There finally seems to be a path forward for GST. Centre and states must strike bargain

Arvind Subramanian, Josh Felman write: States should give up their demand for an extension of GST compensation mechanism, while the Centre should offer resources during an economic downturn.

Tomorrow, the GST Council is set to meet. Although the agenda focuses on specifics, the time is ripe to take up a broader objective: Leaving the disputes behind and constructing a way forward for GST, one of the major policy achievements of the government.

What has set back the GST for the past year and a half? The contributors are many but the critical one has been simply a lack of revenues. The chart tells the story. In 2016-17 the various taxes that were folded into the GST yielded revenues of Rs 9.7 lakh crore (Economic Survey, 2017-18). Initially, the GST performed well, with collections soaring to Rs 11.8 lakh crore in the first full year of implementation in 2018-19. But in 2019-20, the growth rate decelerated sharply. And in 2020-21, collections actually fell.

As a result, there have not been enough resources to satisfy the needs of the Centre or the states. Moreover, because future collections became uncertain, a gap opened up between the amount that the Centre felt it could afford to promise and the minimum that the states felt they needed and were entitled to. Spanning this chasm has proved difficult.

More recently, however, confidence in GST has improved. Collections have revived, averaging Rs 1.1 lakh crore in the first five months of the current fiscal year, exceeding even pre-pandemic levels. Even more important, the GST’s past performance now seems much better than it once did. We now know the economy turned south after 2018-19, with nominal GDP growth slowing from 10.5 per cent in 2018-19 to 7.8 per cent the next year and -3 per cent in 2020-21. Moreover, as the RBI has pointed out, the effective tax rate has fallen by nearly 3 percentage points because of reckless rate cutting in 2019, in which both the Centre and states were complicit. Thus the weak revenue performance of the GST now seems attributable to wider economic difficulties and policy actions, rather than problems with the tax itself.

Consequently, most of the ingredients for a compromise are now in place: A sense that the country is in this together and confidence that sufficient resources will be available. So, what is to be done?

In our view, three key changes are necessary: Re-casting compensation, simplifying the rate structure, and improving governance. First, the principle of compensation must be re-cast, because the original needs have vanished and new ones have taken their place. The logic of the five-year compensation was simple: The GST was a new tax, so states needed to be guaranteed against the teething troubles that would inevitably arise. Five years on, this logic is less compelling. The GST is no longer an infant; of course, it still needs improvements but as a tax reform it has reached maturity, well understood by producers, consumers, and tax officials.

At the same time, the last few years have exposed the vulnerability of the states to shocks. When Covid arrived, states’ revenues collapsed, eviscerating their ability to spend on health and welfare precisely at the time when such spending was needed most and when states found their fiscal space constricted. To prevent this situation from recurring, the authorities should create a revenue buffer that could be tapped in a time of need. And the most obvious source of funding is the GST, which accounts for over 40 per cent of the states’ own revenues.

In sum, there is a bargain waiting to be struck: The states give up their demand for an extension of the compensation mechanism, while the Centre offers a new counter-cyclical buffer. Put another way, the compensation guarantee should be converted into revenue insurance. As the figure shows, in good economic times, GST revenues will be robust but it is against downturns that states need protection.

The details of this insurance would need to be negotiated, including the threshold for triggering the mechanism, as well as the amount and timing of the compensation. But just to give one example, states could be promised transfers equivalent to 1 percentage point of GSDP for every 3 percentage point shortfall from an agreed trend rate of growth. The transfers would be paid quarterly following any two quarters in which the shortfall exceeded 3 percentage points.

The shift to revenue insurance, in turn, should allow the compensation cess to be abolished. This siloing of what is a common pot of money has led only to accounting shenanigans and bickering. Once it is gone, all payments could again be made from the consolidated fund of India.

Second, the GST structure needs to be simplified and rationalised, as recommended by the Fifteenth Finance Commission and the Revenue Neutral Rate report that one of us authored. To achieve the promised Good and Simple Tax, a new structure should have one low rate (between 8 and 10 per cent), one standard rate (between 16 and 18 per cent) and one rate for all demerit goods. The average incidence of the GST will increase as the rate cuts effected since 2019 are reversed, as they must. The single rate on demerit goods also requires eliminating the cesses with all their complexity. For example, taxes/cesses based on the length of cigarettes are an absurdity deserving immediate abolition.

Finally, the GST Council’s working needs tweaking. Under Arun Jaitley’s stewardship, all GST decisions were taken by consensus. But that can be sustained only if there is a shared sense of participatory and inclusive governance. Nearly two decades ago, when the VAT was being introduced, Yashwant Sinha established a culture of consensual discussions on indirect taxes. He did this by requiring the Empowered Committee of State Finance Ministers to be headed by a finance minister from an Opposition-run state government, such as Asim Dasgupta from West Bengal (during the NDA government’s tenure) and Sushil Modi from Bihar (during the UPA’s tenure).

The spirit of this idea could be translated to the GST Council. For example, discussions in the Council could be steered by the central Finance Minister (Chair), aided by a finance minister (Vice-chair) from an Opposition state, 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.

In sum, after one and a half years of dispute, and with the economy showing signs of recovery, a path forward for the GST finally seems visible. This opportunity needs to be seized — and not just because of the inherent importance of the GST. India will fly or falter on the stake of cooperative federalism. And cooperative federalism is not a gesture or one-off outcome. It is, above all, a disposition, resulting from quotidian democratic practice. By rehabilitating cooperative federalism’s finest achievement — the GST — the Centre and states can help restore India’s broader economic prospects.

This column first appeared in the print edition on September 16, 2021 under the title ‘A win-won bargain’. Subramanian, a former chief economic adviser, is with Brown University and Felman, former IMF resident representative in India, is Principal JH Consulting

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