Home / Opinion / Columns /  There’s a way out of India’s GST compensation impasse

Maharashtra Chief Minister Uddhav Thackeray has said that it is time to ask if India’s old indirect tax regime was better than the goods and services tax (GST) rolled out in mid-2017. It remains to be seen if other chief ministers harbour the same thought. If they do, one of India’s most important policy reforms in recent years could be at risk.

There is now thankfully a growing consensus that GST Version 1.0 is suboptimal, though it is still better than the system it replaced. This column has argued since 2016 that India was moving towards a flawed GST. It was also an international outlier in terms of its number of tax rates. The World Bank had said in March 2018 that 49 countries have a single-rate GST, 28 countries have two rates, and only five countries have four rates other than zero. India is one of these five countries, along with Italy, Luxembourg, Ghana and Pakistan.

India’s recent attempts to rationalize the GST system were focused on tax cuts that have pushed the effective weighted tax rate, as estimated by the Reserve Bank of India (RBI), below what had been calculated at its launch as the revenue-neutral one—11.6% compared to 15.3%. However, the economic rationale for GST still remains valid. The integration of the Indian market as a result of this indirect tax reform helps rationalize fragmented domestic supply chains. GST ensures that only final consumption, rather than production across the value chain, is taxed, broadly meeting the requirements of the celebrated production efficiency theorem in optimal tax theory.

The blazing controversy right now is over the promised compensation to states to make up for any shortfalls in their tax collections due to GST implementation. As part of the grand federal bargain reached for its introduction, Parliament passed a law that states shall be compensated for any loss of revenue due to its adoption for five years. The Union government was guaranteeing 14% annual tax revenue growth, irrespective of the rate at which the underlying economy grew in nominal terms. This insurance undermined the incentive of states to seek a GST structure that maximized growth, though it was also necessary to assuage fears based on previous experience that verbal commitments would not be met. India’s major manufacturing states were especially concerned, since the GST regime shifts the tax base from production to consumption.

In an insightful paper written for the Pune International Centre, V. Bhaskar and Vijay Kelkar show through a careful study of the minutes of GST Council meetings that there were several models proposed for determining the compensation to be paid to states, including transfers linked to growth in nominal gross domestic product (GDP) as well as a fixed rate of 12%. The bargaining at GST Council meetings eventually led to the guarantee of 14% annual growth in indirect tax collections. “With the benefit of hindsight, it can be argued that the best option—guaranteeing revenue growth mirroring the nominal GDP growth in the country—was neither examined nor adequately discussed," say Bhaskar and Kelkar.

The Union government also used an accounting tweak to make its budget numbers look better in fiscal years 2017-18 and 2018-19, though that was reversed in the Union budget announced in February 2020. New Delhi used the excess GST compensation cess collected in the first two years to bolster its tax revenues, rather than keep it aside for any future shocks—or more technically, funds meant to be held in the Public Account of India were shifted to the Consolidated Fund of India. This was not exactly a confidence-building exercise.

What now? The Union government argues that it is liable to cover revenue shortfalls arising only from the country’s transition to the new tax regime, and not because of other events such as a pandemic. Last week, it offered two options to the states, both placing the onus of extra borrowing on them. State governments are clearly not amused. As Rathin Roy has recently pointed out, the Union government has asymmetrical financial powers during a crisis. It has more corporate assets to sell, it has access to the profits of India’s central bank, and it can even borrow money overseas if need be.

On the other hand, states are at the front line of the battle against covid-19. They need resources to carry on this fight. Economic damage will worsen with every failure in pandemic control. Economic stability is a national public good, and the Union government cannot turn a blind eye to the consequences of underfunded states at a time such as this. It must work to win their confidence rather than get drawn into interpretative battles with them.

However, state governments also need to offer something at the bargaining table. It is clear that a 14% revenue guarantee was unrealistic. It is time for states to accept this, and agree at the GST Council to a lower level, ideally linked to the growth rate of the Indian economy in nominal terms. The Union government thus needs to lead the country out of its GST impasse by borrowing more from financial markets or directly from RBI. States should reciprocate by settling for a more realistic compensation rate.

The country’s grand federal bargain—in effect a bargain between national and local elites—should not be weakened to an extent that the very idea of a national value-added tax comes under threat.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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