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Saturday, June 19, 2021

Why the distortions built into GST are coming undone

Had there been a proportional representation of voting in the GST council either as a proportion of the size of a state or by its contribution to the GST revenue pool, Covid products would have been tax free by now.

Written by Palanivel Thiaga Rajan , Praveen Chakravarty |
Updated: June 7, 2021 8:20:20 am
The Prime Minister Narendra Modi-led government implemented the GST in 2017. (File Photo)

At a time when most nations have suspended regular safeguards to expedite responding to Covid-19, the Goods and Services Tax (GST) Council in India is still engaged in a “discussion” on whether life-saving and hard-to-come-by products should be taxed. A consensus on a zero per cent GST rate on products essential to fight Covid-19 remained elusive at the Council meeting on May 28. Council members (ministers) of some states argued for a continued tax levy on such products, sometimes vociferously and repeatedly. This seeming lack of compassion can largely be explained by the distorted design and incentive structure of the GST itself.

The GST Council has representatives from 31 states. The taxes collected under GST (from states) are accumulated by the Union government and a portion is transferred back to each state under a formula. As is the case with most federal countries, there is a large imbalance in the collection and distribution of taxes between states, and this holds true also for income accrued to, and distributed, from the GST pool. Four states — Maharashtra, Tamil Nadu, Karnataka, and Gujarat contribute nearly as much (~45 per cent) as the remaining 27 states combined. Most federal countries exhibit this characteristic where a few large, rich, provinces or states contribute disproportionately. For example, in the US, six states contribute as much to federal tax revenues as the remaining 44 states combined.

Every state in India has two major components of revenues — the state’s own revenues and transfers from the Union government, consisting of both share of taxes collected by the Union as well as grants. Only about 30 per cent of the overall revenue of the states mentioned above — Maharashtra, Tamil Nadu, Gujarat, and Karnataka — comes from the Union government. But for the remaining 27 states, roughly 60 per cent of their revenues are obtained through transfers from the Union government. For the smaller Northeastern states, these transfers from the Union government constitute 80-90 per cent of their total revenues. In effect, the states that contribute the most to the GST pool are the least dependent on transfers from the Union government while the ones that contribute the least are the most dependent. Again, such net-transfers are not unique to India and are the norm in most countries, though usually not to this degree, or persistence over decades.

But in India’s case, there are two unique problems — one of longer standing, and another that has developed in the last seven years. The problem of longer standing is that such net-transfers have become increasingly one-sided, particularly over the last 25 years or so. In almost every federal union, net-transfers work to reduce differences in development between states over time. That is, the quantum of net-transfers diminishes, as states become more equal through such transfers. But in India, the opposite has occurred.

The Union government of the last seven years has greatly exacerbated this problem through two actions. First, it has re-constructed the composition of taxation away from the fair and progressive channel of direct taxation towards the inherently regressive and unfair channel of indirect taxes. To make matters worse, the Union has shifted a large proportion of taxation (roughly 18 per cent of its overall revenues) into cesses, a special form of taxes that remain outside the GST pool and hence do not have to be shared with the states. Since 2014, cess revenues grew 21 per cent every year leading to a doubling in terms of its share of GDP. In effect, while the common citizen has been paying higher taxes every year, a large part of these taxes went solely to the Union government.

The combined effect of these problems is that all states (collectively) get a lower share of overall revenues, and that individual states face an ever-increasing disparity in the ratio of funds received from the Union as a proportion of taxes collected by the Union from that state. This is an affront to fiscal federalism and an assault on “cooperative federalism”.

This is the scenario in which the “one state one vote” model (each state, regardless of its size or contribution to the GST pool has one vote in the GST Council) causes further grave injustice. It is true that this model for the GST Council was established by the previous UPA government to incentivise states to agree to the idea of GST. It has been proven to be distortionary. States that are more dependent on transfers from the Union want to maximise GST collections while states that are less dependent can afford to be more sensitive to citizens’ concerns.

The case of taxes on Covid products is perhaps the starkest instance of such differences. Most large states are ready to forego this tax revenue for humanitarian considerations. Twelve states representing nearly 70 per cent of India’s population do not want to levy Covid taxes on their people.

But 19 states representing the remaining 30 per cent of the population seem keen to continue to levy GST on Covid products. These are mostly smaller states, and those whose governments are in political alignment with the Union Government. Given the smaller population of such states, the adverse impact of Covid taxes will be minimal for them. But they will reap the benefits of additional revenues from GST on Covid products levied on the much larger populations of the bigger states.

The issue has been referred to a Group of Ministers of the GST Council (whose composition itself is curiously weighted towards the pro-tax position) for deliberation, even as thousands continue to succumb to Covid.

This is not a “minority rights” (of small states) issue. People pay taxes, not governments. And tax policy should reflect the needs and aspirations of people in a democracy. Had there been a proportional representation of voting in the GST Council either as a proportion of the size of a state or by its contribution to the GST revenue pool, Covid products would have been tax free by now.

In any federal structure, the Union government ought to play the role of the fair arbiter. When direct tax policy decisions are legislated by Parliament, which has proportional representation from states according to their size of population, why should indirect tax policy decisions be subject to a “one state one vote” formula? The “one state one vote” structure under GST is untenable and coming undone.

This column first appeared in the print edition on June 7, 2021, under the title “Uncooperative federalism”. Rajan is finance minister, Tamil Nadu and Chakravarty is a political economist and Congress leader

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