Fiscal Federalism and GST: In Conversation with Sudipto Mundle

India has emerged as one of the fastest-growing economies in the world.[i] To reform its governance structure and promote ease of doing business in this era of globalization and increased competitiveness, India is working to change the landscape of its Center-State relations by promoting a more cooperative structure.[ii] Post-independence, India has followed a quasi-federal constitutional model, which it is now trying to upgrade. For this reason, various reforms have been initiated by the government, like the setting up of the NITI Aayog, formation of the GST (Goods and Services Tax) Council, devolving more grants to the states by the 14th Finance Commission, withdrawing from Regional Comprehensive Economic Partnership (RCEP), and relaxing foreign investor rules.[iii] However, it is clear that a lot more needs to be done on the reforms side, given that India faces a slowing growth rate, rising corporate and household debt, and increasing unemployment.[iv] The Government of India must work in unison alongside State governments to reverse the downturn the economy and also to entrench cooperative federalism in the country. The world is currently in increasing turmoil because of factors, inter alia, like the global economic slowdown, protectionist policies adopted by the USA, and the withdrawal of the United Kingdom from the European Union. It is imperative that cooperative federalism between the Union and the States is encouraged for India’s economy to remain resilient in the face of international economic turbulence. Ashima Mahajan speaks to Sudipto Mundle about fiscal federalism, GST, Finance Commission, and possible solutions to having a cooperative fiscal arrangement between the Center and states.

Sudipto Mundle is a Distinguished Fellow at the National Council of Applied Economic Research (NCAER). He was formerly an Emeritus Professor at the National Institute of Public Finance and Policy (NIPFP), New Delhi. He has also been a member of the Fourteenth Finance Commission, the erstwhile Monetary Policy Advisory Committee of the RBI, the Chairman of the National Statistical Commission as well as the Chairman of the Research Advisory Committee of Research and Information System for Developing Countries (RIS), a think tank affiliated to the Ministry of External Affairs. Mundle has spent much of his career at the Asian Development Bank, Manila. Currently, he is a visiting faculty member at the Indian School of Public Policy (ISPP), New Delhi.


1. Fiscal federalism in India has its roots in the British colonial rule. It primarily dates back to the Government of India (‘GoI’) Act of 1919 and Government of India Act 1935. While the GoI Act of 1919 saw a revenue sharing model between the Center and the Provinces, the GoI Act of 1935 enabled a further revenue redistribution to the Provinces with the provision of Grants-in-Aid.  What are your views on this with respect to the evolution of fiscal federalism in India?

These observations are context-specific. The 1919 Act wanted a more centralized picture and the 1935 Act was a bit decentralized. The specific context of why the Acts were designed so relates to the historical moment of the time. But what is relevant for us from today’s perspective, is why the founding fathers adopted a Constitution which was more centralized.

There were many compulsions.  There was a concern about regulatory capture by the local elites at the state level. Another concern was that, given the absence of a strong Centre, there would be fissiparous tendencies that could lead to Balkanization. We have seen this happening around many countries that became independent at that time. So, I think these were the driving concerns of the founding fathers and the reasons why they incorporated unitary features in the federal system, giving us a system today that is only quasi-federal in nature.

2. How has the implementation of the Goods and Services Tax (GST) affected the federal structure of India?  Has the GST Council circumscribed the fiscal autonomy of states?

I am not sure I agree that the GST has compromised the fiscal autonomy of the States. If it has compromised their fiscal autonomy, then it would imply that it has also compromised the fiscal autonomy of the Center. This is because all decisions relating to GST are made by the GST Council which is made up of all State Finance Ministers along with the Union Finance Minister as its chair – this body then collectively makes decisions. As an institution, if states have given up some power, then the Centre has also given up power (because central taxes have also been subsumed under it). Additionally, the GST Council has a very cleverly balanced alignment of voting powers. The decisions are made by a 75 percent majority, but Center has a larger voting power compared to individual states. The Center has a voting power of 33 percent, so no decisions can go through without its agreement. But equally a collection of states also has veto power, since the voting power of states adds up to more than 25 percent.

We cannot say that it has reduced the autonomy of states vis-à-vis the Centre. To address the fear among the states that they might lose revenue, assurance was given that the Centre would compensate the states for five years at the then prevailing growth rate of 14 percent. At the time, the inflation rate was higher, and the states have been more than compensated for some state-level taxes being subsumed under the GST. The Centre is now finding it difficult to keep to its commitment. But it also can neither renege on its commitment nor can it increase the compensation cess because the economy is growing at a much slower rate.

GST exemplifies how an institution of cooperative federalism can work with a fine balance of powers of the Center and the States. The institution is very well designed; however, it has not been able to work properly because of three reasons. First, the tax design that the government came up with was flawed. It had half a dozen rates.  Most countries would have just one rate. At the most, we can have three rates but having six is completely irrational.

Second, it is actually a very good tax, but it depends critically on an extremely well-functioning tax information system. We need an efficient system to manage the tax crediting component of the law and to be able to match invoices. If such systems are not in place, GST mechanism is meaningless. There is a belief that something is wrong with the way GST has been designed.  However, the core of the problem is not design but the inefficient machinery in place that is unable to implement the Act properly.

Third, GST needs sound professional secretariat of experts to implement it. I see no reason why the GST Council cannot employ such a body of experts. But, by default, the matter has been left to the Finance Ministry, which in turn, has put in place a Committee essentially composed of bureaucrats from the Central Board of Indirect Taxes and Customs (CBIC). The CBIC officers are interested in their own power rather than making the system work. They are bureaucrats and not experts at running a complex value-added system.

With multiple rates, there is room for discretion in the classification of goods and services. Given that and a complete GSTN system not being in place, there is much room for leakage and corruption. This is damaging the reputation of what is actually a very good tax. If GST administration could be assigned to a permanent secretariat of the GST Council, a professional body of properly trained officials who are permanently based there, then the system would work. There are too many vested interests working against the GST. If the GST is allowed to work properly, then it is such a good transparent tax that there would be little room for any leakages.

3. There are overlapping functions between the GST Council and the Finance Commission (FC). While the Finance Commission recommends distribution of revenue between the Union and the States; everything with respect to GST rates, exemptions, changes, and implementation of indirect taxes are entirely within the domain of the GST Council. How can we achieve coordination between these two bodies without conflict?

I think this is a very good question and is something that the 15th Finance Commission is contemplating. They are both constitutional bodies and can have a formal interaction. Though, a meeting of the FC with GST council is not going to be very productive because then about 29-30 ministers of states would be in attendance with a much leaner FC. Also, within the GST council, we have half a dozen professionals, economists, another three or four chartered accountants, but the rest are not experts in finance. So, there is a lot of herd mentality at work there. If we look at the minutes of the meetings of the GST Council, it leaves much to be desired with respect to its functioning. But that does not mean that a good productive relationship between the FC and the GST Council cannot be developed. I think coordination between them is very essential. This is because a major part of tax revenues which the FC has to factor into its award on tax devolution or grants are the revenues from the GST. A lot can be achieved through informal discussions between the Chairman of FC with some members of the GST Council, and also with more informed professionals among the State Finance Minister(s). 

4. Schedule 7 of the Indian Constitution has three lists – Union, State and Concurrent. Over the recent years, the State List has shrunk and the Center has expanded its influence in State policies, encroaching territory of the States. What are your views on the same?

First of all, it is a fact that there has been an encroachment and that is not desirable. But I think it is incorrect to think that the lists that were made 70 years are cast in stone. The circumstances have changed, and we must revisit them. Flexibility also needs to be there and, in the way, that the concurrent list has been expanded, we can see the presence of flexibility in India’s administrative structure.  However, the argument against too much decentralization is that all states are not equal – some have high capacity while others have low capacity. Sometimes being more centralized is more equitable than more decentralization. With high decentralization, the states are competing with each other and obviously the stronger ones will gain, while others will lose out. Therefore, it is always beneficial to have a kind of referee who can be more even-handed and more concerned about equity.

5. The 15th Finance Commission (FC) amended the Terms of Reference by seeking a separate fund allocation to the defence and internal security before dividing money between the Center and the States. If implemented, this would reduce the fiscal space available to states while increasing it for the Central government. This may be considered a threat to federalism in India. In case need arises, how are we to combat this situation?

First of all, it is for the Finance Commission to decide the scope of their mandate. Constitutionally, it is their responsibility. It is not for any other institution to direct the Finance Commission to look into an issue or not. I think there has been some overstepping on part of the central government in trying to lay down the scope for the Finance Commission’s domain. If the FC wants, it can completely ignore it.

Secondly, defence is a national subject but internal security is not (internal security is enlisted in the Concurrent List). Whatever is earmarked for internal security is not reducing the fiscal space of the states. It’s simply reducing their autonomy in deciding the allocation. Anyway, the states were spending money on internal security but they were the decision makers with respect to, say, the number of battalions in the state police force. Now, the Center will. The Center is trying to co-opt some of the autonomous functions of the States rather than their fiscal space as far as internal security is concerned. Defence, in any case is under its own domain.

It is unconstitutional to ask FC to carve out money for defence and internal security before allocating to the States. For instance, when the 14th FC decided to transfer 42 percent of net tax revenue to the States, it was part of a larger scheme because the Center had other resources like public enterprises’ profit, cesses, surcharges, and so on. In fact, all that put together, the allocation worked out to be 62 percent of the total resources for the States, given that some of the money belonging to the Central government got transferred to States through the framework of centrally-sponsored schemes. The ultimate division of resources was something like 63 percent-37 percent in favor of the States, which was not very different from what it was during the 13th FC.

In the case that this proposal is adopted, the provision for defence and internal security would need to be factored in while deciding the devolution amount. When an allocation for defense is set aside before the devolution, then this will be reflected in the devolution formula as a lower share for the Centre. It is only after budgeting for all center’s responsibilities, including defence, that a devolution share can be estimated. So, again, what is there to be set aside? If you really think about this, it’s quite meaningless because the allocation of the tax share of the center is to provide for this allocation.

6. Why has the 14th FC transferred funds directly from Center to Gram Panchayats, the third tier of governance, bypassing the State Finance Commissions (SFCs)?

The grant that was given said very clearly that the utilization of funds was to be done in accordance with the recommendations of the SFCs. So it was, in fact, also an attempt to empower the SFCs along with the local governments, because in order to use that money the State governments have to take the SFC report seriously. It was certainly not the intention of the 14th FC to bypass the SFCs but an attempt to empower them by making them a stakeholder with respect to the decision regarding how the transferred money was to be used by the local governments.

7. Why is the fiscal balance always tilted in favor of the Center while the States have been interested in the welfare and developmental tasks? Why is this imbalance seen?

It is the quasi-federal constitutional allocation of assigning funds which gives greater importance to the Center as compared to the States. There are other reasons why it is important for the central government to be the authority which collects certain types of taxes and not the states. In principle,  there is nothing wrong with having a difference in the assignment of revenue-raising powers and the assignment of expenditure spending powers. We have an instrument to deal with that, which is transfers, that’s why we have the Finance Commissions. Constitution makers envisaged this need and mandated the appointment of Finance Commissions to make decisions with respect to  the allocation of tax revenues between the Center and the States. That particular imbalance is already provided for through the instrument or institution of the FC.

8. The NK Singh Committee has recommended a fiscal deficit of 2.5% of GDP by FY 2022-23 but currently, the FY 2016-17 fiscal deficit is 3.5% of the GDP (Fiscal Responsibility and Budget Management (FRBM) Act mentions it to be around 3%). Arvind Subramanian didn’t agree with this target and recommended to eliminate the government’s primary deficit over the next 5 years. What are your views on the same?

First of all, I think the way the FRBM Committee recommended the fiscal deficit is flawed, completely, because it makes it pro-cyclical. If you fix the percentage, then when growth is high, the amount also goes up, and when the growth is low, the amount goes down. The movement of the fiscal deficit should be exactly the opposite, as it is supposed to be counter-cyclical. The idea  in theory, and it is being implemented in many countries, is to target the structural fiscal deficit or a cyclically adjusted fiscal deficit which is kind of a self-correcting device. You fix it so that when the growth is too high, then the deficit becomes low and when growth is too low, the deficit becomes high. But the FRBM Committee did not do that. Some of us pointed it out then, some of us have continued to mention it. And I’m very pleased to say that I think the 15th Finance Commission is contemplating whether it should revisit this predicament.

9. With the protectionist approach adopted by the USA and the recent withdrawal of India from RCEP agreement, do you think this will affect India’s economic prospects? If yes, how can we improve the situation because we cannot opt for being a closed economy again?

Given the terms of RCEP, I don’t think India was in a position to sign up and had no option but to withdraw. But not joining RCEP is also not an option because the global multilateral trading system is more or less falling apart. Trade is increasing being conducted through regional agreements and RCEP is a mega one for Asia. So, India will have to get into it. But before we do that, we need to do a couple of things. First of all, you need a body of professionals and not leave it to bureaucrats in the Commerce Ministry to deal with trade agreements.  They are not equipped and do not have the requisite professional skills to do so. You need specialized technical experts, trade experts, economists, lawyers, and so on – a solid body secretariat for RCEP to do in-depth analysis. Any serious country will do that.

Second is that, at the end of the day, India will have to become competitive while joining free trade bodies. India will lose its trade share if it is not competitive. We need to fix our infrastructure, ease up our business system, and sort the mess with GST. We need efficient governance systems, efficient infrastructure and a competitive environment rather than a protected environment. Korea for instance, forced the manufactures to compete and stand up to global competition. In 1991, when we liberalized, the manufacturers were scared but actually, mostly they all did well. Some fell but others came up and India did quite well. We had a long period of very good export growth. This will again happen when we join RCEP and we should prepare for it properly.

10. The National Council of Applied Economic Research (NCAER), National Institute of Public Finance and Policy (NIPFP), and other think tanks that work closely with the government are assigned projects by the Ministry of Finance regularly. How does the government use the work and the analysis produced by these organizations? How can these institutions be further developed to assist the government in its functions?

The institutions mentioned are being used by the government from time to time. It’s good that NIPFP is used in a more focused way for public finance issues than NCAER, which is used for various other things as well. In my view, an attitudinal change is required in government in order to build a systematic relationship with think-tanks and use them in a more organized way. It should not be piecemeal and there is a need to build structured relationships of the kind you may find in countries like the United States, Korea, Japan and China. Think tanks need to be taken much more seriously because they have greater expertise than the government. It is unfortunate that these think tanks are not very market-oriented and are getting priced out. The government is not realizing that they are giving up efficient and cheaply priced assets. There has to be funding for think tanks. We need to look at China on how they are spending a lot of money on research. We should learn from the US on how they are working.


ENDNOTES

[i] World Economic Forum. “Why Cooperative and Competitive Federalism Is the Secret to India’s Success.” Accessed January 4, 2020. https://www.weforum.org/agenda/2019/10/what-is-cooperative-and-competitive-federalism-india/.

[ii] Sahoo, Niranjan. “Center-State Relations in India: Time for a New Framework.” ORF. Accessed January 4, 2020. https://www.orfonline.org/research/Center-state-relations-in-india-time-for-a-new-framework/.

[iii] Modi’s Labour Reform Push May Remove Key Hurdle for Investors – The Economic Times.” Accessed January 4, 2020. https://economictimes.indiatimes.com/news/economy/policy/modis-labour-reform-push-may-remove-key-hurdle-for-investors/articleshow/72234136.cms?from=mdr.

[iv] December 6, Raghuram Rajan, 2019 ISSUE DATE: December 16, 2019UPDATED: December 9, and 2019 21:06 Ist. “Exclusive: Raghuram Rajan Explains How to Fix the Economy.” India Today. Accessed January 4, 2020. https://www.indiatoday.in/magazine/cover-story/story/20191216-how-to-fix-the-economy-1625364-2019-12-06.

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