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Photo: Vipin Kumar/HT
Photo: Vipin Kumar/HT

Redefining fiscal federalism

It is time that the debate on GST focuses on strengthening the institutional framework of the GST council rather than on tax rates

In all likelihood, the good and services tax (GST) proposal will not be passed in this session of Parliament. The bill, which was initiated by the United Progressive Alliance (UPA) government, has been under discussion for several years and was finally passed by the Lok Sabha on 6 May. Despite talk of differences, it is clear that there aren’t any between various political parties on the broad contours of the bill. That is why it is just a matter of time before the measure takes effect.

The bill is an important part of the broad reform agenda of the government and will create a unified market for goods and services in the country. It will eventually replace all the local taxes, octroi and sales taxes imposed by state governments. It is likely to help the economy by broadening the tax base, eliminating the cascading of taxes, increasing compliance and reducing economic distortions caused by inter-state variations in taxes. There is hardly any disagreement that GST will usher in a more efficient system of tax collection.

But the bill has seen fierce opposition from states, particularly the industrialized ones which are likely to lose out on some of their revenue. Although the current provisions of the bill ensure that it is revenue-neutral, with modalities in place for compensating the states, GST will certainly bring in a new era of fiscal federalism.

The new architecture of fiscal federalism has to be seen not just in the context of the GST bill but also with respect to two other changes in the way fiscal relations between the states and the centre have hitherto been defined. Of these, the most important is the 14th Finance Commission recommendations, which increased the share of states in the total divisible tax pool to 42% from the earlier 32%.

The recommendations of the finance commission have been welcomed by all and rightly so, given that they give more autonomy to states in deciding their expenditure. Given the weak financial situation of many of the poorer state governments, the finance commission award is also justified on the grounds of the greater share of states in developmental expenditure.

Since a majority of spending on development issues such as health, education, agriculture and rural development is borne by states, the increased spending is likely to improve the spending on these. This is all the more true given the track record of some of the poorer states which have shown good improvement in some of these indicators as well as in introduction of innovative schemes along with improved implementation of existing schemes.

While the performance varies across states, there are certainly valid grounds for giving more autonomy to states. This was also accompanied by streamlining and cutting down of centrally sponsored schemes which again was welcomed by states on the grounds of greater autonomy.

Unfortunately, this move has come at the cost of shrinking the central government budget, the effects of which were seen in this year’s budget, where there was a severe cutback in the outlay of several schemes vital for improvement in human development outcomes. The net effect of the cutback will depend on whether states have been able to fill the gap using their enhanced resources or not. Given the track record of states in spending on developmental outcomes, there are bound to be variations in outcomes.

Needless to say, the key concern on expenditure on some of these has assumed greater importance this year given the stress in the rural economy.

The second big change has been the abolition of the Planning Commission. While the finance commission awards give the broad guidelines for sharing the divisible tax pool, the Planning Commission played allocated resources across states for developmental expenditure. It also played an important role in deciding capital expenditure for the government in consultation with states.

Given that some of these developmental as well as capital expenditures have positive externalities, the role of the Planning Commission was certainly crucial in mapping out the broad contours of development and investment in the economy. Not to forget, it also acted as the secretariat for the National Development Council (NDC), which was the nodal body for coordination between the centre and states.

Although the replacement of the Planning Commission, the NITI Aayog, is supposed to play a role in advising the centre and states to undertake reforms, given its lack of financial powers, it is unlikely that it will be able to play this role effectively. One year after it came into being, it is clear that the NITI Aayog isn’t performing the role of mediating between the centre and states.

Whatever the outcome of GST, the fact is that this year has witnessed a significant change in the architecture of centre-state relations. While this is certainly obvious in terms of fiscal relations, the change will also have repercussions on the broader investment climate of the country as well as on issues of human development.

Whether the new architecture will facilitate a climate of competitive federalism or cooperative federalism will only be clear later, but it is certain that the agenda of reforms cannot be taken forward without taking states along.

The GST bill has to be seen not only in terms of the efficiency that it will bring to the economy through better tax compliance and integration of markets but also in terms of its impact on centre-state relations. The repercussions also need to be discussed in the context of the likely impact of the proposed bill on the ability of states to generate additional revenues for development and other expenditure. The greater autonomy in spending brought in by the finance commission then needs to be viewed in the context of the reduced autonomy that the GST bill will impose on the revenue side.

But an important question that certainly needs greater clarity is the institutional mechanism of coordinating between states and the centre. This is not only important in the context of fiscal reasons but also from the point of view of coordinated investment in human and physical infrastructure.

The proposed GST council may emerge as the alternative institutional mechanism in the absence of the Planning Commission. Given that this body will have central ministers as well as the state finance ministers as permanent members, what is needed is some discussion on the new institutional mechanism of resolving disputes between different states and between states and the centre. It is time that the debate on GST focuses on strengthening the institutional framework of the GST council rather than on tax rates.

Himanshu is an associate professor at Jawaharlal Nehru University and visiting fellow at Centre de Sciences Humaines, New Delhi.

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