States should get GST revenue that Jaitley promised

Former finance minister Arun Jaitley displayed a masterly generosity of spirit and long-term vision in guaranteeing the states revenue growth of 14% per year for five years to clinch a deal on an all-India Goods and Services Tax (GST) to replace hundreds of different central and state taxes. This would improve efficiency, reduce tax evasion and inspector harassment, and accelerate long-term growth.

However, the Covid-induced crash in GDP (down 24% in the first quarter and maybe 10% for the full year) has devastated GST revenue, sparking an angry Centrestate ruckus on sharing the pain. Finance minister Nirmala Sitharaman has offered a one-sided deal that the states have rejected furiously with accusations of betrayal. She should return to Jaitley’s spirit.

The GST deal was rightly hailed as a great reform with long-term benefits. Earlier, GST had been discussed for a decade without fruition. All states would not agree to the reform, since some were potential losers, and many states were reluctant to give up their taxation powers permanently in the hope that GST would yield more in the long run.

Their fears were assuaged only by Jaitley’s generosity. He was willing to make major financial sacrifices to get the states on board. That enabled him to succeed where many predecessors had failed.

Jaitley guaranteed the states an increase in their share of GST revenue of 14% per year for five years till March 2022. He promised that the Centre would make good any shortfall in the guaranteed 14% target. This was generous since even with a real GDP growth of 7% and inflation at the RBI targeted level of 4%, nominal GDP growth could be expected to rise by only 11% per year, and tax revenues at a similar rate. Jaitley’s guaranteed 14% was far greater. It was agreed that new central cesses would be imposed to fund the GST shortfalls to the states for five years.

Jaitley hoped that fast GDP growth would reduce the pains of transition. Alas, growth started dipping steadily after the GST deal was signed. GDP growth declined from 8.2% in 2016-17 to 7%, 6.1% and 4.2% in the next three years. The coronavirus will now send growth crashing to maybe minus 10% this year. That has blown a huge hole in central and state finances.

The central cesses are grossly inadequate to fund the shortfall in the 14% revenue growth promised to the states. There is a doctrine of “force majeure” or “act of God” in commercial contracts that enables a party to escape from a guarantee in the event of a natural disaster for which it is not responsible. In effect, Sitharaman has invoked force majeure to avoid paying the states anything more than collected by the cesses, which in today’s situation are grossly inadequate to meet the 14% guarantee.

Instead, Sitharaman has offered the states two choices to deal with the shortfall. First, the states can borrow Rs 97,000 crore from the Reserve Bank of India via a special window with a low interest rate. According to the Centre, this is the shortfall due to GST implementation.

In addition, there are Covid-induced losses, making a total shortfall of Rs 2.5 lakh crore. Sitharaman’s second option is for the states to borrow this full sum from the markets, at what will undoubtedly be a higher rate of interest.

The states have howled that neither option is acceptable. They say Jaitley’s guarantee means the Centre must compensate the states in full even if the cesses to finance that compensation are not yielding the expected revenue.

The states are right. GST was not a commercial deal between two corporate parties, one of which can invoke force majeure. It was above all a political pact between the Centre and states. Jaitley understood that fully. His successor needs to do so too.

The Centre can simply borrow the additional Rs 2.35 lakh crore from the RBI to compensate the states in full. This will increase the central fiscal deficit by 1.25% of GDP, a substantial sum but not so large as to trigger a credit downgrade by rating agencies, something Sitharaman rightly wants to avoid.

The same approach of full compensation for the states should hold for 2021-22, the last of the five years of Jaitley’s guarantee. This will mean a two-year bulge in central debt. That can be recouped by continuing with the cesses for a few years beyond 2021-22. This is not rocket science.

Ever since the GST deal was signed, the BJP has taken pride in saying it has promoted fiscal federalism. It should live up to that ideal.

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