Why States' Battle for GST Compensation Is More Important Than Ever

The dilution of several defining characteristics of fiscal federalism in India doesn’t come as a surprise, but that just means it is worth fighting for.

The estimated Rs 30,000 crore shortfall in Goods and Services Tax compensation for states has come at a time when waning fiscal federalism is a burning issue. The Centre’s latest decision to suspend the Members of Parliament Local Area Development (MPLAD) Scheme and divert that money to the Consolidated Fund of India is the latest step towards the centralising of this country’s financial resources.

This money, if correctly utilised, would have gone to all the parliamentary constituencies of the country, thereby helping a remote taluk or village panchayat. The money from the Consolidated Fund of India will be now devolved to states as per the recommendations of the Finance Commission.

In a large country like India, an effective fight against a pandemic such as COVID-19 requires financial strengthening of its states, without which it would be impossible to reach the last mile of affordable healthcare facilities for the poor and needy.

Since the adoption of the constitution, there have been concerted efforts, in the form of recommendations of the Sarkaria Commission, 10th Finance Commission and Punchhi Commission, to give more financial independence to state governments.

Even then, devolution of taxes to states, from the divisible pool of taxes of the Union, is far from satisfactory: Rajendra Prasad’s hope that provinces will not be treated as charity boys of the North Block of the Secretariat is yet to materialise.

Devolution of resources before independence

The Government of India Act, 1919, which was enacted as a result of the Montague-Chelmsford Report, for the first time, provided for devolution rules. The devolution of resources was criticised by the provinces as they were inadequate to meet their needs. Soon, expert studies followed, which were incorporated in the Government of India Act, 1935.

This 1935 Act, which was indeed used as a template for the constitution, provided for four modes of taxes:

  1. Levied and collected by the Federal Government;
  2. Levied and collected by the provinces;
  3. Levied by the Federal Government but shared with provinces; and
  4. Levied by the Federal Government but collected and retained by the provinces.

At the time of drafting of the constitution, an Expert Committee headed by Nalini Ranjan Sarkar was asked to study the provisions of the 1935 Act and make recommendations relating to taxation and borrowing powers of the states. While acknowledging the need to provide adequate resources to the states without placing too much strain on the Union, the Expert Committee recommended setting up of a Finance Commission, an independent body, to devise the allocation of shareable taxes between the Union and the states. This was approved by the Drafting Committee and discussed and confirmed in the Premiers’ Conference in 1949.

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Finance Commission

The Finance Commission, set up under Article 280 of the constitution, has been bestowed with the exclusive power to make recommendations to the president as to the distribution between the Union and the states of the net proceeds of taxes which are to be, or may be, divided between them and the allocation between the states of respective shares of such proceeds. The states obeyed and took home whatever the Finance Commission allocated. The Sixth Finance Commission (1974-1979), a pragmatic one too, submitted in its report:

‘When the emphasis is on social justice, there is no escape from realignment of resources in favour of States, because services and programmes which are at the core of a more equitable social order come within the purview of the States under the Constitution.”

This socialist objective found a taker in the report of the Tenth Finance Commission (1995-2000), which led to the Constitution (Eightieth Amendment) Act, 2000. Until then, only a few Central taxes (income tax and excise duty) formed the divisible tax pool that was to be shared between the Union and the States. The Tenth Finance Commission recommended to provide for the sharing of net proceeds of all union taxes (except a few mentioned in Articles 268, 269 and 271).

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The intended net-result of this overhaul were:

(i) with a given share being allotted to the States in the aggregate revenues from Central taxes, the States will be able to share the aggregate buoyancy of Central taxes;

(ii) the Central Government can pursue tax reforms without the need to consider whether a tax is shareable in the states or not;

(iii) the impact of fluctuations in Central tax revenues would be felt alike by the Central and the State Governments;

(iv) Should the taxes mentioned in articles 268 and/or 269 form part of this arrangement, there will be greater likelihood of their being tapped; and

(v) the progress of reforms will be greatly facilitated if the ambit of tax sharing arrangement is enlarged so as to give greater certainty of resource flows to (sic), and increased flexibility in tax reform. (Statement of Objects and Reasons, 80th Constitution Amendment Act)

This constitution amendment helped the states cross the first hurdle, which was, to get a share of all Union taxes and duties. The second hurdle remained: the percentage share to be devolved among the states was not guaranteed under the constitution but was fixed by the Finance Commission.

One step forward, two steps back

The Constitution (One Hundred and First Amendment) Act, 2016, which introduced GST in India, negated the progress we achieved through the recommendations of the Tenth Finance Commission and the Constitution (Eightieth Amendment) Act, 2000.

GST is a dual levy wherein both the Union and the states can levy tax on supply of goods and services. It has subsumed eight taxes/cesses levied by the Union and nine taxes levied by the states. To mitigate the loss of revenue for the states on account of introduction of GST, for the first five years, a compensation cess was brought in under section 18 of the 101st Constitution Amendment Act. This guarantee, however, has not been inserted in the Constitution. A separate GST (Compensation to States) Act, 2017 was enacted, which provided, under section 8, that:

“The compensation payable to a State shall be provisionally calculated and released at the end of every two months period, and shall be finally calculated for every financial year after the receipt of final revenue figures, as audited by the Comptroller and Auditor-General of India”.

Now what happens if the Union doesn’t release compensation cess at the end of every two months? A dispute ensues. Under Article 279A(11) of the constitution, the GST Council must establish a mechanism to adjudicate between the Centre and one or more states. However, even in the recently concluded 39th GST Council meeting, no steps were taken to create such a dispute resolution mechanism.

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With the Union having weightage of one-third of the total votes cast, and when it requires not less than three-fourths of the weighted votes of the members present and voting to take a decision, the Union and its politically aligned states wield a sword over other states.

In the absence of an alternate remedy, the only option left for states like Kerala and Punjab is to approach the Supreme Court under Article 131 of the Constitution. Such a judicial remedy to establish fiscal federalism of the states would indeed be an unholy sight. A state like Kerala, which faced two floods in successive years in the recent past, has to now control a COVID-19 outbreak and explore legal options to secure its share of GST compensation cess, at least in instalments.

The dilution of several defining characteristics of fiscal federalism in India doesn’t come as a surprise. The Montague-Chelmsford Report considered federalism in British India as a “distant prospect” (as H.M. Seervai put it). Even during the constituent assembly debates, no concrete measures were taken to evolve an equitable procedure for devolution of tax revenue of the Union.

An equitable procedure should have been accompanied with a constitutional guarantee that there will not be any default in such payments to the states. Without such guarantees, the states in India will always be the charity boys of the North Block.

Rahul Unnikrishnan is an advocate of the Madras high court.