Impact of the New Economic Measures on Fiscal Ties Between the Union and States in India

At midnight on 30 June 2017, in the Central Hall of Parliament, India launched the goods and services tax. It replaced a maze of central and state levies, including excise, service tax, value added tax, octroi and entry taxes, with a single tax on goods and services, shared by the Centre and the states. Never before had India's states given up so much of their power to tax. The 101st Amendment to the Constitution, passed in 2016, had created a new Article 279A establishing the GST Council, in which the Centre and the states would decide jointly on rates and rules. The change is the clearest example of how new economic measures have altered the fiscal ties between the Union and the states.

The constitutional scheme of 1950 was highly centralised in finance. The Union held the powers to tax incomes, corporations, customs and most excise duties, which were the most buoyant sources of revenue. The states had the responsibility for most of the services that people need, such as police, health, education and agriculture, but their taxes, such as sales tax and land revenue, were less productive. The gap between responsibilities and resources is known as vertical imbalance, and it is closed by transfers from the Union, mainly through the Finance Commission appointed every five years.

Before the GST, the system had two problems. Taxes on goods were levied by the Centre on manufacture and by the states on sale, leading to cascading, in which tax was charged on tax, and to barriers at state borders, where trucks waited in queues for checks. The idea of a unified tax had been discussed since the 1990s, but states feared losing their autonomy and revenue. The agreement was reached only after the Centre promised to compensate states for any loss in revenue for five years, at a growth rate of fourteen per cent a year over their base in 2015 and 2016.

The structure of the GST Council is the key novelty. It has the Union finance minister as chair, the Union minister of state for revenue, and the finance ministers of all the states. Decisions require a majority of three quarters of the weighted votes, in which the Centre has one third and all the states together have two thirds. This means the Centre cannot pass a decision without the support of a good number of states, and the states cannot act without the Centre. It is a rare institution of shared sovereignty in a federation, and its early meetings reached consensus on rate slabs and exemptions.

It is a rare institution of shared sovereignty in a federation, and its early meetings reached consensus on rate slabs and exemptions.

The consequences for states are mixed. On one side, they gained a larger tax base, since the GST covers services as well as goods, and the Centre agreed to share revenue on an equal footing. The removal of check posts and the creation of a single national market may raise growth, from which all states benefit. On the other side, they lost the freedom to set tax rates and to offer tax incentives to attract investment, an important tool of competition among states. Petroleum products, alcohol and electricity were left outside the GST, which preserved some of the states' own revenue sources, but the loss of control over the rest is real.

A parallel change came from the Fourteenth Finance Commission, which reported in 2014 and recommended raising the states' share of the divisible pool of central taxes from thirty two to forty two per cent, the largest increase ever. The Commission argued that states should have more freedom to decide their own spending. The Centre accepted the recommendation, and the share of untied transfers rose. At the same time the Centre reduced its support for centrally sponsored schemes, and states had to bear more of the cost of programmes such as the rural employment guarantee and health missions. The net effect on a state's finances varied, and several complained that the gain was less than it appeared.

The abolition of the Planning Commission in 2014 and its replacement by the NITI Aayog in 2015 changed the relationship too. The Planning Commission had approved state plans and allocated plan grants, and many states resented its power. The NITI Aayog is a think tank without power over funds, and describes itself as promoting cooperative and competitive federalism. States therefore enjoy more discretion, though they have lost a forum in which they could negotiate for assistance, and the role of the Finance Commission has grown.

Concerns about the direction of change have been raised. The Union has increasingly used cesses and surcharges, which are not shared with the states, and their share of gross tax revenue has grown to a considerable amount. The Centre's control over the compensation fund, the role of the Union in the Council, in which it has a veto because of its one third of votes, and the general growth of central schemes create a sense of centralisation. Opposition states argue that the autonomy promised has been narrowed. Poorer states, which depend on transfers, fear that a tax based on consumption will favour manufacturing states where goods are made and services consumed.

On the other hand, supporters argue that the new arrangement is an advance of cooperative federalism. The GST Council has no parallel in India's earlier history, and has made decisions on a consensual basis. The larger share of devolution lets states plan for themselves. The creation of a common market lowers costs for firms and consumers throughout the country. Federal systems elsewhere, such as Germany and Australia, also pool taxes and share revenue, and have found that fiscal discipline requires a centre that can coordinate.

The future will depend on how the arrangement behaves under pressure. If revenue grows as hoped, the Council will be a model of cooperation. If growth falters, and the five year guarantee of compensation expires in 2022, disputes may arise over who bears the shortfall. The system has therefore been placed on trial. What the new measures have produced is a bargain in which states hold a legal voice and the Centre a financial weight, and a fiscal federation that depends as much on the habit of mutual trust as on the clauses of the Constitution.