The introduction of the Goods and Services Tax (GST) in India on July 1, 2017, marked a watershed moment in the country’s fiscal history, fundamentally reshaping its indirect tax landscape and, consequently, the Centre-State financial relations. Conceived as a ‘One Nation, One Tax’ reform, GST subsumed a multitude of central and state indirect taxes, aiming to simplify the tax structure, reduce cascading effects, and enhance tax compliance and revenue buoyancy. Its implementation necessitated an unprecedented degree of cooperative federalism, given that both the Union and State governments relinquished significant sovereign taxation powers in favour of a shared tax base and a common administrative framework.
At the heart of this new fiscal architecture lies the GST Council, a unique constitutional body designed to facilitate joint decision-making between the Centre and States on all matters related to GST. While the initial years of GST focused on smooth implementation, rate rationalization, and technological integration, recent years have witnessed significant shifts and challenges in Centre-State financial dynamics, primarily triggered by the expiration of the guaranteed compensation mechanism, the fiscal pressures exacerbated by the COVID-19 pandemic, and evolving debates surrounding the tax’s scope and administration. These developments have not only tested the spirit of cooperative federalism but have also brought to the forefront critical questions about states’ fiscal autonomy, revenue certainty, and the future trajectory of India’s unique federal structure.
The Foundation of GST and Centre-State Financial Relations
The Goods and Services Tax was designed on a dual model, mirroring India’s federal structure, allowing both the Union and State governments to simultaneously levy tax on the same transaction of goods and services. This dual levy comprises the Central GST (CGST) and the State GST (SGST), collected by the Centre and the respective State governments, respectively, on intra-state supplies. For inter-state transactions, the Integrated GST (IGST) is levied, which is collected by the Union government but then apportioned between the Centre and the destination state, ensuring that the principle of a consumption-based tax is upheld. This mechanism was a radical departure from the previous origin-based taxation system, where taxes like Central Sales Tax (CST) were collected by the originating state.
The cornerstone of this new fiscal compact was the GST Council, established under Article 279A of the Constitution. This body comprises the Union Finance Minister (as Chairperson), the Union Minister of State in charge of Revenue or Finance, and the Ministers in charge of Finance or Taxation or any other Minister nominated by each State government. The Council is vested with the authority to make recommendations on various aspects of GST, including tax rates, exemptions, thresholds, rules, and procedures. A critical aspect of its functioning is the weighted voting mechanism, where the Centre’s vote has a weight of one-third of the total votes cast, and the votes of all State governments taken together have a weight of two-thirds, with decisions requiring a three-fourths majority of the weighted votes cast. This structure was meticulously crafted to ensure that neither the Centre nor the States could unilaterally impose decisions, thereby fostering consensus and cooperative federalism.
Crucially, to assuage the fears of states regarding potential revenue losses arising from the transition to GST – particularly for manufacturing states that would lose revenue from CST and other origin-based taxes – the Constitution (One Hundred and First Amendment) Act, 2016, included a provision for compensating states for a period of five years. This compensation was guaranteed for any shortfall in revenue below a protected growth rate of 14% per annum over the base year of 2015-16. The compensation was to be funded through a GST Compensation Cess levied on certain luxury and sin goods, such as tobacco products, aerated drinks, and motor vehicles. This mechanism was designed to provide fiscal certainty to states during the initial phase of GST implementation, allowing them time to adjust to the new tax regime and build confidence in its revenue potential.
The Pivotal Shift: Expiration of GST Compensation
Perhaps the most significant recent change affecting Centre-State financial relations concerning GST has been the expiration of the guaranteed compensation mechanism. The five-year period for compensation concluded on June 30, 2022. This event had profound implications for states, many of whom had grown reliant on these compensation payments to meet their fiscal obligations. While the initial rationale for compensation was to mitigate transition-related revenue losses, the persistent slowdown in economic activity, even before the pandemic, meant that many states continued to face revenue shortfalls relative to the protected 14% growth rate.
The cessation of this compensation has placed immense fiscal pressure on states. Without the guaranteed transfers, states are now entirely dependent on their share of CGST, SGST, IGST, and their own source non-GST revenues. This shift has exposed their fiscal vulnerabilities, particularly for states that are net consumers and derive less benefit from the destination-based principle of GST or those with lower economic growth rates. States have argued that the original five-year period was insufficient for them to achieve revenue buoyancy under GST, citing various factors including the complex rate structure, persistent economic headwinds, and the non-inclusion of high-revenue items like petroleum and alcohol within the GST ambit.
While states largely lobbied for an extension of the compensation period, the Union government maintained its stance that the five-year guarantee was a solemn commitment that had been met. Extending the compensation would have necessitated either continued collection of the compensation cess, potentially burdening consumers, or diverting funds from other central revenues, impacting the Centre’s own fiscal balance. The Centre’s position emphasised the need for states to enhance their own revenue collection efficiencies, improve compliance, and rationalize their expenditure, fostering greater fiscal discipline. The end of compensation has thus forced states to re-evaluate their fiscal strategies, potentially leading to increased market borrowings, adjustments in spending priorities, or a renewed push for bringing more items under GST to expand the tax base.
Navigating the COVID-19 Fiscal Crisis
The Centre-State financial relations under GST faced an unprecedented stress test during the COVID-19 pandemic. The nationwide lockdowns and severe economic contraction led to a sharp and immediate decline in GST collections for both the Centre and the States. This revenue shock immediately brought to light a critical flaw in the compensation mechanism: the compensation cess collected was insufficient to cover the guaranteed revenue shortfalls for states, leading to a massive gap.
This shortfall triggered a significant standoff between the Centre and the States in 2020. States argued that the Centre was constitutionally obligated to compensate them for revenue losses, irrespective of the cess collection. The Centre, however, interpreted the compensation guarantee as contingent on the availability of funds from the cess. Amidst this dispute, the Centre proposed two options to states: either borrow the compensation shortfall from the market, with the principal and interest to be repaid from future cess collections, or borrow a lower amount (the revenue shortfall due to GST implementation itself, excluding the impact of the pandemic), with the interest to be borne by the Centre.
After intense negotiations and several GST Council meetings, the Centre facilitated “back-to-back” loans to states to meet the GST compensation shortfall. Under this arrangement, the Centre borrowed from the market and passed it on to the states as loans, with the understanding that these loans would be serviced and repaid from the future proceeds of the compensation cess. This innovative, albeit contentious, mechanism helped bridge the immediate fiscal gap but also highlighted the inherent vulnerabilities of the compensation framework and the need for robust fiscal buffers in times of economic distress. While it temporarily resolved the crisis, it underscored the fragility of trust and cooperation when faced with severe financial pressures and divergent interpretations of constitutional obligations.
Evolving Dynamics within the GST Council
The functionality and dynamics of the GST Council have also undergone a subtle yet significant evolution. Initially hailed as a beacon of cooperative federalism, where consensus often prevailed, the Council has faced increasing challenges in forging unanimous decisions, particularly on contentious issues like compensation, rate rationalisation, and the inclusion of new items. The fiscal strains exacerbated by the pandemic and the post-compensation scenario have made states more assertive in safeguarding their fiscal interests, leading to more robust debates and occasional disagreements.
While the Council largely operates on consensus, the weighted voting mechanism becomes crucial when unanimity is elusive. States, particularly those governed by opposition parties, have increasingly voiced concerns about the Centre’s perceived dominance in decision-making and the erosion of their fiscal autonomy. The reliance on Group of Ministers (GoMs) to deliberate on complex issues, while sometimes effective in building consensus, can also be viewed as a mechanism to defer difficult decisions or to influence outcomes before they reach the full Council. The debates surrounding issues like the GST on casinos, online gaming, and horse racing, or the composition of the Appellate Tribunal, have demonstrated the complexities and diverging views within the Council, requiring persistent deliberation to reach common ground.
Persistent Debates: Rate Rationalisation and Inclusion of Excluded Items
Two ongoing debates within the GST framework continue to shape Centre-State financial relations: the rationalisation of the GST rate structure and the inclusion of currently excluded high-revenue items. The GST, originally envisioned with a simple rate structure, has evolved into a multi-rate system with numerous exemptions, leading to complexities in compliance and administration. There have been continuous discussions about merging some of the existing slabs (e.g., 12% and 18%) to simplify the structure, reduce classification disputes, and potentially improve revenue buoyancy.
However, any significant rate rationalisation effort directly impacts state revenues. Lowering rates on certain goods might reduce collection, while raising rates might face resistance from industries and consumers. Therefore, decisions on rate rationalisation are meticulously debated within the GST Council, with states often prioritising revenue protection over simplification. A Group of Ministers (GoM) has been working on this issue, but reaching a consensus that satisfies both revenue requirements and industry demands remains a challenge.
More critically, the non-inclusion of five key items – petroleum crude, motor spirit (petrol), high-speed diesel, natural gas, and aviation turbine fuel (ATF) – along with alcohol for human consumption and electricity, remains a major point of contention. These items currently fall outside the GST ambit and are subject to separate Central and State taxes (excise duty, VAT, sales tax). States vehemently oppose their inclusion in GST, as these items are significant revenue generators for them, providing much-needed fiscal flexibility. Bringing them under GST would mean states would lose their independent power to tax these commodities and would instead receive a share from the common GST pool, potentially reducing their overall revenue and fiscal autonomy.
While their inclusion would eliminate the cascading effect, allow input tax credit for businesses, and simplify the tax structure for these sectors, states are unwilling to surrender their sovereign rights over such crucial revenue streams. The Centre, too, benefits from the existing structure, as specific central excise duties on petroleum products are not shared with states, allowing the Centre greater fiscal space. This impasse continues to be a major hurdle in achieving the true ‘One Nation, One Tax’ objective and significantly limits the comprehensive benefits of GST, while preserving a critical component of states’ fiscal independence.
Emerging Concerns and Areas of Strain
Beyond the headline issues, several other factors contribute to the evolving Centre-State financial relations under GST. One emerging concern for states is the increasing reliance by the Union government on cesses and surcharges. Unlike the divisible pool of central taxes, which is shared with states as per the recommendations of the Finance Commission, cesses and surcharges are collected by the Centre for specific purposes and do not form part of the divisible pool. An increasing proportion of central revenue coming from these non-shareable levies reduces the funds available for vertical devolution to states, indirectly impacting their fiscal health and increasing their reliance on discretionary grants or centrally sponsored schemes.
Another area of concern is the absence of a formal, independent dispute resolution mechanism outside the GST Council. While the Council has a mandate to resolve disputes, if a deadlock occurs within the Council itself, there isn’t a specified judicial or quasi-judicial body to arbitrate. This lacuna was highlighted during the compensation dispute, where a clear constitutional or legal path for resolution was not immediately apparent, leading to political negotiations rather than legal recourse.
Furthermore, while technological enhancements like e-invoicing, e-way bills, and advanced data analytics have significantly improved compliance and revenue collection under GST, they also raise questions about data sharing, control, and the potential for increased central oversight over state economic activity. Ensuring transparent and equitable sharing of data and analytics derived from the GST Network (GSTN) is crucial for both levels of government to fully leverage the benefits of the digital infrastructure. The interplay between GST compensation and the recommendations of the 15th Finance Commission also needs consideration. The Finance Commission, while making its recommendations for revenue sharing, assumed the end of GST compensation, prompting states to seek higher central transfers to compensate for the anticipated revenue loss.
Impact on States' Fiscal Autonomy and Development
The totality of these recent changes has a profound impact on states’ fiscal autonomy and their ability to finance development initiatives. The expiration of GST compensation means that states must now generate higher own-source revenue from GST or enhance their non-GST revenue streams. For states with limited avenues for additional taxation, this translates to reduced fiscal space and increased dependence on central transfers or market borrowings. This reduction in fiscal flexibility could potentially hinder their ability to undertake state-specific welfare programs, invest in critical infrastructure, or respond effectively to local economic shocks.
The vision of GST was not merely revenue maximization but also fostering a stronger, more integrated Indian economy through a unified market. However, the ongoing debates and the fiscal pressures faced by states highlight the delicate balance between achieving national economic integration and preserving the fiscal sovereignty of sub-national entities in a federal system. The success of GST in the long run will depend not only on its administrative efficiency and revenue buoyancy but also on its ability to evolve through continuous dialogue, mutual trust, and a genuine spirit of cooperative federalism.
The Goods and Services Tax, since its inception, has profoundly redefined the financial relationship between the Centre and the States in India, transitioning from a fragmented indirect tax system to a unified consumption-based tax. While it ushered in a new era of cooperative fiscal federalism, epitomized by the GST Council, recent developments have significantly tested the foundational principles of this intricate financial architecture. The most pivotal shift has been the cessation of the guaranteed GST compensation to states, which concluded in July 2022. This crucial mechanism, initially designed to mitigate states’ revenue losses during the transition period, had become a significant, almost indispensable, part of many states’ fiscal planning, and its expiry has ushered in a period of heightened fiscal uncertainty and pressure for sub-national governments.
Furthermore, the unprecedented fiscal shock delivered by the COVID-19 pandemic exposed the vulnerabilities within the compensation framework, necessitating an unconventional borrowing mechanism to bridge the massive revenue shortfall. This episode, while temporarily averting a major fiscal crisis for states, underscored the need for greater clarity and robustness in fiscal contingency plans within the GST framework. These events have also subtly altered the dynamics within the GST Council, moving from an initial phase of consensus-building towards more overt negotiations and occasional disagreements, as states increasingly assert their fiscal interests in the absence of guaranteed compensation. Persistent debates over rate rationalization and the contentious inclusion of high-revenue items like petroleum products and alcohol within the GST ambit continue to highlight the ongoing tension between national harmonization goals and states’ desires to retain fiscal autonomy over key revenue sources.
Ultimately, the trajectory of Centre-State financial relations under GST remains a dynamic and evolving landscape. The system has moved past its initial implementation challenges and the safety net of compensation. The future success of GST as a cornerstone of India’s fiscal architecture hinges on the continued ability of both the Union and State governments to engage in constructive dialogue, foster mutual trust, and adapt to evolving economic realities. Striking a sustainable balance between revenue buoyancy for both tiers of government, ensuring fiscal autonomy for states, and upholding the spirit of cooperative federalism will be paramount for GST to truly realize its full potential in strengthening India’s economy and its federal structure.