Has GST reduced inter-state disparities?

‘Convergence’ was one of the many arguments being touted for the advantages of a GST regime.
‘Convergence’ was one of the many arguments being touted for the advantages of a GST regime.


Are states better off in their tax collections than they were in the pre-GST era?

This financial year, the goods and services tax (GST), may be finally coming into its own. Two months in 2022-23—April and October—have seen the highest revenue mobilization under this ‘one country, one tax’ system since its introduction in July 2017.

This year also marks a crucial milestone for GST, with the compensation that the central government paid to states to smoothen their transition to the new tax regime coming to an end.

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When GST was introduced, the big fear of states was that the new regime would lead to less revenue in their coffers than the pre-GST regime. This led the central government to effectively guarantee a growth of 14% per year in state tax revenue, and promise to make up for any shortfalls. This compensation (paid out of a cess imposed on GST on certain goods) was only for a five-year period, which ended this July. States are now on their own.

The five-year mark is also a good time to revisit one of the initial promises—that the new regime would reduce inter-state disparities in income and living standards. Has that happened? And are states better off in their tax collections than they were in the pre-GST era?

Two Virtuous Cycles

Speaking in 2018, just around the time GST had begun rolling out, then chief economic adviser Arvind Subramanian had said that the rollout of the new tax would lead to more “convergence" across states. That is economist speak for poorer states growing faster than richer states, thus eventually narrowing the economic gap between themselves and their richer counterparts.

“Under GST regime, no state can offer incentives to attract investments. GST will be placing some restriction on states in placing incentives to industries…so, GST would actually promote convergence and reduce divergence among states," Subramanian had said at the time. He was referring to the practice, widespread in the pre-GST era, of states offering tax breaks and tax incentives to lure investments. A level-playing field would ensure that investments were more widely dispersed.

The logic behind Subramanian’s argument was that the imposition of a national standard tax on commodities, which replaced the myriad of local and state taxes, would effectively create a national market for any good, reducing transaction costs and local barriers to trade. In such a market, it would be much easier for a company to pick a more ‘undeveloped’ area to set up a plant, taking advantage of lower labour costs, and then move those goods to markets (perhaps based in a large metro), where it could be sold to final customers. In the pre-GST era, the argument went, the burden of local and state taxes could often be high enough to offset any advantages of lower labour costs that a poorer region might have.

‘Convergence’ was just one of the many arguments being touted for the advantages of a GST regime. Another argument was a related one—a single national tax on any given good would reduce compliance and administrative costs for firms. For governments across the state and at the national level, having to administer a single set of taxes would be far less costly, and less burdensome. Better enforcement and compliance meant tax revenues would rise, implying higher revenues for each given level of economic activity pre-GST, and thus higher tax revenues for all levels of government, enabling them to spend more on development.

Thus, a GST regime would create two virtuous circles. First, a national market for goods would reduce transaction costs, increasing the level and spread of economic activity and higher per capita incomes, even for poorer states. For governments, this in turn would lead to higher tax revenues. The second virtuous circle would reinforce the first one, with better compliance and lower administrative costs, again leading to higher tax revenues.

Has this happened in the five years of GST? The biggest caveat in undertaking any such judgement call, based on the data available, would be that of these five years, the last two have been affected by the covid-19 crisis. Lockdowns dramatically reduced the level of economic activity. In such circumstances, any tax regime, not just the GST one, would have produced lower tax revenues. Even if we assume that the covid period lasted from April 2020 to June 2021, a little over a year, its economic effects did last longer. This fact alone makes comparisons difficult.

Redistributing Investments?

Did GST lead to poorer states drawing more investments? Since the introduction of the new tax system, over half of the proposed industrial investment—including capacity expansions—are still accounted for by just three, relatively industrialised states: Gujarat, Maharashtra, and Karnataka. Ten states account for over 85% of investment proposals made between 2018 and August 2022. This data is based on documents filed with the government by entrepreneurs who intend to set up a factory in a particular location. (See chart 1)

This status, of a few states garnering the lion’s share of investment, is little changed from the period 2014 to 2017. The list of states with the largest volume of investment proposals—Karnataka, Gujarat, Maharashtra and Chhattisgarh—broadly remained the same. And while the top 10 states in both periods included some lower-income states, most notably Uttar Pradesh, the pattern remained the same. States that already had a big manufacturing or mining industry were more successful in attracting new investments.

If ‘convergence’ in income terms has to happen, this has to change, and this shift has not yet happened in any noticeable way. The caveat, as stated above, is that the GST regime has been buffeted by covid-19 lockdowns.

Government Revenues

Did GST result in higher tax revenues for states? The data in chart 2, based on a working paper by Sacchidananda Mukherjee at the National Institute for Public Finance and Policy (NIPFP), shows the shift in tax revenue pre- and post-GST. The chart compares revenues from GST in 2021-22 with the revenue to states (as a share of GDP) from a range of taxes subsequently subsumed under GST during 2015-16 and 2016-17. The 22 states studied here have been ordered by their rank in 2019-20 per capita income from the poorest (Bihar) to the richest (Goa). The data shows the change in tax revenues in the two periods.

This data shows a uniform decline across most states, rich or poor, in the tax to state GDP ratio. The exceptions are states like Maharashtra and Haryana (which are richer states) and Rajasthan (which is a middle-income state). This is perhaps why the guaranteed revenue promised by the central government to states to meet shortfalls following the transition to GST was so highly valued by states, and that many states are deeply concerned about the end of the compensation system.

During the covid years, in 2020-21 and 2021-22, the central government borrowed 2.69 trillion to pay GST compensation to states. While the compensation period to states ended in June 2022, the central government extended the period for which cess would be imposed on taxpayers to 2026 to raise revenues to service these loans and settle any outstanding GST dues.

On the face of it, while states can be compensated for a shortfall in GST, the central government has no such recourse. However, as Mukherjee points out in his paper, the central government has found other sources of income to cope with any shortfall—mainly through increasing revenues through Union excise duties (through non-shareable duties and cesses on commodities, which too are not shared with states).

Petroleum products such as petrol, diesel and aviation turbine fuel attract Union excise duties under the GST regime. “This shows that in a federal setup, taxation power to levy taxes helps the federal government to cope up with the revenue shortfall associated with big tax reform like GST," says Mukherjee. “However, provincial governments may not either enjoy the power of taxation like the federal government or may not exercise the power to levy new taxes or raise additional revenue, due to political reluctance."

What are the ways out of this? One way of doing this is enforcing better compliance—cracking down on tax evasion, investing in better technology to get people to pay their dues at a faster rate, and making the entire GST system easier to navigate for businesses. But in the longer-run, this is not enough.

GST is a consumption-based tax. Thus, as Mukherjee points out, states can expand GST revenues in the long term by doing two things: by reducing the transaction costs and other costs of doing business so that businesses do not move to other states (so-called ‘base erosion’), and by increasing consumption within the state by expanding economic opportunity in other ways, and increasing incomes.

One of the expected outcomes in the GST regime was that richer, more industrialized states, would, in a sense ‘lose out’ to poorer states because goods would be transported out of them, to consumers in another state, and be taxed there. As it turns out, more industrialized states such as Maharashtra and Gujarat also have a high consumption base comprised of a relatively more affluent population, and are thus able to ‘capture’ the tax within their state borders.

The Contradiction

But expanding consumption runs up against one of the other adverse consequences of a GST regime. Expanding consumption presumes that employment rates and per capita incomes within a state are rising. But one of the sectors worst affected by GST has been the medium and small enterprises (MSME) sector. Across states, the MSME sector is a huge employer since it tends to be much more labour-intensive than large industry.

A study by the Reserve Bank of India in 2018 on the impact of demonetization and GST on the MSME industry points out that in India, the MSME sector comprised over 63 million units and employed over 111 million people. Since many MSMEs are in the informal sector, demonetization hit them severely. Further, the RBI study points out that exports by MSME units were hit by GST “due to delay in refund of upfront GST and input tax credit affecting cash-driven working capital requirements". More broadly, even as the latest survey on the labour force does show a dip in unemployment, as the country returns to normal business after the covid years, the economy has been affected by chronic unemployment and under-employment, which predates demonetization and the GST regime.

This is the big problem with state finances and the economic effects of GST—it is not really about GST but about the broader trajectory of the economy. Even if GST norms are tweaked to make compliance easier and lower the burden on small businesses, the bigger problem is the stagnation in overall investment and employment. The creation of a national market when the market itself is growing slowly, or not growing at all in many states, will in itself have little effect.

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