GST: Cooler heads for constructive ends

The goods and services tax (GST) is once again fuelling impassioned debate, this time stoked by a controversial Supreme Court ruling. Questioning the very idea of the GST is gaining wider currency. That’s understandable since the tax has generally generated less revenue — and much more discord between the Centre and states than anyone expected. But the GST is beginning to fulfil its potential as a buoyant revenue source. And there are ways to reduce Centre-state friction. It’s consequently imperative that cooler heads prevail and compromises be found that will restore the workings of the cooperative GST system.

Start by considering the data. The chart shows GST collection from 2018-19 (the first full year of GST implementation) to 2021-22. For the first few years, the tax seemed to perform poorly, with collections steadily shrinking as a share of GDP. But in 2021-22, there was an impressive rebound, with revenues improving by 0.6 percentage points to 6.4 per cent of GDP.
 

Judging from these headline numbers, it is difficult to be sure about last year’s performance. It could be a sign that the GST is finally coming of age. Or it could just be an aberration, which will be reversed in the coming years.

Digging deeper provides clues to what is going on. The first point to note is that unlike 2018-19, 2019-20 and 2020-21 were years of weak economic growth and possibly also years when the GST tax base shrank as a share of GDP, because much of the economy’s growth was in agriculture, which is not subject to the tax. So, the lacklustre performance of the GST in these years may have been due to cyclical factors.   

Second, there have been substantial reductions in rates. The Reserve Bank of India has estimated that the effective GST rate has been reduced by 2-3 percentage points, which could have reduced collections by at least 1 percentage point of GDP. Put differently, had rates not been cut, the GST/GDP ratio could be well over 7.5 per cent today.

Why has the underlying revenue (excluding the rate cuts) improved so sharply? Mainly, because the government and the states have been improving GST administration. GST invoices must now be posted before input tax credits are given, firms must fill e-way bills, and more firms are joining the system.

In addition, a hitherto unrecognised factor seems to be playing a role: A structural change in the way indirect taxes operate. Previously, central excises were collected on imports as countervailing duties. But the VAT levied by states on imported goods was collected only when the goods were sold to consumers. Now central and state GST on imports are collected as Integrated GST as soon as goods cross the international border. In effect, the GST has become a “withholding tax” at the border. This withholding tax might have increased collections.

For all these reasons, it seems likely that GST collections will remain buoyant, provided that further rate reductions are avoided. And this in turn will generate the revenues needed to smooth relations between the Centre and the states. But money alone will be insufficient to overcome the stress that has built up over the past few years. How exactly can this be overcome?

Consider why the GST has been under stress. The Centre’s reluctance to share Integrated GST revenues (in 2018 and 2019) and provide the pledged compensation (during the pandemic years) fostered deep mistrust in the states. In some ways, this was the original sin. Then, GST collections under-performed because of a weak economy and irresponsible tax cuts in which the Centre and states were both complicit. This combination of high-handedness and weak collections led to a rising chorus of complaints by the states.

Over time, these grievances have morphed into a broader critique, namely that the GST was foisted on the states at the cost of a severe loss of fiscal sovereignty. But it is important to get the history right. Far from being a case of technocrats foisting their ideas on an unsuspecting political class, the passage of the GST reflected one of those rare examples in recent Indian history of bipartisan political consensus on a major policy reform. To the extent that there was opposition, it came from the BJP-ruled states of Gujarat and Maharashtra, and to some extent Tamil Nadu. Even then, all the Constitutional amendments were passed without a single opposing vote. And all states agreed to the governance and decision-making structure in the GST Council.

The truthful part of the critique is that the GST did entail giving up or pooling fiscal sovereignty. But all states were fully aware of the trade-off: Some sovereignty was exchanged in return for efficiency gains and more buoyant revenues. And as the Supreme Court pointed out, state legislatures still retain some ultimate constitutional authority on GST tax policy.

The question now is how the states will use this power. The Supreme Court stated that “the states can use various forms of contestation if they disagree with the decision of the Centre”. Leaving aside this provocative language, which has the whiff of the Court compensating for its other failings, is contestation really the right way forward?

To be sure, the cooperative spirit has gone missing since about 2018, reflecting the heavy-handedness of the Centre, not just on the GST but across a range of issues. But it does not help for the states or the Supreme Court to further weaken that spirit.

Instead, the spirit of co-operative federalism that led to the creation of the GST needs to be revived. The centre should make the first move by displaying retrospective magnanimity, in one of possibly two ways.

The Centre could use the additional GST collections in the compensation pool to ensure that all states receive the full amounts promised for the five-year period from 2016-17 to 2021-22, based on the guaranteed 14 per cent GST revenue growth. Any state that has received less would receive a top-up. To be sure, there will be a cost to the Centre, which we estimate around Rs 1 trillion, but regaining the trust of the states is surely worth the fiscal cost.

Alternatively, the Centre could extend compensation for another few years. The exact terms (duration and magnitude) would need to be negotiated, but they would surely involve a guaranteed amount of revenue growth, perhaps from the 2021-22 baseline and perhaps with a phase-out provision to avoid a “fiscal cliff”, whereby states suddenly suffer a large loss in revenues.

In either case, the new agreement should commit the Centre and states to work together in the GST Council to simplify and rationalise rates—and, in some cases, raise them as originally envisaged, perhaps not immediately but as economic conditions improve. This would provide more revenues to all parties. And bringing petroleum into the GST should not be pursued as that would further erode the fiscal sovereignty of the states.

There should also be governance changes in the working of the GST Council, as we have earlier proposed. For example, discussions in the Council could be steered by the Union finance minister (Chair), aided by a finance minister from a state (as Vice-chair), rotating periodically. The agenda-setting and technical work could be done jointly by these two, and they could even take turns chairing Council meetings. The Council secretariat would report to both officials, and state and central tax departments should be sharing and analysing data together and continually. Cooperative federalism in the GST Council should become a quotidian, administrative reality.

Magnanimity from the Centre, more accurate historical remembering by the states, collective action by the Centre and the states, and judicious self-restraint from the judiciary could be a good recipe going forward to restore the GST to its proper and important role. With political will, goodwill can be rescued from the current ill-will.

The writers are, respectively, former chief economic advisor to the Government of India, and former IMF resident representative to India