GST: End Of The Road For Cooperative Federalism?

India’s grand bargain, once heralded as a new era in cooperative federalism, the Goods and Services Tax regime, less than four years since its adoption, is today the new battleground for centre-state fiscal wars. It is a measure of how broke the ‘grand bargain’ is that the widely celebrated poster child of the new era of cooperative federalism, the GST Council at its meeting last week, became the site for Tamil Nadu’s newly elected Finance Minister, Palanivel Thiaga Rajan to remind the union government that “there is no Union without the States”. The grand bargain has now given way to a widening trust deficit. One that risks undermining the potential of a long-awaited economic reform but also India’s precarious federal consensus.

To understand this trust deficit, it is important to locate the GST debate within the political economy of centre-state fiscal relations. The impulse to centralise has been a persistent feature in our politics. Successive union governments’ have drawn on their powers to encroach on state government functions. States routinely complain and it is in this ensuing tug of war that the dynamics of centre-state fiscal relations have been shaped.

In the coalition era, state chief ministers were deft, as political scientist Louise Tillin’s work has shown, at deploying centralisation to their advantage, claiming political credit for implementing central welfare schemes, and, in my view, blaming the union government when implementation failed.

Post-2014, this dynamic shifted. The politics of centralisation deepened. The BJP’s political strategies combined with the personalisation of schemes with Prime Minister Modi and widespread use of technology have meant that voters increasingly attribute political credit for schemes to Modi and not their state leaders.

This deepening of political centralisation sat in sharp contrast with the policy rhetoric in the early days of the Modi government. In 2014 cooperative federalism was the policy mantra and to its credit, the union government introduced crucial structural reforms. These included accepting the 14th Finance Commission recommendation to enhance the states’ share in the divisible pool of taxes from 32% to 42%, dismantling the Planning Commission, and with it discontinuing the practice of transferring plan funds to states.

In July 2017, the GST was ushered in. The GST was a remarkable achievement, given the constant tug of war between centre and states. States willingly gave up fiscal autonomy for the promise of economic efficiency. That this consensus was forged on the back of painstaking negotiations and compromises notably the GST compensation cess demonstrated the possibilities of the emergence of a genuine federal politics based on principles of cooperation.

But even as these reforms were put in place, the union government confronted another challenge. Weak fiscal management had brought the union to the brink of what economist Rathin Roy has called a silent fiscal crisis. This crisis was a result of persistent revenue shortfalls (amounting to 0.7% GDP in FY2019-20) and failure to meet disinvestment targets. Faced with its coffers running dry and a political strategy premised on greater spending, it was only inevitable that the union government would resort to squeezing revenue from states.

Despite welcoming the 14th Finance Commission mandate, the union government carefully avoided fulfilling it by increasing levies on cess and surcharges (not shareable with states). Actual transfers to states as a share of gross tax revenue ranged between 33-35% throughout the 14th Finance Commission's period. Union government spending on central schemes increased as did the contribution extracted from states.

But the greatest transgressions were made in the management of the GST. Faced with a fiscal crisis of its own making, the union was quick to break its hard-won bargain. Rather than being honest about its macro-fiscal position, the union resorted to tactics such as delaying payments and transferring cess to its own coffers. As the GST unfolded it became amply clear that the union and states needed to work together to resolve the structural design flaws — from the complex rate structure to the tyrannical e-way bills — that risked undermining the promise of efficiency gains and revenue growth, that were at the heart of the GST compromise. A radical overhaul was needed. But the impulse to squeeze states left little room for new negotiations.

Then came Covid-19. The pandemic expectedly played havoc with union and state finances. But repeated appeals from state governments for the union to deploy its financial powers and provide fiscal support were ignored. Instead, states were asked to rely on market borrowing while the union continued in the practice of sweeping revenues by increasing cess and surcharges. Revenue shortfalls inevitably meant that the terms of the compensation cess calculated on a remarkably generous assumption of 14% guaranteed revenue growth would be difficult to fulfill. But the union closed-off space for negotiation by playing every trick in the book to place the burden of its failure to fulfill the compensation guarantee to states, unto them. The union ought to have borrowed and transferred the cess to states. Instead, it borrowed and onward lent Rs 1.1 lakh crore to states, thus undoing the very foundations of the GST bargain.

Rather than coming together, the pandemic has widened the trust deficit, and now realpolitik has taken over. BJP-administered states have chosen silence or are siding firmly with the union (despite facing losses) making the GST challenge a BJP versus opposition issue rather than a matter of federal principles.

The only way out of the GST impasse is for the union government to show political maturity and build bridges with states. Last week’s meeting was a missed opportunity. Crucial decisions related to state demands for exemptions on Covid-essentials were pushed to a group of ministers and here too the process has been undermined with petty politics. A direct battle on the compensation issue was avoided through the decision to provide back-to-back loans to states but contentious negotiations have been pushed down the road to July 2021. Meanwhile, states are demanding greater independence.

Ironically, these demands come at a time, when the union needs states. Crucial decisions need to be taken that will have a direct impact on union finances – from recalculating the 14% compensation rate to resolving the question of what next in July 2022 when the five-year period of assured compensation is over.

Above all, the GST structure needs an overhaul for the revenue-enhancing promise to be met. The union still has an opportunity. It can at minimum do three things.

• First, reaffirm its commitment to cooperative, consultative principles of federalism by reforming the functioning of the GST Council. In the run-up to last week’s meeting, several states made suggestions on improving the functioning of the council. A special council meeting to debate these suggestions must be called.
• Second, offer the FY21 compensation cess as a transfer, not a back-to-back loan with the caveat that the compensation rate will be re-negotiated.
• Third, be transparent about the current macro-economic scenario through an honest appraisal that revisits revenue projections and offers a set of strategic pathways for consultation with states through a special session between the Union Finance Minister and state finance ministers.

The union needs to act now. The future of India’s hard-fought federal consensus is at stake.

Yamini Aiyar is the President and Chief Executive of the Centre for Policy Research.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.