The Goods and Services Tax – a nationwide indirect tax that subsumes all state and Central levies – is that rare measure in India that enjoys broad support. The policy was initiated by the Congress-led United Progressive Alliance and the ball was picked up by the Bharatiya Janata Party government after 2014.

Yet, there were some dissenters who worried that states losing the power to unilaterally decide taxes would end up harming federalism. Specifically, manufacturing states were worried they would end up losing revenue given that the Goods and Services Tax is a consumption-based tax, a departure from the old system of taxation that was applied at the destination of manufacture.

The Economic Survey – the government’s annual report of the state of the economy, which was tabled in Parliament on Monday – has argued that the fears of the manufacturing states are unfounded. It has done this by running a correlation between each state’s share in the potential Goods and Services Tax base and its gross domestic product (the total value of the goods and services it produces).

It concluded that since “each state’s share in the GST base is almost perfectly correlated [coefficient of 0.95] with its share in overall GSDP”, hence, “the biggest tax bases still seem to be in the biggest producing states”.

Yet, the survey also provided data that seems to simultaneously back up the fears of the manufacturing states.

The report explained this away by arguing that the Goods and Services Tax base of Maharashtra and Gujarat might be lower than their share in manufacturing but that is balanced out by their “significant presence in services”. This, however, does not really counter the argument that the new tax penalises manufacturing states. In the future, if a state were to leave out services and only concentrate on manufacturing – a core skill that India direly needs – it would lose out on its rightful share of tax, as per the Economic Survey’s analysis.

More fundamentally, correlating state gross domestic product and potential Goods and Services Tax share does not really address the fears of some states that they would lose revenue. A high correlation could still theoretically result in a scenario where a state’s revenue under the Goods and Services Tax is lower than it was under the previous tax regime. In fact, that is exactly what is happening. It is estimated that the shortfall in revenue for the financial year 2017-2018 is approximately Rs 1,00,000 crores. It is this historical comparison vis-a-vis revenue under the previous tax regime that will determine whether the move to the Goods and Services Tax in July has benefitted the states.

Fiscal decentralisation?

The survey also loftily – and correctly – argued that “fiscal decentralisation is often embraced as not just a desirable economic but also as a political and philosophical principle”. It said: “This is captured in the idea that spending and tax decisions must reflect local preferences as far as possible.”

After laying this out, however, the survey pronounced that the Goods and Services Tax meets these needs since “decisions and tax administration are done by both [the Union and the states]”.

This is a curious non sequitur since the Goods and Services Tax actually represents a move away from “fiscal decentralisation”. States have lost the power to unilaterally decide a host of taxes. Moreover, given the structure of the Goods and Services Tax Council – the top decision-making body of the new tax regime – the Union government holds a veto. So, the Union, in net, has only gained taxing power while the states have lost a large chunk of their sovereign power to tax.

This is an acknowledged fact and the states agreed to this arrangement only after a quid pro quo with the Union government: the promise of a significant increase in revenue, calculated at a year-on-year increase of 14%.

Low state revenue

The impact of this loss of taxing power of the states is brought into sharp relief with data in the Economic Survey pointing to how the Indian Union’s states generate a low share of their total revenue on their own compared to other federal countries.

This gap is made even more acute by the fact that India is 6 times the size of Brazil and 16 times the size of Germany – so if anything, it needs to be a lot more fiscally federal than either country to balance out overcentralisation.

India’s case for greater fiscal federalism is made more urgent by the fact that states now actually do more heavy-lifting governance as compared to the Union government. And given the trend, this gap will only grow.

States now outspend the Union government. Note: ULB refers to "urban local bodies" and RLB refers to "rural local bodies".
States now outspend the Union government. Note: ULB refers to "urban local bodies" and RLB refers to "rural local bodies".

The Economic Survey lay out the problem: “In comparison with their counterparts in some other federal countries, they [states and local bodies] rely much more on devolved resources and much less on their own tax resources, and they collect less direct taxes.”

States responsible for overcentralisation?

Yet, the report also blamed the victim, in a manner of speaking. “The reason does not seem to be so much that they don’t have enough taxation power” but that “they are not fully utilising the taxation powers they already possess”, the report read. It used land revenue collection data to make its point:

It argued that since the average across all states in the Union is only 18.8%, “complaints about inadequate tax and revenue devolution are less persuasive under such conditions of serious under-collection”.

However, this data would only support the Union government’s move of taking away the taxing powers of states if it were more efficient at tax collection. But when the report looked at how the Union territories administered directly by Delhi had performed, it found that “the under-collection of direct taxes relative to potential afflicts the Centre as much as the other two tiers [states and local government bodies]”.

Given that states and the Union government are equally inefficient at collecting taxes, there seems to be little logical justification for centralising taxation. More so when the harm caused by centralisation is well known. The survey itself pointed out that depending on outside sources of revenue runs counter to engendering conditions for good governance. In fact, making a strong point, the report compared revenue transfers from the Union government to “foreign aid” that “come with weak accountability mechanisms and weak own resource generation capacity”.