The Indian Constitution has divided taxation powers between the Centre and states quite neatly, in general. However, the division of taxation powers on goods and services is not so clear-cut.
Excise duty on the manufacture of goods was placed in the Centre’s domain, while sales tax on manufactured and other goods was assigned to states. Excise duty on alcoholic preparations was given to states. Inter-state sales fell between two stools. The Constitution had to be amended to assign legislative powers thereon to the Centre, but the authority to fix rates and collect taxes was assigned to the originating states.
The concept of services as value-creators, like goods, did not exist at that time. Very few services, for example, entertainment, electricity, etc, were consciously recognised, and they were broadly assigned to states. Services as a class had to be invented in the 1990s by interpreting the residual Entry 97 in the Union List, which led to the Centre assuming the authority to tax all services.
The GST system, like Rome, was not built in a day. With efforts that started in 1999, the GST finally came into effect in 2017.
After Chidambaram backtracked on the compensation promise during the global financial crisis, states felt short-changed a second time in 2020-21, when the Centre, instead of holding the states’ hands, invoked the ‘act of god’ clause and refused to meet the revenue shortfall, attributing most of the GST revenue loss to COVID-19.
States are most concerned about the GST revenue shortfall.
The GST was a grand bargain. If the Centre displays good leadership, there are prospects of striking another mini bargain to resolve pending issues.
A 14% GST compensation guarantee need not be extended for another five years, but imaginative use of extended GST compensation can help find a solution.
Taxation of imported goods to countervail excise duties was within the Central government’s domain. The power to administer sales tax on some special goods, such as sugar, textiles, etc, was assigned by agreement among states to the Central government, with the proceeds distributed among states.
Not surprisingly, after India became independent, the system of taxation of goods and services developed and operated in a very disjointed and fragmented manner. Consequently, India had an unproductive, dysfunctional, cascading and value-leaking product taxation system in the 1970s.
There was also a race to the bottom amongst states, with governments offering lower taxes on goods sold within their territory. Car ‘melas’ (fairs) were common, with low or no sales tax. Diesel was undertaxed by some to under-cut neighbouring states.
India’s dysfunctional indirect taxation system was crying for change.
GST Was Not Built in a Day
The Goods and Services Tax (GST) system, like Rome, was not built in a day.
For building cooperation and trust among the competing Centre and states, serious efforts first started in 1999, when Yashwant Sinha established a Committee of State Finance Ministers and encouraged an opposition state Finance Minister to head it. These efforts brought some good results. There was an agreement on minimum sales tax rates. States agreed not to levy sales tax at rates lower than the agreed minimum. This established a minimum rate floor.
The next major move came in 2005, when P Chidambaram got states to agree to change the system of sales taxes into value-added taxes. Chidambaram offered a compensation formula to states if tax growth faltered. All states adopted VAT laws by 2006. But when Chidambaram did not honour the compensation deal around the global financial crisis, states rightly felt let down.
Chidambaram announced in Budget 2006 that the Goods and Services Tax (GST) will be implemented from 1 April 2010. States, short-changed by the dishonouring of the promised compensation, remained unconvinced, which protracted GST negotiations.
Finally, it required the persuasiveness of Arun Jaitley to bring the states to accept the GST system in 2016. He made several compromises and gave water-tight assurances to bring states on board. Petroleum products and excise duties on alcoholic products were kept outside the purview of GST. Compensation was offered if states’ GST revenue grew by less than 14% compounded growth rate. A constitutional guarantee was provided for compensation. Many states – especially the manufacturing states – came on board in spite of their reluctance.
The GST came into operation in the country in July 2017.
States Felt Cheated, Again
There were some implementation issues, due to technical, conceptual, policy and rate problems. These were taken as teething troubles and solved gradually. The compensation was paid on time in 2017-18 and in 2018-19.
But fissures started appearing in 2019. The Central government turned populist pre-Lok Sabha elections and GST rates on several items were reduced. This, coupled with the slowdown in the economy, brought the effective GST rate to around 11-12%, against the revenue-neutral rate of 15 to 15.5%.
An increased GST compensation was paid for 2019-20, but after undue delay.
Next, COVID-19 and lockdowns made GST collections nosedive in 2020-21. States faced the spectre of a huge GST revenue shortfall of 30-60%.
Instead of holding the states’ hands, the Centre invoked the ‘act of god’ clause and refused to meet the revenue shortfall, attributing most of the GST revenue loss to COVID-19. Later, the Centre relented but decided to borrow and provided the states with back-to-back loans.
States now felt short-changed a second time on the compensation issue.
Important GST Reforms are Pending
There are three major reforms awaiting agreement between the Centre and states:
bringing petroleum and other leftover products within the GST framework;
reforming GST rates,
finding a solution for states’ GST revenue shortfall
States are most concerned about the GST revenue shortfall. Their interest in discussing the other two agendas is critically linked to this.
The GST cess has been extended for four years, ie, until 30 June 2026. The cess receipts are to be used for paying back the loans taken in 2020-22 in order to provide cash to states in lieu of GST compensation.
Can the Centre Strike a 'Mini Bargain'?
The GST was a grand bargain. If the Centre displays good leadership, there are prospects of striking another mini bargain to resolve pending issues.
However, this opportunity was squandered at the GST council meeting in Chandigarh on 29 June. Many states demanded that the GST compensation be extended for another five years. But the Centre only listened.
GST compensation stops from today. But, it is not lost forever. A 14% GST compensation guarantee need not be extended for another five years, but imaginative use of extended GST compensation can surely help find a solution.
There are three parts to this new ‘mini-bargain’.
First, the GST compensation cess should be extended for five years instead of four years. This will yield a GST cess of about Rs 6.5 to 7 lakh crore, instead of about Rs 5 to 5.5 lakh crore.
Second, loans taken for GST compensation are only Rs 2.7 lakh crore. These loans, with interest, can be paid over a period of five years in a staggered, back-loaded manner.
Third, the remaining compensation cess of about 3.5 to 4 lakh crore can be used to pay the states’ compensation for the shortfall in their GST revenues over the next five years, calculated at a rate at which the available GST compensation cess equals the shortfall.
Striking this bargain requires strong leadership and persuasive skills. Nirmala Sitharaman needs to rise to the occasion. If this deal is struck, states are likely to come to the negotiating table to talk about the remaining issues as well.
(The author is economic and fiscal policy advisor, SUBHANJALI, former Finance & Economic Affairs Secretary, and author of The $10 Trillion Dream. This is an opinion article and the views expressed are the author's own. The Quint neither endorses nor is responsible for them.)
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