Pushed into a corner, since the Goods and Services Tax (GST) compensation period ended, state governments are resorting to a variety of tax increases – from land to liquor. With the Union Government turning down the demand of the states to extend the protected revenue period beyond June 2022, they are forced to raise funds from the avenues remaining open to them.

The compensation period was valid for five years starting July 2017 when the GST was implemented.

While bigger states such as Tamil Nadu and Kerala have relied on increasing excise duties on alcohol to boost their coffers, Goa has hiked taxes on property and infrastructure to fund its expenditure on public utilities.

The latest to join the ranks is Karnataka, which increased excise duty on Indian Made Foreign Liquor by 20 percentage points and on beer to 185 percent from 175 percent in the budget presented on July 7.

The higher alcohol taxes, the proposal to revise guidance value of properties in the state, and tax on certain vehicle categories with revision could boost the Karnataka exchequer by more than Rs 13,000 crore.

GST conundrum

But such financial levers may not keep producing results. According to Madhavi Arora and Harshal Patel, economists at Emkay Global Financial Services, states need to increase compliance, plug leakages, and widen their tax base to boost local revenues.

"Overall, there is a significant gap opening up in revenue for states which will need to be plugged, as higher tax buoyancy by itself may not be enough. This is especially true for producer states such as Punjab, Chhattisgarh, Odisha, and Jharkhand, among others, as GST is a destination-based tax and as consumption will take place outside state lines; these states will face bigger challenges in meeting the revenue shortfall," Arora and Patel wrote in a July 21 report.

The fiscal trouble for states was accentuated 13 months ago after the five-year compensation period for any shortfall in GST revenues ended on June 30, 2022. While there have been demands to extend the compensation period by 3-5 years, they have fallen on deaf ears.

According to the Chhattisgarh Deputy Chief Minister, TS Singh Deo, the GST treatment should be different for producing and consuming states.

"The GST regime is skewed. Manufacturing states are on the losing end, while the consuming states are benefitting. That is where the autonomy of states has been impacted and loss of revenues is the biggest concern," Deo told Moneycontrol.

The Centre, however, does not have an answer to ease the suffering of mineral-rich producer states in a tax regime that is destination-based.

"I don't see how we can come up with something which is specifically targeted at them – unless the Finance Commission looks at it and changes the devolution formula and gives them something additional," Vivek Johri, Chairman of the Central Board of Indirect Taxes and Customs (CBIC) told Moneycontrol in an interview in July.

The numbers, though, are hard to ignore. The Karnataka government has estimated a loss of Rs 26,954 crore in GST collections for 2023-24 due to the discontinuation of the GST compensation from the Centre, while Punjab has termed it as a significant fiscal risk for the state and has predicted a possible "fall-off-the-cliff" situation.

Deo expects Chhattisgarh to lose as much as 4 percent in annual revenues on account of discontinuation of the GST compensation.

Election pressures

Besides, some states have been looking to push up their receipts on account of regional elections, with key states such as Rajasthan, Madhya Pradesh, Chhattisgarh, and Telangana set to go to polls in the last couple of months of 2023. And one can expect political parties to announce several so-called 'freebies' – as was the case ahead of the Karnataka assembly elections in May – to woo voters.

In Rajasthan, a Rs 2,500-crore minimum income guarantee scheme has been announced, with the Ashok Gehlot-led Congress government’s budget also featuring subsidised gas cylinders, free electricity, and a welfare scheme for gig workers. Meanwhile, Chhattisgarh is banking on providing a monthly allowance scheme for unemployed youth and Madhya Pradesh has announced a welfare scheme for women.

Without getting into the merit of these schemes – freebies can be beneficial from a socio-economic perspective and do not always undermine the credit culture or distort prices –they do raise governments' committed expenditure and strain their finances.

The election pressures are such that several Opposition as well as Bharatiya Janata Party-governed states have made a move back to the Old Pension Scheme (OPS), forcing the Centre to constitute a committee chaired by Finance Secretary T V Somanathan to examine the issues plaguing the New Pension Scheme (NPS) and "evolve an approach which addresses the needs of the employees while maintaining fiscal prudence to protect the common citizens".

According to ratings agency ICRA, while a shift to the OPS will improve states' cash-flow position in the near term as NPS contributions will end, a return to the old scheme is a "regressive step" as far as the long-term fiscal health of state finances is concerned.

Headline hides risks

Most aggregate-level studies of state finances show deficits are comfortable when viewed in a consolidated manner.

"However, the trend in consolidated state finances is masking the significant inter-state variations," Morgan Stanley economists said in a report on July 23.

"Indeed, amongst the large states, while Punjab, Madhya Pradesh, Rajasthan, West Bengal, and Andhra Pradesh incurred an average fiscal deficit of above 3.5 percent of GDP, Gujarat, Maharashtra, and Karnataka ran ratios of less than 2 percent in 2022-23. Similarly, 17 states have state debt-to-GDP higher than the aggregate average of 27.9 percent as of 2022-23," they added.

The Reserve Bank of India said something similar in its risk analysis of state finances in June 2022: the debt-to-GDP ratio of all states taken together is seen falling by 2026-27 largely due to the "stellar fiscal performance" of five states – Gujarat, Maharashtra, Delhi, Karnataka, and Odisha.

To be sure, just like the Centre, states too must find ways to enhance their revenue sources and increase the efficiency of tax collection. However, the changing fiscal dynamic between the Centre and states and the fractured political landscape has pushed regional governments into a tight corner.