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Photo: Hindustan Times
Photo: Hindustan Times

The GST pact must hold for this tax reform to work out

The Centre could create a constitutional crisis and imperil the GST system if it reneges on compensation

As India’s government reneges on compensating the states for GST shortfalls, there are murmurs of a sovereign default, constitutional crisis and breakdown of federalism. Unfortunately, the current situation includes elements of all three.

Debt is used by governments to loosen constraints and spend more than they raise in revenue. Borrowing has immediate benefits for political actors, while passing costs on to future generations. Lenders find it difficult to enforce contracts with sovereign governments and collect on their debt. But, a host of global rating agencies, financial institutions and markets make it reputationally very costly for a government to default on debt commitments, by making it very difficult to borrow funds in the future.

In the current Indian scenario, defaulting on a constitutional obligation to states is technically not the same as defaulting on sovereign debt borrowed from the market— as many economists have pointed out. It appears the Union government is avoiding a scenario where it must borrow and struggle in the future if the post-pandemic economic slump continues. Instead, the Centre would rather states had debt on their books, hoping richer states do better, and there are few to no state debt defaults to deal with in the future. This is short-sighted; eventually, the Centre will have to bail states out.

The Centre’s latest move should be treated as worse than a sovereign default—as a constitutional default. Just as the Constitution is placed above any ordinary statute, a constitutional contract trumps an ordinary contract. It binds all governments for generations. Defaulting on the GST contract is one step worse. The Narendra Modi government did not inherit a constitutional GST arrangement from its framers. This tax regime, the revenue compensation arrangement between the Union and the states, and the related constitutional contract are entirely its design.

The point of the compensation commitment was to cover states’ shortfall even if the economic climate was bad. So, reneging at a time the economy is doing badly renders it moot. Further, the Centre’s distinction of revenue shortfalls because of GST implementation versus covid is irrelevant; it was the Centre that locked down all states, preventing them from evaluating the trade-off between covid containment and revenue-raising economic activity. Even if New Delhi argues that the pandemic is an “Act of God" (it is not), the decision to lock down the country for months on end was an Act of the Union Government.

The constitutional trade-off with GST was that states would lose some more of their fiscal/federal autonomy in an already centripetal fiscal structure. But in return, states would gain the benefits of a larger market, the key to long-run prosperity. In that sense, GST is a trade treaty as much as a tax pact. The benefits of a larger free-trade zone with no differential tariffs and checkpoints was clear for all to see. And since these benefits would take some time to materialize, a compensation structure was created to ensure that short-term costs don’t hamper long-run benefits.

But this fiscal design also made the Centre more responsible for pushing India onto a higher economic growth trajectory to compensate revenues. India’s centripetal fiscal structure means that historically, the Centre has set the economic reforms and growth agenda. If India’s economic growth has faltered, it is time to place the blame also on the Union government—not just the present government, but on the accumulated sins of many past governments. So, it is the Centre that must bear the brunt of the latest economic crisis.

Reneging on the deal is worse than having no GST in the first place. It will push India into a new stage of federalism, where states have little reason to cooperate unless the Union is ruled by the same party. Now each state may have an excuse to levy its own additional taxes or break away from GST entirely, becoming protectionist for short-term political gains. Or, under the rescue plan hatched by the Centre and the Reserve Bank of India, states will have to borrow funds at costly rates that they have little hope of paying back. The big reform needed was GST simplification, not more uncertainty by defaulting on states and jeopardizing the federal indirect tax system.

The Modi government could now face a full-blown constitutional and federal crisis, with states tempted to break their commitments and let GST and non-GST tax rates proliferate. It could mean more border controls and bigger enforcement problems, which could drive India toward economic balkanization and an even worse slump. Or the Centre must tighten its belt, curtail its own spending and borrowing, and keep its commitment to the states.

It could be done by sending a costly signal. The revenue shortfall from GST is about 3 trillion. According to the 2020 Budget, expenditure estimates for all centrally-sponsored schemes put together is nearly 3.4 trillion (likely to be revised). The path out of this mess, if we wish to avoid both fiscal profligacy and a constitutional crisis, is for the Centre to cough up the compensation. One way forward is to cut down a bulk of those centrally-sponsored schemes, the Union government to borrow the rest, and give the money to the states to spend as they see fit. If the states find a central scheme valuable, they could choose to spend on it themselves.

Funding the states will keep the Centre’s constitutional commitment and also give states more autonomy, which they desperately need to deal with covid.

Shruti Rajagopalan is a senior research fellow with the Mercatus Center at George Mason University, US

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