What does the Covid-19 crisis tell us about GST’s defects?

In 2016, India’s parliament voted to introduce a new Goods and Services Tax. With it, the country replaced a large number of indirect taxes at both the state and federal level and replaces it with one tax – rates for which will be determined by a council of state finance ministers and the Union government.

At the time, this centralisation in tax structure was largely held to be a good thing with proponents of GST arguing that the new tax would – by eliminating state barriers – increase India’s rate of GDP growth by as much as 2%.

While this did not happen, GST’s centralised structure has emerged as a roadblock during the Covid-19 crisis.

Funds shortage

During the United Progressive Alliance years, the Goods and Services tax was sharply resisted by many states – including, ironically, Gujarat where Narendra Modi was the chief minister. Yet, within two years of moving to the New Delhi, as prime minister, Modi was able to reverse this, convincing the states that GST should actually be adopted.

A significant part of this deal was driven by a large carrot the Modi government offered: states would be compensated by the Centre for low GST collections for the first five years as compared to normal state revenues in the older tax regime.

However, in reality, this was more than compensation. The compensation amount assumed that state revenues grew at 14% year-on-year: an absurdly high figure. This compensation amount, therefore, actually promised the states a revenue bounty for five years.

This compensation was little discussed in the media when GST was introduced – but was perhaps critical to overcoming state opposition. “I feel without this 14% compensation deal, it would have been difficult to get all the states on board,” argued Manish Gupta, assistant professor at the National Institute of Public Finance and Policy in Delhi.

Bad designed

In 2019, the 15th Finance Commission Chairman, NK Singh, had pointed out that the GST mechanism had severely harmed state abilities to raise their own finances with governments being “lulled into a state of complacency” due to the assured 14% compensation. His attempt to change the formula, however, was rejected by the states. And with the law clearly mentioning the specific rate of compensation, there was little the Union government could do to change this – even though it clearly did not have the money to pay out the unrealistic increase it had promised in 2016.

If things were this bad before Covid-19, not surprisingly matters became much worse as India went into lockdown in March. States found their revenue streams drying up even as expenditure went up due to the health emergency. However, at that moment, the Centre refused to release pending GST compensation for the year 2019-’20 to the states.

The situation was critical enough to even force some BJP-ruled states to press the Centre: Gujarat, for example, wrote to the Modi government asking for its dues. As part of this belligerence, Kerala even threatened to take the Union government to court.

Desperate solutions

Eventually, GST compensation for December 2019 to February 2020 was released only on June 4. This means, remarkably, that dues that preceded the lockdown were cleared as the lockdown was getting lifted.

Very low tax revenue during the lockdown means that the problem of GST compensation would become even more acute following the June 4 payment. As a way out of this emergency situation, the GST council on June 12 discussed a unique way out: for the council itself to take a loan in order to pay the states their GST dues.

The proposal has itself thrown up a number of questions given that there is no precedent of a constitutional body borrowing money. “I don’t think compensation should be paid in this way,” argued economist Arun Kumar. “It is not the GST council’s job nor mandate to borrow or lend money. Instead, it should be the Centre that should borrow and hand over to states.”

Non-GST tweaks

With GST gummed up, how have governments managed the funds crunch? On the revenue side, governments have concentrated on the two items left out of the GST framework in 2016: alcohol and fuel.

In May, India opened up its liquor stores – the first non-essential economic activity permitted even as the rest of the country was placed under a harsh containment regime. The reason for this unusual decision was clear: in the absence of GST revenue, states were desperate for tax revenues from alcohol. So desperate that they were ready to partially relax the lockdown and risk weakening social disancting as liquor shops saw huge crowds when they opened. At the same time, three states – Andhra, Delhi and Bengal – announced steep hikes in alcohol taxes to even further shore up revenue.

A similar movement took place on fuel. In May, the Union government hiked excise duty on petrol by a record Rs 10 per litre while the duty on diesel went up by Rs 13 a litre. In the meanwhile, as many as 13 states announced a hike in their own fuel taxes. This extreme reliance on this stream of revenue means India has one of the highest rates of tax on fuel: as high as 260% on petrol and 256% in the case of diesel to take Delhi as an example.

Why were taxes on alcohol and fuel harnessed to meet the exigencies of Covid-19?

“With no need to refer to the GST council, states were able to quickly use alcohol and fuel to raise revenue since these were in their control,” explained Manish Gupta.

At the time when GST was being introduced, its proponents focused mostly on the positives of a single taxation structure across the Indian Union. “There was an elite consensus that these differential structures across India’s states were creating serious impediments and there is no doubt that supply chains in Indian seamlessly span states,” explained Yamini Aiyar, President and Chief Executive of the Delhi think-tank Centre for Policy Research. “But maybe not enough attention was paid to the trade offs of states giving up such a significant degree of autonomy when it comes to setting rates for indirect taxes.”