GST 2.0 and the states’ squeeze

When the Goods and Services Tax (GST) was introduced in July 2017, it was hailed as India’s biggest tax reform, a move towards ‘one nation, one tax’. Seven years on, as the GST Council prepares to discuss the contours of ‘GST 2.0’, the initial optimism has been tempered by the reality of its impact on state finances. While the GST regime has undeniably streamlined the indirect tax system, improved tax buoyancy, and brought a large part of the informal economy into the formal sector, it has come at a significant cost to the fiscal autonomy of states. This has created a new set of challenges that need to be addressed if India is to maintain its federal structure in spirit and not just in letter.

The grand bargain of GST was that states would cede their power to tax sales and a host of other local levies in exchange for a share in a national GST. To allay their fears of revenue loss, the Centre promised to compensate them for any shortfall for the first five years, assuming a 14% year-on-year growth over the base year of 2015-16. This compensation mechanism was a critical cushion that made the transition politically palatable. However, this safety net was withdrawn in June 2022, and since then, the states have been on their own. The consequences have been stark. Many states have seen their revenue growth falter, leaving them with gaping holes in their budgets.

Before the GST rollout, states had significant autonomy in setting tax rates on goods sold within their borders. Sales tax was a major source of their own tax revenue, accounting for nearly half of it. This gave them the flexibility to raise resources to fund their development priorities and social welfare schemes. With GST, this power has been transferred to the GST Council, a body where the Centre holds one-third of the voting power. Since all decisions require a three-fourths majority, the Centre effectively has a veto. This has tilted the balance of power decisively in favour of the Centre, reducing states to supplicants, dependent on the Centre’s largesse.

The end of the compensation period has brought the issue of fiscal federalism to the forefront. States, particularly those ruled by Opposition parties, have been vocal about the financial squeeze they are facing. They argue that the promised 14% revenue growth was a fair estimate of what they would have earned in the old regime, and the current system is not delivering on that promise. The recent Lok Sabha election results, where regional parties have performed strongly, will likely amplify these voices. The demand for extending the compensation period or increasing the states’ share of the GST pie is likely to get louder.

The agenda for GST 2.0 includes several contentious issues. There is a proposal to rationalise the tax slabs, possibly merging the 12% and 18% slabs, to simplify the structure. While this may be a sound economic move, it will have revenue implications for the states. Another major issue is the inclusion of petroleum products, electricity, and real estate under the GST ambit. These are major sources of revenue for both the Centre and the states, and bringing them under GST will require a grand consensus, which seems elusive at the moment. States are wary of giving up their right to tax petroleum products, as it is a cash cow for them.

The upcoming meetings of the GST Council will be a test of the Centre’s commitment to cooperative federalism. The Centre needs to recognise that financially stable states are a prerequisite for a strong nation. A one-size-fits-all approach to taxation may not be suitable for a country as diverse as India. The Council needs to evolve a mechanism to address the specific concerns of states that are losing out in the new regime. This could involve a more flexible compensation scheme or a higher devolution of taxes to the states. Ignoring the states’ plea for greater financial autonomy could lead to serious friction in Centre-state relations and undermine the very foundation of India’s federal structure. The debate over GST 2.0 is not just about tax rates and slabs; it is about the future of fiscal federalism in India.