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The agreement to unify and harmonize domestic trade taxes was a great example of cooperative federalism and the entire edifice now threatens to collapse in just three years. (Photo: PTI)
The agreement to unify and harmonize domestic trade taxes was a great example of cooperative federalism and the entire edifice now threatens to collapse in just three years. (Photo: PTI)

Why GST saga is a terrible low point

  • The battle over compensation is a tipping point that could set back Union-state relations by years
  • The biggest loss due to this year’s revenue sharing battle is the camaraderie in the GST Council. Until now, the proceedings in the council have been conducted in the spirit of mutual respect

BENGALURU : The 43rd GST Council meeting that is set to take place on Monday holds enormous significance. The outcome will not only decide whether states have adequate resources to fight covid-19, but will also determine the future course of the Union-state relationship. There is a third element: whether the future response of the collective of states to any economic issue will be guided by the interest of the states or will become hostage to political alignments.

It goes to the credit of both the Union government and the states that they agreed to sacrificing fiscal autonomy in the interest of unifying and harmonizing domestic indirect taxes so that a destination-based Goods and Services Tax (GST) system could evolve. That was a great example of cooperative federalism. In a system where there are not credible institutions for inter-governmental bargaining, coordination and conflict resolution, the creation of a GST Council provided a model and could be a harbinger for many future cooperative institutions.

The biggest loss due to this year’s revenue sharing battle is the camaraderie in the GST Council. Until now, the proceedings in the council have been conducted in the spirit of mutual respect, camaraderie and the spirit of give-and-take without paying heed to any political leanings. The discussions have been free, based on merits, and in the interests of each state and the Centre. A careful reading of the minutes of the GST Council meetings show that there was no groupism and positions were not taken on the basis of political allegiance.

The saga of compensation payments, which has played out in the 41st and 42nd council meetings, threatens to disrupt this and it is entirely the responsibility of the Union government. All the states feel the crunch, but the states ruled by the Bharatiya Janata Party (BJP) or its allies are more than willing to accept a solution presented by the Centre even as they know that it will severely constrain their finances. There are also fence-sitting states which are trying to reach a bargain, or those that want to align with the ruling coalition at the Centre. This certainly does not augur well for the future of Union-state financial relations.

The 42nd meeting of the council, held on 5 October, failed to resolve the issue of promised compensation for the loss of revenue to the states. The Union government had estimated the compensation amount and had placed two options before the council in the 41st meeting on 27 August.

The total loss of revenue to the states was estimated at 3 trillion, of which 65,000 crore was expected to accrue from the compensation cess this year. Of the remaining 2.35 trillion, the loss due to the so-called “act of God" (the pandemic) was estimated at 1.28 trillion. The first option presented to the states was allowing them to borrow 97,000 Crore, which was later revised to 1.1 trillion, under the special window to be opened by the Reserve Bank of India and both interest payments and repayments will be made from the future collections of the cess.

In the second option, the entire shortfall of 2.35 trillion could be borrowed from the market and the states will have to bear the interest cost, but the repayment will be adjusted against future collections of the cess. While the states ruled by the BJP and its allies have opted to take the first option, the 10 states ruled mainly by the opposition parties have rejected both the options and have stated that the responsibility for making compensation payment is the Centre’s and, therefore, it is for the Centre to borrow and compensate the states in full.

The genesis

Building the necessary consensus that culminated in the creation of a GST Council in 2017 took a lot of work. States were naturally reluctant to sign up for reform as it involved sacrificing fiscal autonomy. In fact, they were reluctant due to the bad experience they went through with the regard to the Central Sales Tax (which was reduced from 4% to 3% in 2007 and further to 2% in 2008). The finance minister in the 2006-07 budget speech had stated that the compensation for reduced CST will be paid until 2010 when the GST will be implemented.

As the GST regime was not implemented in 2010, the Centre wanted to discontinue the compensation payment which brought in tremendous loss of trust and confidence on the Centre. Concerned with the CST compensation experience, the states wanted all possible assurances regarding compensation for any shortfall in revenue in the run up to 2017.

A close reading of the minutes of the 7th and 8th GST Council meeting shows the strong concern about the issue of compensation in the event of revenue from the cess falling short of the required amount. Most of the states wanted the Centre to commit to paying compensation from the Consolidated Fund of India (CFI) at which the Union finance minister Arun Jaitley stated, “…the demand for payment of compensation from the CFI essentially meant funding of compensation from income tax or non-tax revenues of the central government, which would be a challenge as the central government also had its own committed expenditures".

At the same time, he stated, “There was a constitutional commitment by the Central government to provide 100% compensation and how it would be done was for the council to decide" (para 21 of 7th council meeting minutes).

The matter was reiterated by the finance minister in the eighth council meeting when he stated, “….Compensation to the states shall be paid for 5 years in full within the stipulated period of 5 years and, in case the amount in the GST compensation fund falls short of the compensation payable in any bi-monthly period, the GST Council shall decide the mode of raising additional resources including borrowing from the market which could be repaid by collection of cess in the sixth year or further subsequent years" (para 23 iii. page 27 of the minutes).

Thus, there was a clear commitment from the Centre on the issue of compensation and the method of recouping the loss, including borrowing by the Centre and/or the states, had to be decided by the council. It wasn’t supposed to be presented as a fait accompli.

The debacle

But since there was no attempt at collective decision making, this entire episode has plunged the Union-state relationships to a new low. Besides the issue of compensation itself, the way the entire episode has been managed smacks of gaming and strategizing in a period of crisis, which does not augur well for the future of Union-state relationships.

First, the presentation of the two options without any actual discussion and then mandating the states to choose any one within a week is not in the spirit in which the compensation for the loss of revenue to the states was promised. It was an important promise which made reform possible. In fact, reneging on the agreement by not recognizing the Centre’s commitment will make the states wary of any future reform proposal involving the Centre and the states.

Second, giving selective press statements from time to time through “officials" and “sources" to pressurize the states to accept one or the other option, instead of deliberating the matter inside the council, does not bring credit to the central government. There was a statement in the press a few days ago that 21 states have accepted option one and if the rest of the states do not exercise an option within a week, they will have to wait until 2022. Surely, this could not have been the decision taken by the GST Council.

Third, there is an attempt to take away the decision about the nature of borrowing from the ambit of the council. Another press report indicates that the government’s position is the council only has the necessary jurisdiction to extend the levy of compensation cess to make up for a shortfall. “It has done that. Now, the ball is in the court of individual states, not the GST Council," one anonymous central government official is quoted as saying. Further, it was stated that borrowing is individual state and Centre’s decision under Article 293 of the Constitution. “When something is not under the jurisdiction of the GST Council, how can voting or division be permitted on the subject? Voting can occur in the council only in those matters that are under express jurisdiction of the council". That’s the official position.

Should the states know about this from the press? Why were the two borrowing options presented to the states in the meeting of the council if the council did not have any jurisdiction? This is completely contrary to the promise made by the then finance minister in the 8th meeting of the council cited above. The entire episode smacks of gaming.

The ‘source’ is reported to have said, “Can Assam be prevented from borrowing if Kerala does not want to borrow?" The issue is one of compensation to be paid to the states for which the solution has to be found. As there is a central government commitment to find the mechanism for compensation in the GST Council, and as borrowing is one of the options, both Assam, Kerala, as well as other states, along with the Centre, have to find the solution.

Furthermore, if the commitment of the Centre is recognized as admitted by the then finance minister in the 7th meeting of the council, then, given the relative fiscal strength of the Centre and the states and as the interest rate for the Centre’s borrowing is much lower than that of the states, the Centre should take the responsibility to borrow and pay compensation to the states. Both interest payments and repayment of the principal liability can be met from future collections from the cess. At the same time, the council can also decide on the way to augment cess revenue by including more items.

The path ahead

The argument for central responsibility gets strengthened when it is considered that it wanted to appropriate the excess collections of cess into the CFI. In the original GST Act, the central government could appropriate 50% of the unutilized amount in the compensation fund at the end of five years and the remaining 50% would be distributed to the states. It is not clear how the Centre could be a claimant for the compensation cess! This was further liberalized to enable the Centre to appropriate the balance in the fund to the consolidate fund “at any point of time".

The eventual Act passed in Parliament does not provide for the Centre retaining the consolidated cess amount in the consolidated fund, but as pointed out by the Comptroller and Auditor General in the financial audit report of 2018-19, it did not transfer the compensation cess revenue to the GST compensation fund amounting to 47,000 crore in 2017-18 and 2018-19 and utilized it as its own revenue, thereby, showing lower revenue and fiscal deficits.

Thus, for all practical purposes, it utilized the amount as its own revenue when there was surplus, but now, when the states are faced with a dire need for resources, it is attempting to shift the responsibility. The Union government also wants to invoke terms like “act of God" like an insurance company, as if the problems caused by covid-19 on the finances of the state governments could be wished away.

The controversy surrounding the compensation for the loss of revenue to the states due to the implementation of GST is not merely about revenue loss. This is an issue which could impact the confidence and trust that states decide to place on the Centre. The real issue at stake is whether commitments and agreements will be honoured or not.

By its very nature, in a federation with high centripetal bias, the Union and the states have unequal relationships. The agreement to unify and harmonize domestic trade taxes was a great example of cooperative federalism and the entire edifice now threatens to collapse in just three years. It is for the government of India to save it from collapsing. The future of a harmonious fiscal federalism will depend crucially upon the way in which central governments deal with the ripple effects of this saga.

The author was a member of the fourteenth Finance Commission and a former Director, NIPFP. Views are personal

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