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How the GST is a threat to India’s fiscal federalism

In case you missed it, India is trying to implement a massive transformation of the indirect taxation regime. The Goods and Services Tax was supposed to, in theory, replace each state’s valued added tax, entry tax, and other indirect taxes, and the Union Government’s excise and service taxes. Everyone would then have to pay only a single tax on goods and services, thus simplifying the tax system to a great extent. Businesses would be able to claim input credit for the taxes they paid on their inputs, allowing them to bring down the prices of goods. Governments would widen the tax net as everyone would maintain proper accounts and invoices to avail the system. In theory, a win-win-win for all.

In theory.

The reality has been horribly messy, and if anything, possibly made the tax system more bizarre and byzantine. It’s not been smooth sailing for the government either. The initial revenue figures seem to be lower than expected, but what has sent some shockwaves has been the extraordinarily high refund claims that the government may find difficult to pay! Already states are worried that their revenue projections, based on the Centre’s assurances that it would compensate them if their revenue growth from GST was less than 14% year-on-year, may be looking far too rosy.

How did we get here?

How states get money

Let’s start with the fact that the Constitution, as we have seen in earlier pieces, retained the Government of India Act, 1935’s structure in distributing legislative powers between the Union and the states. This includes taxing powers, the bulk of which have been given to the Union. The Union has the power to tax income (of individuals and entities), manufacturing (except alcohol and petro-products), and customs, among other things whereas the states have the power to levy taxes on the sale of goods and on land and buildings. The Union has thirteen taxing entries in List I, whereas the States have seventeen taxing entries in List II. There are no taxing entries in the Concurrent List (this is important as we shall see). While both the Union and the States have plenary taxing powers, the breadth of the subjects over which the Union has exclusive taxing power is much greater.

If the states had to rely on their tax and non-tax revenues only, most probably wouldn’t be able to provide anything like a government to their citizens. We see this from the latest budget figures for these States (all numbers taken from PRS’ section on State budgets):

Except Delhi and Maharashtra, most states get at least a quarter of their revenue from the Central Government through taxes and grants-in-aid.

Money from the Union to the states – two routes

States are entitled, under the Constitution, to receive, in accordance with the recommendations of the Finance Commission, a share of all the taxes collected by the Union. The Finance Commission is a non-partisan constitutional authority which is constituted every five years by the President to decide how much States will get from such tax revenue and what grants they will get under Article 275 (“Grants from the Union to certain States”).

But this isn’t the only way that states get money from the Union. The “grants” that it receives from the Union are discretionary and not strictly in accordance with the formula fixed by the Finance Commission. Under Article 282 of the Constitution, the Union may give the states a grant on a discretionary basis for any public purpose. This used to be governed by the Planning Commission, which as the name suggests, drew up plans on which the money was disbursed to the states by the Union.

Here is the source of much controversy – what route should the bulk of the states’ revenue from the Centre take: the Finance Commission’s recommendations or the Centre’s discretionary grants? One view, espoused most famously by Nani Palkhivala, is that the grants should be given only on the recommendation of the Finance Commission or not at all. As data from the Fourteenth Finance Commission Report shows, between the financial years 2010-11 and 2014-15, States have received between 27% to 40% of their revenues from non-Finance Commission recommended grants by the Union Government. The bulk of these were the “plan grants” given out in accordance with the Planning Commission’s recommendations. Although the Planning Commission has been replaced by the NITI Aayog, it remains to be seen if the Centre has reduced the role of discretionary grants in State finances.

So where does the GST tie into all of this?

Fiscal federalism

The independent legislative and executive powers enjoyed by a state in a federal polity would mean nothing if they have to go to the Centre, cap in hand, for every major expenditure.

Federal polities have tried to strike a balance between a uniform tax system and the federal structure of government. In countries such as Canada where the power to impose indirect taxes is exclusively with the Centre, there was not much of an issue. In a country such as Australia where this power was concurrent, the GST was introduced on the basis of a binding agreement between the federal and state governments which would govern all aspects of the GST. The concern is that while uniformity and simplicity is good, it cannot come at the cost of damaging the fiscal independence of states. In trying to create a uniform tax system, has the GST compromised the fiscal independence of the states?

How the GST eats away at fiscal federalism

In most states, the bulk of the tax revenue comes from indirect taxes that have now been subsumed under the GST which has uniform rates fixed by the GST Council. The Centre has a veto over the Council’s decisions. Where a state could previously impose special cesses and levies to boost its income for social and other spending, it is now at the mercy of the GST Council (and thereby the Centre). This is not a remote possibility. MG Ramachandran, as Chief Minister of Tamil Nadu, funded the mid-day meal scheme in schools with an increase in taxes. This would be impossible under the GST unless the Centre and other states permit it.

The strange part of all of this is that none of the state governments (except Tamil Nadu, obviously) seem to have noticed what the GST Amendment has done to their fiscal powers. There has been very little pushback from the states about the GST Council’s voting structure and the lack of remedy against an adverse decision. Did they get complacent once the Centre promised them, through a law, a guaranteed 14% increase in revenue due to GST? Or did they just not read the constitutional amendment?

Whatever it is, the chaos of GST is going to bite the state governments soon. How they react and what happens next will tell us a lot about the strength of India’s federalism.

Alok Prasanna Kumar is a Senior Resident Fellow of the Vidhi Centre for Legal Policy and heads its Bengaluru office.

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