back in March now and the arrangement that was put in place eventually, after much negotiation, will have to be reviewed. How do you view this arrangement continuing? How do you view what the outcomes will be over time? How do you view the longevity of GST as it currently exists?

Just your question itself I think highlights the complexity of where we are. The expectation that states had when they signed up to the GST basis the compromise that was struck in some senses was twofold.

A) that ‘Acche Din’ will arrive, the assumption was that the overall revenue generating capabilities consequent to the GST would be revenue enhancing and also revenue neutral. The reality is, that's not quite panned out. Almost as soon as the GST was implemented we have seen the complex nature of the GST itself has been part of the problem. GDP had started slowing and the Black Swan event of the pandemic is only exaggerating this.

B) The challenge with the GST compensation cess is fundamentally now, a challenge of a breakdown in centre-state trust. Over the course of the implementation of the GST, we have seen the centre hold back, slow down on even its pre-pandemic commitment of paying the cess, as payments have been delayed and payments have been slowed down.

But, because the centre reneged --and in the tensions of last summer, particularly July through September, when options were given to states, rather than taking on the responsibility of using its monetary and fiscal powers, of which the centre has greater powers constitutionally to be able to fulfil its commitments to states, the centre essentially pushed those commitments onto states in a way that the states really had no choice in accepting the options that were made available to it -- that now leaves us in a difficult place where renegotiating a compromise against the backdrop of the new realities of today is going to be difficult, and it is really now for the centre to take steps forward in re-enhancing and rebuilding trust.

That means that the centre is caught to some degree between a rock and a hard place. It does have to extend itself further than it perhaps can, given the constraints of the pandemic as well and the fact that revenues are not going to reach pre-pandemic levels anytime soon. It now, I think, has no option but to reach out further and try and at least be in a position where it supports states rather than further pushes the GST cess commitments through loans, etc. for the long term. Really then can we talk about a renegotiation - that renegotiation is necessary though.

The reason I brought up GST first was because it is the largest loss of revenue independence for states. We’ve seen subsequent actions by the centre that have continued to chip away at the independence. For instance, in the new farm laws states cannot levy any additional taxes or fees in the non-APMC areas. Now, this may be borne out of one problem with regards to FCI purchases in Punjab, but has been implemented nationwide. Not to forget that many might argue that the centre has legislated on an issue that lies constitutionally with the states. So, how do you look at some of these pieces coming together?

Let's take a step back. If you look at the dynamic of centre-state fiscal relations over the last decade plus you'll see a very interesting trend. The centre is increasingly shrinking, by which I mean expenditure as a percentage of GDP. While states, in fact have been expanding in terms of expenditure as a percentage of GDP. Yet, the political considerations that have pushed the central government to continue to encroach on state subjects (that I talked about at the start of this interview) have remained strong through 2010 onwards and, in the present dynamic of politics, even sharper.

What has happened is that the centre has increasingly been borrowing to continue financing its recurring expenditure, and the nature of this recurring expenditure has in fact been even more sharply in the direction of central schemes and centrally sponsored schemes. So, the 14th Finance Commission, recognising this long term trend of the centre encroaching on states, had made an attempt at re-addressing this by expanding the vertical devolution from 32% to 42% so that states had more access to untied money and money from the divisible pool that they could then allocate to their specific needs and requirements.

But in that same period, rather than the central schemes reducing, they've in fact enhanced because of the nature of our politics. There is a political context in which you see a lot more centralisation. One of the ways in which the centre has found the fiscal space to do this is through the imposition of cesses and surcharges or rather the increase of cesses and surcharges. The 15th Finance Commission has in fact noted this fact that they have increased from 2011 onwards and are going to continue to increase.

We saw it in this budget when the new agri-infra cess was also introduced, ironically at a time when these farm laws are reducing state access to taxation related to the mandis as you just described. So that's one part of the problem.

There has been a general exhaustion, within the policy elites in particular, with states’ ability to take the bull by its horns and be at the front end of this.

Actually I would argue that we've been unfair to states because these are deeply complex and extremely dynamic. And, the very things that we thought were necessary conditions in 1991, have in fact transformed completely because economic and social life has transformed as a consequence of the reforms of 1991. So, different states are at different places of their structural transformation. Therefore, they require a very different set of support for taking reforms to the next level. Yet we haven't addressed that fully. We've just got exhausted and there is a general push for the central government to move things, which is the context in which legitimacy was built for the central government to do reforms on what are what are fundamentally state subjects.

Forget the politics around it, it’s just this which is something that we do need to confront as we talk about federalism going forward.

Conditionalities: Carrots + Sticks

To come back to the issue that you brought up of low hanging reform fruit having been picked. The proportion of grants to states that are now conditional on specified reforms being undertaken is 57% now versus 17% earlier. Some may say that's good as it forces states to move down the reform path. Others might say it further erodes state independence.

In absolute terms these conditional grants are not as high. There are two worries though.

One is, if you look at the action taken report from the Government of India, they clearly say that they will reflect on this and consider these conditionalities in the context of the centrally-sponsored schemes and central sector schemes. So, in some ways, now the two have come together, both the conditionality-based grants and the centrally-sponsored schemes. I mean we'll have to see how this all pans out practically over the next few years but I think that combination suggests that these central schemes are now increasingly going to be tied to even further conditions as they were already linked to conditionalities.

Two, our response to that challenge has always been impose conditionalities rather than build on the enabling conditions that will ensure that all states are capable of delivering high quality, public services to all citizens of India.

By that I mean, one of the big things we lost when the all centralising, somewhat or completely defunct Planning Commission disappeared was the ability for poorer states, that were dependent on the Planning Commission for building plans and having predictability in funding over a period of time, to be able to make up for what Vijay Kelkar has called the ‘Developmental Imbalance’.

We don't have that institutional structure anymore. So, that fundamental enabling condition has disappeared. Yet you will impose conditions on states to perform in a certain way. It never works.

The 13th Finance Commission had performance grants for health, which when we looked at closely we found that what it did is that it enhanced the ability of states that were closer to the performance outcomes to get more money while those that hadn't quite met those, who were further away and in fact needed more money to make up the gap, lost out completely. The focus has to be on enabling conditions, not on choking states through these conditions and what inevitably happens with these conditions is, eventually towards the end of the fiscal period, when monies have to be spent, there will be a sudden push of money.

We saw this closely with the performance grants for the rural local government under the 14th Finance Commission which my colleagues tracked quite closely. A number of performance-based conditionalities were imposed on these panchayats. The enabling conditions simply did not exist and as a consequence, the panchayats never fulfilled those conditions. But there was money that needed to be spent towards the end of the 14th Finance Commission period, so suddenly the conditions were lifted and money was pushed leading to inefficient, ineffective, poor quality expenditure right at the end.

So, we know historically, that these conditions don't work. We should trust to a degree, the democratic process at the state and local level to work itself out. There will be some mis-expenditure, but the conditionalities are not going to solve that problem.

Can I then break up the problem in two parts: That there are conditionalities is not necessarily all bad. The states inability to achieve those goals is a different question. How do you resolve this? How do you get the states to move faster, in a more organised fashion?

It is the role of the centre to set national standards, no doubt. The question is whether it is the role of the centre to direct the pathway through which you can achieve that national standard because the conditions will vary state by state, panchayat by panchayat and municipality to municipality. When your starting point is imposing conditions on finances as opposed to creating supportive, enabling conditions, you inevitably find yourself in a place where the conditions will never be met and the goals will always be ineffective. In fact, the conditions will be used to undermine the capability of states and local governments to achieve their goals.

So, I would actually think about this much more by asking the question, what are the enabling conditions and how best can the centre facilitate those enabling conditions?

One part of those enabling conditions is to be able to create platforms for better centre-state deliberation, exchange of ideas, negotiation and ensuring that there is complete transparency and predictability in financing. That, very small yet ineffective measure was possible with the Planning Commission, the National Development Council. Now, that doesn't exist. So, we do need to move towards building an institutional architecture that allows for this. The Finance Commission is not necessarily the place to do this. This vacuum hasn't been recognised, isn't being debated and answers are not being sought. Instead, we are trying to do what the Indian government has traditionally done very well, carrots and sticks. And never have these carrots and sticks worked well. Ultimately for governments to function well you need to have enabling conditions and an accountability with your voters.

Could someone argue that you're being very kind to states?

Absolutely. States are no saints in and of themselves in two ways. A, they are slow, they do look at their own conditions and their own political economy realities when they make choices. B, they make very bad decentralisers too. In fact, the Finance Commission vents its frustration, as far as local governments are concerned, on states when it says that State Finance Commissions are not being set up, they aren't functioning well.

Thirdly, I myself was quite surprised after the 14th Finance Commission recommendations were implemented when the very states that cried murder over the centrally-sponsored schemes, that were one size fit all directing us to do things, the minute those were removed the states started asking for them to be back. So, the states do play a very complicated, double game.

There's no question that states need to be moved or need to be egged in the right direction that states also need to be the push for reform, they need to be accelerated at the state level and then that states do need to maintain the fiscal discipline because minus that they wait for the Centre to bail them out. No question. The argument I'm making is on the ‘How’ - how do we do this? Do we do this by deepening control or do we do this by deepening accountability of states. I would urge in the direction of the latter not the former. The latter is slower, the latter is filled with possible divergence because different states will behave in different ways, the latter requires a much deeper trust between Centre and state for the Centre to constructively impose carrots and sticks and not destructively impose carrots and sticks.

What happens today is that states blame the Centre, the Centre blames the states and when all else fails, you can blame the local governments. That's exactly the accountability conundrum we need to get out of - conditionalities don't help us.

Time For An Interstate Council?

What could these mechanisms be? A return to the Planning Commission can hardly be the solution.

When the Planning Commission was dismantled there was a lot of public debate on what should replace it. Many people went back to the old, dusty libraries and pulled out various old government reports and rediscovered an institution that in fact exists constitutionally called the Interstate Council. It exists. It even has a joint secretary or perhaps even an additional secretary if I'm not mistaken.

Its fundamental role is important because it is a political body at one level. It is an interstate council, so all political entities, chief ministers, heads of state and the heads of the union government are meant to interact through the platform of this council. It has a Secretariat that can enable interaction and engagement across executives of centre and the state. Many argued that rather than another Planning Commission, which wasn't in the Constitution, that we should actually empower, enable and strengthen the Interstate Council. I think the realities of today should pause us and pursue this argument all over again.

We need these engagements at a political level, so they are not ad hoc. What is happening today is, you have a Covid crisis and the Prime Minister will, on an ad hoc basis, have video conferences with state chief ministers. Now we need a vaccination plan maybe an ad hoc set of video conferences. That's not going to work.

Within that there can be special councils, like GST, that are issue-specific, that are sector-specific and that allow the executive and the political class to interact with each other, deliberate and come up with collective solutions.

One of the great things about this combination is that the politics will always remain at the level of rhetoric and signaling but it is for the bureaucrats to pick up on the signals and build the negotiations across each other. The Interstate Council in its architecture at least enables that. I think we have an answer but we need to revive it and revitalise it to the 21st century challenges.

If the political will is to take away power from the states even an Interstate Council can’t fix anything. But it may allow for dialogue to calm things down.

Absolutely. The politics will play itself out but the institutional setting for dialogue and deliberation is necessary to be able to iron out the tensions of politics and ultimately, politics too, has a way of working through its own tensions. Hopefully, ultimately both the centre and the states need to work together. I think they do recognise this, but it needs to be done in a setting where at least fundamental trust can be built even as a political signalling plays itself out. We started this well with the NITI Aayog, the narrative of cooperative federalism, states are silos of change... perhaps a little bit of money where its mouth is will help move this along.