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India’s Debilitating Fiscal Federalism

The country has been following the back and forth between the Centre and the States around the GST compensation issue for nearly a month now. While 21 of India’s state governments, those governed by BJP, have accepted the Centre’s suggestions on acquiring the shortfall the remaining states refuse to accept these methods. A major reason for the same is that while the total GST compensation shortfall is 2.35 lakh crores, the Centre is only willing to compensate the States 1.1 lakh crore. The reason cited for this is the sharp decline in GST collections this fiscal year, due to the coronavirus pandemic. The Centre initially claimed that of the 2.35 lakh crore only 97,000 crore will be repaid through the compensation as only that amount was owed due to GST implementation, the rest of the shortfall was due to “an act of God”, this amount was later changed to 1.1 lakh crore after opposition from non-BJP states.

The Centre suggested the following methods to fulfill the GST revenue compensation shortfall; state governments could borrow the amount of 1.1lakh crore whose principle and interest will be fulfilled by the GST compensation fund till 2022 or they could raise the entire amount of 2.35 lakh crore in the market; however the interest on this will not be paid by the Centre. Both these methods have been deemed inadequate by some state governments.

GST revenue compensation was guaranteed to State governments by the 101st Amendment after the Goods and Services Tax was implemented in the year 2016. This was done in order to compensate States for their loss in revenue due to the GST system which replaced the Value Added Tax among others. VAT, an indirect tax usually levied by the state governments, was a major source of their revenue.

The Centre’s unwillingness to compensate the states rightfully, as is legally guaranteed to them, has been deemed an attack on India’s cooperative federal nature. As the nation battles with the coronavirus, state government expenditures have skyrocketed- health is a state subject, it seems as if the Centre is slowly deserting the states financially or absolving their accountability to them. This tussle questions the strength of India’s federal system, however, a deeper inquiry indicates that India’s fiscal federal system has been debilitating for some time now.

India’s economy was declining much before the pandemic; higher than targeted inflation, low aggregate demand, high unemployment, abysmally low GDP predictions and subsequently diminishing tax revenues. Diminishing tax revenues for the Union naturally implied lower devolutions to the states. The centre even stopped releasing bi-monthly GST compensation to states, as was guaranteed to them, in FY 2019-20 due to the declining GST cess collections. Moreover, the consistent overestimating of revenue and tax collections by the Union budget always hurts State budget predictions.

The further damage done by the pandemic has cost the Union and State governments alike. Due to the Union’s higher financial prowess and dwindling state economies, the dependence of state’s on the centre only increases. However, it appears that the Centre’s ability to manage this increasing dependency is questionable due to the nature of the economy and government revenues. Tax buoyancy in India was actually negative in the previous financial year. Tax buoyancy is the ratio of change in the centre’s total gross revenue and change in GDP, it essentially measures the efficiency of tax mobilisation especially in times when GDP is increasing. A tax buoyancy ratio of more than 1 indicates that government’s revenue is rising faster than GDP, however, here we observe that despite a positive GDP change tax collections have actually decreased leading to a negative ratio. India’s tax buoyancy has been falling since 2017 and eventually reached negative numbers in 2019. This indicates the government’s low efficiency in turning India’s rising GDP capacity into higher revenue numbers.

Some of this can be attributed to the Centre’s policy to cut corporate taxes for domestic manufacturers, however, such moves should be calculated so as not to reach such a situation of negative tax buoyancy.

In such times of economic distress, the Centre is actually reducing total tax devolution to states. The 14th Financial commission set the share of States in the Centre’s tax collection at 42% in 2015, however, this was not met. In FY 2018-19 state’s share peaked at 36.6% and then fell to 30.3% in FY 2019-20, FY 2020-21 saw state share rise by a mere 2%.

A reason given for the Centre’s decreasing devolution of Union taxes to the state’s is the increasing cess and surcharges collection. The Centre’s tax policy is such that cess and surcharges are not shared with the states, so an increase in these leads to a lower pool of taxes to divide for the states. Research undertaken by ICICI PD revealed that the share of cess and surcharges in central taxes has been increasing; from less than 10% in 2014 to over 15% in 2019. The current government is increasing their reliance on cess and surcharges, especially by imposing more of the same; the Swachh Bharat cess or the Krishi Kalyan cess were freshly imposed by the current government among others. Cess and surcharges have always been a matter of contention between the Centre and State, state governments even appealed to the 14th financial commission to either abolish cess and surcharges or include them in the divisible tax pool. Moreover, the Comptroller Auditor General even commented on the lack of transparency in the utilisation of these cess collections.

Due to the pandemic, the Centre released 50% of the funds due to the states from the State Disaster Risk Management Fund (SDRMF) as a first installment. While this move was welcome, though deemed inadequate by some experts, the Centre’s new ambitious Aatmanirbhar Bharat policy provides little to no relief for state governments. The policy limits additional borrowing of states to 2% of their GDP, where only 0.5% of this additional borrowing is unconditional and the rest 1.5% is conditional pending permission by the Union. This move to attach conditions for additional borrowings was deemed as an attempt by the Centre to coerce the states into implementing their own agenda by experts.

The Centre’s new controversial agricultural bills too end up cutting state revenues by reducing the role of Agricultural Produce Market Committee (APMC) mandis in facilitating trade of farmer’s produce. The APMC’s charge state taxes and fees to farmers trading that through them. The the Farmers’ Produce Trade and Commerce (Promotion and Facilitation) Bill, 2020, on the other hand, permits farmers to sell their produce outside the APMC’s without paying such state taxes. Such a move is set to reduce state revenues, especially the Punjab government’s by a large amount (8.5%). The state of Punjab in addition to mandi tax imposes an additional tax of 2.5% for government procurement of produce as well. While it is argued that additional taxation on farmers trying to sell their produce was unfair itself and the bills aims to reduce this burden, the fall in revenues for states like Punjab, Haryana as well as Rajasthan will be quite high. Considering that Punjab is one of the highest government procurers of farm produce and relies on some tax collection for the same, the magnitude of fall in revenue and this is concerning. One of the major criticisms of the bills from the states has been that agriculture is a state subject, and the Centre legislating on it undermines them. The Centre has actually been prodding the states for a while to amend this law granting the power of regulating agricultural marketing to the states, around seven states out of which five were ruled by NDA parties took lead in amending these laws as well.

The Union’s policies push for fiscal centralisation, and this hurts India’s federal character. A part of this undermining of federalism lies in the fact that 21 of India’s 29 states are ruled by BJP, these states act in absolute accordance with the Centre’s actions and hence not much push back on any kind of policies is observed. Moreover, the remaining states ruled by opposition parties have bitter relationships with the Centre which do not help the case of cooperative federalism in India. Issues like the GST impasse only exacerbate the nature of these bitter relationships as well as India’s dwindling federal structure.


Featured Image Credits: The Himalayan Times


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