The goods and services tax (GST) regime will complete five years in July. The euphoria that greeted the new tax system at its inception was based on the belief that it would give a boost to the country’s economy and lead to cooperative federalism. Much against the meat of that narrative, things have turned thorny at the near arrival of the first milestone of the new system, and Centre-state relations have turned sour.

The bone of contention between the two sides is the 14 per cent compensation on revenue for state governments that the Centre promised for the initial five years of the new tax regime. This period ends in June. While the Centre is happy that it will no longer have to arrange for any shortfall in taxes to provide a 14 per cent year-on-year growth in revenue to state governments, the latter are coming together to demand an extension because of their deteriorating finances.

Deteriorating State Finances

Given the fact that the states are now largely dependent on the Centre for funds as against the situation in the pre-GST era, they are feeling the heat of a slowing economy just as the Centre is.

But, there is an increasing divergence between the condition of their finances in these tough times. According to the data provided by the credit agency ICRA, the Centre improved its fiscal deficit in the April-October 2021 period at Rs 5.5 trillion, as against the deficit of Rs 7.2 trillion in the pre-pandemic period (April-October 2019). The rating agency expects the Centre’s net revenue receipts to exceed the budget estimate by Rs 1.7 trillion on the back of higher GST collections and surplus transfer from the central bank.

The 22 state governments reported fiscal deficit of Rs 3.2 trillion in first seven months of FY22.

On the other hand, 22 state governments reported a fiscal deficit of Rs 3.2 trillion in the first seven months of FY22, up from the pre-Covid-19 level of Rs 2.3 trillion. The cause of the higher deficit was a meagre increase of 4.2 per cent in the tax and non-tax revenue of state governments compared to the pre-pandemic period. Clearly, the Centre has used some tricks to improve its finances, passing on a large burden of the slowdown to the states. A study by the think tank PRS Legislative Research estimates the states to spend 12.8 per cent of their revenue receipts on interest payments in 2021-22. This is higher than the recommended level of 10% by the 15th Finance Commission.

Centre’s Schemes

In February 2015, the Centre agreed to part with 42 per cent of the divisible pool of taxes with states as per the suggestions of the 14th Finance Commission after initially showing reluctance to do so.

But the Modi government has been restructuring the flow of grants to states. To save money, the Centre withdrew its support to a set of schemes completely, while for others, it asked the states to contribute up to 50 per cent more, making a dent in their finances. The Centre used another idea to minimise its loss in the shareable pool of taxes. It steadily increased cesses and surcharges to earn revenue. Since they do not fall under the divisible pool of taxes, an assertive Centre kept the entire amount in its kitty without tempering with the recommendations of the 14th Finance Commission.

States feel now that they do not have any power to fill the shortfall in revenue from within the state by levying local taxes, and the Centre should honour not just the commitment to pay GST arrears, it should be liberal with allocations under other federal acts. For example, they want it to increase the borrowing limit under the Fiscal Responsibility and Budget Management (FRBM) Act to 5 per cent of a state’s gross domestic product from the current 4 per cent. They also want the Centre to hike its contribution for Centrally sponsored schemes. While GST revenues have started to pick up in recent months, the Centre is unlikely to give in to the demand. Its clue can be found in the opinion of BJP national spokesperson Gopal Krishna Agarwal. He blames the states for not curbing their prodigal behaviour, saying, “It is the responsibility of the states to keep their finances under check in accordance with the mandate of the FRBM Act. All the freebies that are announced by the states should be given keeping in mind their resources.”

Pandemic Woes

Covid-19 has put tremendous strain on state budgets, especially in the health sector. The states argue that the implementation of welfare programmes is largely carried out by them, for which they need more financial autonomy. Shamika Ravi, vice-president of economic policy at the Observer Research Foundation, disagrees. She says, “The argument that the GST regime is a highly centralised system is not sound. At the end of the day, a lot of spending responsibilities are indeed borne by the Centre.” She gives the example of the Covid-19 vaccination to support her claim. “Though its implementation ultimately rests with the states, the nature of such problems is that they cannot be left to state capacities. The same applies to markets. Fragmented markets mean big diseconomies. It is not just a taxation issue, but there are also real efficiency gains of a unified market.”

The Centre also believes that agreeing to the demand of the states this time can become a loop that will be difficult to come out of even in the future. But with important state elections lined up this year, can the Centre allow the narrative of states suffering due to the GST to flourish?

To understand this conundrum read: https://www.outlookbusiness.com/the-big-story-1/lead-story-8/one-nation-many-burdens-6480