Only 1.7% of Central Govt Petrol Taxes Shared with States – Where Has Cooperative Federalism Gone?

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Chintan Patel and Vivek Kaul

The devil, as they say, is always in the detail.

Nevertheless, in an era of instant digital journalism, where you, dear reader, are constantly bombarded with information, the real story, or should we say stories, often get buried under numerous headlines, lazy journalism, government press releases and the false news that is the flavour of the day.

But if one is willing to do some basic number-crunching, like we are, some interesting details and narratives can emerge.

This is one such story of the central government taking both the states and the common man, for a ride and that too in broad day light. At the risk of stretching the metaphor a bit too far, the scene of the crime is the petrol pump and the motive, the dire state of the economy.

But to do this story full justice, we need to set up the background with some dry, academic points as well as digress into some adjacent details.

So, kindly bear with us. While sensational things might get you excited and help us get a few more clicks, but as we said at the beginning, the devil is in the detail.

And here’s presenting the detail.

What’s the point?

Over the years, the central government has been sharing less and less of the overall taxes that it collects, with the state governments. This is the main point we make in this piece. 

The annual budget of the central government is presented in February ever year. The budget is analysed by the media in minute detail.

However, amidst all the analyses, one subject that is often ignored is the financial relationship between the central government and the state governments. After all, much of the services that the government provides are in fact delivered by local and state governments.

It is worth remembering that while the central government collects the bulk of the taxes in the country, it’s the states that the taxes ultimately come from. And given that, this money in one way or another needs to go back to the states.

But does it? The short answer is no. And there is a longer answer which explains the reasons, has some nuance and which forms the heart of this piece.

This piece is divided into three sections. The first section provides a background on how tax revenue is transferred from the central government to the state governments and the role of the Finance Commission.

The second section focuses on a special tax category – cess and surcharge, their increased prominence in recent times, and how that raises prices of petrol and diesel.

The third and final section examines the trend of total transfer of funds from the central government to the state governments.

This is an opportune time for such an analysis, since this year’s Union budget was accompanied by the unveiling of the 15th Finance Commission’s report for the period 2021-22 to 2025-26.

So, read on, to find out.  

Who Gets How Much?

The Constitution stipulates how taxes are collected and split between the central government and the state governments. It empowers the central government as well as the state governments to raise revenues from different sources of taxation.

The central government gets to collect more taxes while the state governments end up with the bigger portion of the expenditure, leading to a mismatch. This mismatch of money that is earned through taxes and other routes and money that needs to be spent, is referred to as a “vertical imbalance”.

Take a look at Figure 1. In 2018-19, the Union Government raised 62.7 per cent of the aggregate resources raised by both the Union and states, whereas the states spent 62.4 per cent of the combined aggregate expenditure. While Figure 1 shares data for just one financial year, what’s true for 2018-19 has also been true for other financial years.


Figure 1: Vertical imbalance (2018-19)

           Source: 15th Finance Commission Report. 

To offset this imbalance, the Constitution provides mechanisms for intergovernmental transfers – the transfer of funds from the central government to the state governments. A key player of this setup is the Finance Commission.

The Finance Commission (FC) is an advisory body that is appointed by the President every five years and which evaluates the state of finances of the central as well as the state governments, and determines how taxes collected by the central government are to be distributed between the central government and the state governments, and among the state governments.

Over and above this, the FC also recommends grants to states based on revenue needs, grants for local governments and grants for specific purposes e.g. health sector grants etc. Thus, there are two broad channels of transfer of funds under the FC umbrella – i) devolution of taxes, and ii) grants. 

At the heart of the idea of intergovernmental transfers and tax devolution is the concept of ‘divisible pool’. The divisible pool is the portion of the taxes (technically referred to as the gross tax revenue) collected by the central government, which is distributed between it and the state governments. What this means is that all the taxes collected by the central government aren’t shareable with the state governments.

Till the tenth FC which tabled its report in 1995, only union excise duties and personal income taxes made up the divisible pool. Under this arrangement, 85% of the personal income taxes and 40-45% of excise duties were shared with the state governments.

In 2000, the tenth FC recommended a constitutional amendment to expand the divisible pool to all central taxes. The central government accepted this recommendation and the 80th Amendment was passed making a certain portion of  central government taxes shareable with the state governments, effective retrospectively from April 1, 1996.

Further, the portion of the divisible pool that is shared with the states is referred to as the devolution of taxes and is determined by the FC. Before the14th FC which came into effect from April 2015, 32% of the divisible pool was shared with the states.

The 14th FC increased the share of the state governments in the divisible pool to 42%. At the same time, the sector-specific grants were eliminated. This decision was primarily in response to grievances expressed by the state governments. State governments prefer funding through devolution since such transfers are unconditional.

Other transfers of money, whether they are through FC grants, or through channels outside the FC (like schemes from central government ministries) impose policy priorities set by the central government over the state governments, compromising the latter’s fiscal flexibility or the ability to spend money as the state government deems fit.

To give an example, a FC health-sector grant can only be used for health spending by the states, or funds transferred to the states under Pradhan Mantri Gram Sadak Yojana can only be used to make roads.

When state governments have more flexibility in allocating funds for various initiatives, they can craft policy that is more responsive to the needs on the ground than having to blindly follow policy that is framed in New Delhi.

The 14th FC recognised this and increased the state share of the divisible pool from 32% to 42%. The intent behind this increase was not to increase the amount of transfers but rather change the composition of the transfers – from diverting conditional funds to diverting unconditional funds, to state governments.

The 15th FC tabled in 2021 lowered the divisible pool marginally to 41%, from the earlier 42%. The is because Jammu and Kashmir is no longer a state and the money allocated to it has not been counted as transfer to a state government. Given this, the 15th FC has kept the divisible pool distribution unchanged.  

And now we come to the most important point of this write up. A key detail in this entire discussion is that the only tax revenue that is excluded from the shared divisible pool are different kinds of surcharges and cess.

As we shall see next, this exclusion has proved to be the back door that the central government has been using to divert funds from the states governments’ kitty to its own.

A Tale of Two Taxes

Before we get into the details, let’s first try and understand what surcharge and cess actually are.

A cess is tax on a tax imposed by the central government attached to a specific purpose. For example, an education cess collected should be utilised only for financing education and not for any other purpose. It is worth remembering here that the education cess is imposed on the total income tax and not on the total taxable income.

Hence, as explained earlier, it is a tax on a tax. Examples include infrastructure cess on petrol and diesel, krishi kalyan cess, health and education cess on Income Tax, etc.

In theory, money collected under a cess is to be spent on the specific purpose for which it is collected but that’s not always the case.

A Comptroller and Auditor General (CAG) report for 2018-19 indicates that only Rs 1.64 lakh crore of the Rs 2.74 lakh crore or around 60% of the amount collected from cess and surcharge during 2018-19 had been transferred to their respective funds. Around 40% was still retained in the Consolidated Fund of India, which is the general-purpose fund of the Indian government.

The provision of levying a cess was intended to be used for shorter specific purposes. So, the procedure for introducing a cess is comparatively simpler than introducing new taxes, which usually require change in the law.

Coming to surcharges, a surcharge is also a tax on a tax, but is not tied to a specific purpose like a cess is. Let’s take the example of the surcharge on income tax. It is an added tax on the taxpayers having a higher taxable income during a particular financial year. So, an individual having a taxable income  between Rs 50 Lakhs and Rs 1 crore pays an income tax surcharge of 10%.

Further, an individual with a taxable income between Rs 1 crore and Rs 2 crore, pays an income tax surcharge of 15%, and so on.

Note that this surcharge is only on the base income tax, not on the income itself. So, if an individual earning Rs 1 crore in a year needs to pay an income tax of Rs 20 lakhs, the applicable surcharge would be Rs 2 lakhs (10% of 20 lakhs).

A surcharge can be utilised for any purpose of the government, without having to bend the rules, like they do sometimes for cess collections.

In the last few years, these surcharges and cess, which do not need to be shared with the state governments, have become the central government’s go-to tools to address the tax revenue shortfall.

Take a look at Figure 2a, which basically plots the total amount of surcharges and cess collected by the central government over the years, along with the surcharge and cess it hopes to collect during 2021-22, the current financial year.

Figure 2a: Total cess and surcharge revenue (in Rs crore).

Source: Union budget documents.  

Figure 2a clearly shows that the general trend is upwards, with small blips in 2017-18 and 2018-19. The government expects to collect total surcharges and cess of Rs 4,45,822 crore (revised estimate) in 2020-21.

This is surprising given that overall tax collection during the year is expected to come down. In comparison to the years before 2020-21, the collections for 2021-22 are also expected to be at a very high Rs 4,48,821 crore.

The collections of cess and surcharge surged from Rs 2,53,540 crore in 2019-20 to Rs 4,48,822 crore (RE) in 2020-21, an increase of a whopping 77%. This huge increase is almost entirely due to increased cess and surcharge on petrol and diesel – in particular, the road and infrastructure cess and the additional duty of excise on motor spirit (which is a surcharge), which increased by Rs 1,92,792 crore. Motor spirit is the technical term for petrol.

The increased reliance on cess and surcharge is also seen in Figure 2b below, which plots the total cess and surcharge earned by the central government as a proportion of the Indian gross domestic product (GDP). This is done in order to take the size of the Indian economy into account as well.

Figure 2b: Cess and surcharge revenue expressed
as a proportion of the GDP (in %).

Source: Union budget documents.

The above figure makes for very interesting reading. The total amount of cess and surcharges earned by the central government went up from 1.25% of the GDP in 2019-20 to 2.29% of the GDP in 2020-21, a massive jump of 104 basis points. Some of this jump was obviously because the size of the economy or the GDP is expected to contract in 2020-21. Nevertheless, the fact that cess and surcharges collected by the government went up in a year when the economy contracted, does come as a surprise.

In Figure 3, let us look at the breakdown between cess and surcharges earned by the central government over the years. Looking at the below figure it is evident that cess collections form the bulk of the total revenue.

Figure 3: Cess and surcharge breakdown (in Rs crore).

Source: Union budget documents.

Clearly, cess is bringing in more money for the central government, though the contribution of surcharges has also jumped up since 2019-20.

Now let’s try and understand, why has the central government increasingly become more dependent on earning money through cess and surcharges, and in the process it is sharing lesser proportion of taxes with the state governments.

This increased reliance on cess and surcharges in the last two years can be understood when one looks at what is happening with the total tax revenue. Figure 4 plots the total taxes earned by the central government or gross tax revenue as a proportion of the GDP.

Figure 4: Gross tax revenue as a proportion of GDP (in %).

Source: Union budget documents 

While the negative economic impact of the covid pandemic has been a telling blow, the downward trajectory in tax collections of the central government had started as far as back as 2018-19. The twin economic debacles of PM Modi’s first term – demonetisation and a shaky GST implementation – meant the economy was already tottering before the covid pandemic hit.

An obvious casualty of this slowdown has been a declining tax revenue as a proportion of the GDP. In the normal scheme of things, this would have meant that the central government would have ended up with lesser taxes for itself, after sharing with the state governments.

But this fall has been cushioned with the central government earning a higher amount of taxes through cess and surcharges (as can be seen from Figure 5).

Figure 5: Cess and surcharge as a proportion of total central government taxes. 

Source: Union budget Documents
RE = Revised Estimate
BE = Budget Estimate

 In 2019-20, the total taxes earned by the government or the gross tax revenue had stood at Rs 20.1 lakh crore. In 2020-21, it is expected to fall by 5.5% to Rs 19 lakh crore. The net tax revenue of the central government (what remains after sharing taxes with the state governments) in 2019-20 was at Rs 13.59 lakh core.

This is expected to fall to Rs 13.45 lakh crore in 2020-21, a fall of 0.9%, which is much lower than the 5.5% fall in gross tax revenue. While, the total gross tax revenue is expected to fall by Rs 1.1 lakh crore (Rs 20.1 lakh crore minus Rs 19 lakh crore), the net tax revenue is expected to fall by just Rs 14,000 crore (Rs 13.59 lakh crore minus Rs 13.45 lakh crore). 

In percentage terms, in 2019-20, the central government kept 67.6% of the taxes for itself in 2019-20. This shot up to 70.8% in 2020-21. 

Clearly, the state governments have been short-changed here, with their share of taxes falling from Rs 6.51 lakh crore in 2019-20 to Rs 5.5 lakh crore in 2020-21, a fall of a little over Rs 1 lakh crore or 15.5%, in such economically difficult times.

This is primarily because the share of cess and surcharge in total taxes collected by the central government has jumped from 12.67% in 2019-20 to 23.46% in 2020-21. Do remember that cess and surcharges are outside the divisible pool.

So, when the inflow of these taxes increases, the central government gets to keep all the revenue, as opposed to sharing 41% (15th FC guideline) with the state governments. So, it is far more efficient for the central government to increase cess and surcharge when it needs to increase tax collection. 

This overuse of cess and surcharges by the central government has not gone unnoticed. In fact, the chairman of the 15th FC, NK Singh has talked about introducing a constitutional amendment to include them in the divisible pool.

As he said

“I see no viable solution except a constitutional amendment. If that constitutional amendment is introduced, recognizing some proportion of cess and surcharge to the divisible pool, it will certainly allow greater flexibility to the successive Finance Commissions subsequently to be able to calibrate a framework.”

Ultimately, as we said at the very beginning, whatever might be the term used, a tax, or a cess or a surcharge for that matter, it is being paid by people. And hence, the money thus collected should be shared with the state governments.

How does all this affect you, dear reader?

If you have managed to make it thus far, many of you by now would be like how much gyan are these guys going to give. Why can’t they tell me straightaway how does all this impact me or the world at large or the aam aadmi?

Well, sometimes it is important to take a look at the bigger picture first and then arrive at how it impacts all of us.

The government’s increased reliance primarily on cess actually has had a direct impact on most citizens – in the form of increased prices at the petrol pump.

The biggest contributor to the spike in cess collection over the last two years has been cess collected on the sale of petroleum products. The figure below charts the total cess collected on petroleum products (crude oil, petrol and diesel) over the last five years. While the cess on petrol formed at least 50% of total cess each year, it was as high as 69% of the total cess revenue in financial years 2019-20 and 2020-21. 

Figure 6 clearly shows that the government has resorted to taxing petrol and diesel to make up for revenue shortfalls. This conclusion is hardly a revelation to anyone paying attention to prices at the pump, but the numbers help understand the government’s motivation.

Figure 6: Total cess on petroleum products (in Rs crore).

Source: Union budget documents

There is another way of looking at the cess on petrol and diesel. Table 1 below gives a breakdown of the union taxes on petrol and diesel for 2020-21 and 2021-22. Note that the table below only analyses central excise tax and excludes customs duty. There are technical complications in figuring out the per litre customs duty.  

Table 1: Central government tax breakdown on petrol and diesel.

Source: https://www.ppac.gov.in/content/149_1_PricesPetroleum.aspx

 

The total union excise duty on petrol and diesel, in 2021-22 are Rs 32.90 per litre and Rs 31.80 per litre, respectively, which are marginally lower than the previous year. All taxes other than basic excise duty, including special additional excise duty, which is a surcharge, are exempt from the divisible pool.  

1) For 2021-22, only ~5% of the excise taxes on petrol and diesel will go to the divisible pool. The rest (~95%) will be kept by the central government. In 2020-21, this portion was at around 91% for petrol and 85% for diesel. Clearly, the government is keeping a greater share of petrol and diesel taxes for itself.

2) The above point does not clearly bring out the gravity of the situation. Let’s do a simple calculation to show that. In 2021-22, the total excise duty on petrol stands at Rs 32.90 per litre. Of this, the basic excise duty of Rs 1.4 per litre is the only part which is a part of the divisible pool and hence, will be shared with the states. It is worth remembering only 41% of this or around 57 paisa per litre needs to be shared with the state governments.

What this means is that just 1.7% of the total excise duty earned by the central government per litre of petrol will be shared with the state governments. It was at 3.8% in 2020-21.

3) Now let’s carry out the same exercise for diesel. The total excise duty earned by the central government on the sale of one litre of diesel will be Rs 31.80 during 2021-22. Of this only Rs 1.8 per litre will be shareable with state governments. 41% of this amounts to around 74 paisa per litre.

This amounts to around 2.3% of the total excise duty of Rs 31.8 per litre earned by the central government per litre of diesel. It was at 6.4% in 2020-21.

4) In 2021-22, a new agriculture infra cess has been introduced. It amounts to Rs 2.5 per litre on petrol and Rs 4 per litre on diesel. This has led to the reduction of basic excise duty on petrol from Rs 2.98 per litre to Rs 1.4 per litre and that on diesel from Rs 4.83 per litre to Rs 1.8 litre. As mentioned earlier, only the basic excise duty needs to be shared with the state governments.

Hence, by introducing a new agriculture infra cess, the central government has ensured that state governments get an even lower share of taxes from petrol and diesel in 2021-22.

The general public is quite sensitive to price rise at the petrol pump since it is a highly visible and recurrent cost. That the government has still resorted to this strategy for increasing revenue, speaks to the lack of better options – a fact that is a direct consequence of the tepid economic scenario even before the pandemic began. Of course, the covid pandemic has only made things more difficult for the government on tax front.

Nonetheless, things are even more difficult for state governments, which don’t have many avenues to raise tax. Clearly, this amounts to the centre shortchanging the state governments during difficult economic times.

Oh wait, there is more – Total intergovernmental transfers

Other than the divisible pool of taxes, there are other channels of intergovernmental transfers between the central government and the state governments. So, to get the complete picture on the flow of money from the central government to the state governments, it is instructive to examine the total intergovernmental funds transferred in more detail.

Before diving into those details, a brief overview of intergovernmental transfers would be useful. Figure 7 below is a good graphical representation of all the ways in which the central government can transfer funds to the state governments.

Figure 7:  Vertical fiscal transfer channels. 

Source : Asian Development Bank

Broadly speaking there are two instruments of fund transfers.

1) Finance Commission funds: As discussed earlier, this includes the 41% of the divisible pool revenue, general-purpose grants for states with weak revenue raising capacity and specific purpose grants for funding local governments (panchayats and municipalities) and funding certain specific initiatives (eg. health-sector grants by the 15th FC). Most of the funds provided via the FC channel are not conditional and don’t require state government contributions.

2) Funds from central ministries: In addition to the FC funds, the central government also gives specific purpose grants through the respective ministries. These funds are transferred either through centrally sponsored schemes or central sector schemes. Central sector schemes are entirely funded by the central government. Some examples include the free LPG connections provided to poor households, crop insurance scheme etc.

The centrally sponsored schemes require a matching component from the state governments i.e. they have to fund a portion of the scheme. Examples of this include the Pradhan Mantri Gram Sadak Yojana, the Swachh Bharat Mission etc.

As Figure 7 shows, the mechanism of intergovernmental transfer underwent a major transformation in 2015. Two things led to this. Firstly, the 14th FC gave its recommendations for increasing the devolution share of state governments from 32% to 42% and eliminating a host of specific purpose grants. The underlying rationale was to change the composition of state transfers to increase the “no-strings-attached” outlays and reduce conditional grants to give state governments more financial headroom.

Secondly, the newly elected NDA government disbanded the Planning Commission and replaced it with the NITI Aayog. While the NITI Aayog has some shades of resemblance with the Planning Commission, the five-year plans, which was the responsibility of the Planning Commission, were scrapped.

The five-year plans would have their own grants for states in the annual budget of the central government. The establishment of the NITI Aayog and the approval of the 14th FC recommendations were two initiatives that formed the basis the oft-cited “cooperative federalism” mantra of the NDA government, especially in the early years.

The argument put forth to claim this catchphrase was that the Modi-led administration was reversing the centralising tendencies of earlier governments and ushering in an environment where states had greater fiscal autonomy.

Does the data corroborate these claims? Let us examine. Figure 8 below charts the tax devolution to states as a portion of the gross tax revenue.

Figure 8: Tax Devolution vs Gross Tax Revenue (in %).

Source: Union budget documents

  

Some interesting observations can be made from Figure 8.

1) The first few years after the 14th FC came to effect (April 2015) saw a significant increase in the portion of taxes devolved to the states.

2) This increasing trend of devolution peaked in 2018-19 when the devolution was 36.6%. The last three years have seen this number come down, with the 2020-21 figure (~29%) close to the pre-2015 levels. So, all the talk about cooperative federalism has gone for a toss, in the last few years.

3) Note that these numbers don’t reflect the 32% (pre-2015) or 42% (post-2015) devolution share prescribed by the FC since cess and surcharge revenue is not devolved. This also explains why the devolution percentage has dipped sharply in the last two years, a period when cess revenue has had a corresponding increase (as shown earlier in Figure 5).

While the 14th FC may have been the catalyst, the Modi government can rightfully claim credit for strengthening fiscal federalism, at least in its first term. However, most of these gains have been reversed in their second term. This justifies N.K Singh’s lament

“ It should not be a cat and mouse game that every finance commission raises the devolution number and it then neutralised simultaneously by an increase in cess and surcharge leaving the states where they were, nor the opposite way.”

Next, in Figure 9, let us look at the total transfers made to state governments in recent years, not just tax devolution. The total transfers to states includes tax devolution, finance commission grants, centrally sponsored schemes, central sector schemes and other miscellaneous items listed as state transfers in the union budget.

The figure below charts the total transfers made to states as a percent of the total expenditure of the Union government.

Figure 9: Portion of total expenditure of central government
transferred to state governments (in %).

Source: Union budget documents

 There are two caveats on the chart above.

1) Starting 2014-15 there was a change in how expenditure for central schemes was routed to the states. The figures for 2013-14 have been adjusted to make the comparisons with the subsequent years correctly.

2) We have excluded loans made to states from the total transfer amounts and only included grants and devolution, since loans do need to be repaid.

That said, these figures also lead to similar observations made from Figure 8. The period from 2015-16 to 2018-19 (roughly co-incident with NDA’s first term) had a significant increase in funding to the state governments.

While the increased devolution of taxes could be attributed to the recommendations of the 14th FC, the increase in total transfer of funds was certainly government policy. The last two years (and the projections for the next year) show a steep decline in the intergovernmental transfers.  
The huge spike in cess and surcharge collections which are not shared with states and declining tax revenues during this period contributed to this effect.

There are two other conjectures one can make based on the trends seen above. First, when Narendra Modi won in May 2014, he was a sitting chief minister and his perspective on governance was heavily biased towards the challenges of governing a state.

Hence, financial outlays were perhaps favourable to the states. In the second term, he was well-entrenched as a national leader and the instincts were now honed favouring centralisation.

Second, the Bhartiya Janata Party has adopted an increasingly overt approach favouring homogenisation of the country. Whether it is the abrogation of Article 370, the passage of national farm laws, or flirtations with one-nation-one-language, it is evident that impulse is towards uniformity and centralisation. In this context, the trend of holding back funds from states, seems a natural accompaniment. 

Explained: Why Central Govt Needs to Compensate States for Collapse in GST Collections

Summary: I went looking for the legal reasons being offered by the central government to not compensate the state governments for the dramatic fall in GST collections. I found a central government paper explaining the logic with a lot of legalese. This piece tries to summarise the legalese in simple English. Along with that, I offer many reasons as to why the central government needs to adequately compensate the states. This is definitely not something you will read in the mainstream media.

As has been reported almost everywhere by now, the central government doesn’t want to compensate the state governments for a shortfall in goods and services tax (GST) collections that is going to happen through this year.

In an earlier piece I had explained why this was a bad decision. In today’s piece we will try and understand the central government’s reasoning behind this decision, at the same time we shall also see why the central government is in a much better position to deal with the situation than states are.

The Story So Far

The GST collections between April and June this year have been around 34.5% lower at Rs 2.73 lakh crore than during the same period in July 2019. As the economy contracts in the aftermath of covid-19, the collections will continue to remain subdued during the remaining part of the year.

The central government needs to share a significant part of the GST with the state governments. Over and above this, there is also a guarantee of 14% growth in GST collections for states for the first five years until 2022. If this is not achieved, the central government needs to compensate the state governments for any shortfall.  The central government has decided not to do so.

The Legalese

This public paper explains the central government’s position on the issue. Let’s see why the government is saying what it is saying.

The Constitution (101st Amendment) Act 2016 contains the following provision:

“Parliament shall, by law, on the recommendation of the Goods and Services Tax Council, provide for compensation to the States for loss of revenue arising on account of implementation of the goods and services tax [emphasis added] for a period of five years.”

Following the above provision, the Parliament enacted the Goods and Services Tax (Compensation to States) Act 2017. The preamble of this Act reads as follows:

“An Act to provide for compensation to the States for the loss of revenue arising on account of implementation of the goods and services tax [emphasis added] in pursuance of the provisions of the Constitution (One Hundred and First Amendment) Act.”

In fact, the emphasised parts (in bold italics) in both the 101st amendment as well as the Goods and Services Tax (Compensation to States) Act 2017, read exactly the same. What does this mean in simple English? It means that state governments will be provided a compensation if there is a loss of revenue on account of problems with the implementation of GST (of course, there have been problems galore, but let’s not go there now).

Hence, the central government could have used this technicality in denying the state governments any compensation for a fall in GST collections.

As the policy paper referred to earlier points out: “The Constitution and the preamble to the Act lay out the spirit and purpose of the GST compensation: namely that it is to compensate states for loss of revenue “arising on account of implementation of GST”. The wording of the Constitution and statutory preamble make it clear that the spirit of the law is not to compensate states for all types of revenue losses, but rather for that loss arising from GST implementation.” Ultimately, the GST collections in 2020-21 will fall majorly because of the negative economic impact of the covid-19 pandemic and not just because of the loss of revenue thanks to the botched up implementation of the GST by the central government.

The interesting thing is that the government hasn’t used the above explanation to deny compensating the states for the GST shortfall. It has gone deeper into the legalese to deny the states a compensation.

But before we get into that, the central government has this to say about the GST shortfall: “Parliament obviously could not have contemplated a historically unprecedented situation of huge losses of revenue [thanks to the spread of covid-19] from the base—arising from an Act of God [emphasis added] quite independently of GST implementation—affecting both Central and State revenues, direct and indirect.”

This is where the act of god phrase came into being, also telling us that the government doesn’t do or say anything without putting it on kagaz [paper] first.

Now let’s get back to why the government has denied compensating the states for the GST shortfall. The Section 7 of the the Goods and Services Tax (Compensation to States) Act 2017, provides the detailed mechanism for the calculation as well as the payment of compensation to the state governments when there is a shortfall.

Nevertheless, Section 7 doesn’t make any distinction between the shortfall in GST collections happening due to implementations reasons and non-implementation reasons. As the government paper points out: “Compensation is payable for the entire shortfall (even if it is not on account of GST implementation). This position has been clarified by the Attorney General and is accepted by the Central Government [emphasis in the original].”

So, if this interpretation has been accepted by the central government, why isn’t it compensating the state governments? If your head is already spinning by now, I don’t blame you for it. The legalese behind which the central government is hiding keeps getting better. Let’s move ahead.

The Section 10 of the Goods and Services Tax (Compensation to States) Act 2017 prescribes the manner of payment of the compensation to state governments in case of a shortfall. Let’s look at this pointwise.

1) The compensation is to be paid out of the non-lapsable GST Compensation Fund.

2) Money flows into the GST Compensation Fund from the GST Compensation Cess levied on sin and luxury goods under Section 8, which includes everything from cigarettes to expensive cars. This is made clear under Section 10(1).

3) Section 10(1) also makes it clear that money can flow into the GST Compensation Fund through “such other amounts as may be recommended by the Council”. Hence, other than the GST Compensation Cess only something cleared by the Council can flow into the GST Compensation Fund.

4) Section 10(2) says that compensation under Section 7 “shall be paid out of the Fund”.

Basically, what the government is saying here is that any compensation to state governments on account of a loss of revenue needs to be paid out of the GST Compensation Fund.

So, the government summarises its position by saying: “The states are entitled to compensation…regardless of the cause of the shortfall. However, compensation is to be paid only from the Compensation Fund and it is not an obligation of the Government of India in the event of a shortfall. It is for the GST Council to decide on the mode of making good the shortfall.”

Of course, with the GST collections falling, the compensation cess will not be enough to make up for the shortfall. Also, what the central government is saying is that the GST Council is a different entity from it. This is the point being made on the basis of some complicated legalese. And this rather complicated legalese has been used to basically shaft, for the lack of a better word, the state governments. The central government paper also talks about the spirit of the law.

As far as the act of god point goes, if a fall in GST collections due to covid-19 is act of god for the central government, it is also an act of god for the state governments as well. What are they expected to do in such a scenario?

And given that, the law needs to be changed, simply because the facts have changed and the situation that has arisen currently wasn’t taken into account when the law was first framed. If every law was perfect as it was written first time around, there wouldn’t be so many amendments going around. As the famous British economist, John Maynard Keynes, once supposedly said: “When the facts changeI change my mind. What do you do, sir?

The Central Government Needs to Compensate

The central government needs to compensate the state governments for this shortfall in GST collections. The state governments are at the forefront of fighting the pandemic and hence, need money. Also, state governments spend more money than the central government during the course of any year and that needs to be kept in mind as well, in a scenario, where the private expenditure has collapsed dramatically post covid.

Also, as the government paper points out: “The notion of borrowing by the GST Council is not practically or legally feasible or desirable. This leaves the options of Central or state borrowing.” Let’s look at what the central government is offering the states as a compensation.

1) The shortfall arising out of the loss of revenue due to the GST implementation has been estimated by the central government to be at Rs 97,000 crore. The state governments can borrow this money under a special window coordinated by the finance ministry. The states can repay both principal and interest by using the money they receive from the compensation cess. Also, this borrowing shall not be treated as debt. Hence, it will not limit any state’s overall borrowing ability.

2) The overall shortfall (thanks to implementation and covid impact) in GST collections has been estimated to be at Rs 2.35 lakh crore. The state governments can borrow this entire amount from the market. An amount of Rs 1.38 lakh crore (Rs 2.35 lakh crore minus Rs 97,000 crore) will be considered to be as debt of the state governments. The state governments will have to repay this debt from their own resources. They can repay the principle from the compensation cess.

The government’s logic in getting states to borrow directly from the market is rather bizarre. Nevertheless, let’s take a look at this.

This is what the government paper says: “The Government of India faces a very large borrowing requirement this year. Additional borrowing by the Centre influences the yields on Central government securities (g-secs) and has other macro-economic repercussions. The yield on G-secs acts as a benchmark for State borrowing as well as private sector borrowing. Hence any rise in Central borrowing costs ipso facto drives up borrowing costs for all borrowers, including not only the States but also the entire private sector. On the other hand, the yields on State Government securities do not directly influence other yields and do not have the same type of macroeconomic repercussions.”

What does this mean in simple English (now how many times will I end up saying this)? The central government will end up borrowing more this year than in other years. In this scenario, it will end up needing a greater amount of financial savings to fund itself. This will push up interest rates at which the central government borrows. When the rate of interest at which the central government borrows goes up, the rate of interest for the entire financial system goes up because lending to the central government is the safest form of lending. When this happens, both the private sector as well as the state governments will end up paying higher interest rates on the money they borrow.

The central government’s contention is that the above logic does not apply to when state governments borrow. Their borrowing doesn’t end up pushing overall interest rates.

This is bizarre to say the least. If the state government borrows more from the same pool of savings, it will end up pushing the overall interest rates in the financial system, upwards.

The question is why doesn’t the central government want to borrow more. The government originally expected to borrow Rs 7.8 lakh crore to finance its fiscal deficit in 2020-21. Fiscal deficit is the difference between what a government earns and what it spends. This has already been increased by more than 50% to Rs 12 lakh crore. Any further borrowing will mean, the central government’s already terrible numbers on the fiscal front, will end up looking even more terrible.

I guess that is the logic running in the minds of the babus at the finance ministry and their minister. The trouble is this logic doesn’t hold. Irrespective who borrows, the state governments or the central government, the public debt or the overall debt of the public sector, will go up. Further, there is an implicit sovereign guarantee on state government debt.

As Shaktikanta Das, the governor of the RBI said in November 2019: “There is an implicit sovereign guarantee in them… On the due date of repayment, RBI automatically debits the state government account and makes the repayment. So, there is an implicit sovereign guarantee.” Hence, ultimately, if there is any trouble on this front, it is the central government’s problem.

Further, the central government is in a much better position to raise money. It can sell its stakes in public sector enterprises. It can also sell their land. It has access to a variety of cesses (tax on tax) from which it can earn money. This is money it doesn’t need to share with state governments. It also has access to the profit made by the Reserve Bank of India, as well as its reserves. The ability of the state governments to tax post GST has come down.

Also, various central government institutions (from banks to insurance companies) end up buying bonds issued by the state governments. In that sense the interest on these bonds gets paid to them. The profits made by these institutions end up with the central government, one way or another (corporate income tax/dividends/special dividends etc.).

Hence, there are many reasons as to why the central government should compensate the state governments for a fall in GST collections. But the biggest reason as the deputy chief minister of Bihar, Sushil Modi told the the Press Trust of India: “It is the commitment of the central government to compensate the states for the shortfall in GST collections. It’s true that it is legally not binding on the Centre, but morally, it is.”

Modi belongs to the BJP.

India’s MIDNIGHT TRYST with GST is Turning into a Priyadarshan Comedy

Summary: 

There must be some kind of way outta here
Said the joker to the thief
There’s too much confusion
I can’t get no relief.

— Bob Dylan, All Along the Watchtower.

 

India’s midnight tryst with the Goods and Services Tax (GST) is a little over three years old and is looking more and more like a bad joke which, we brought upon ourselves.

The state of GST takes me back to the last thirty minutes of several Priyadarshan comedies, where everyone is running after everyone else and no one knows what is really happening. (Actually, it can also compared to the ending of the wonderful comedy Andaz Apna Apna).

In reel life, all this confusion has the audience in splits. In real life, those going through the experience feel like they are a part of surreal black comedy.

Yesterday, the finance minister Nirmala Sitharaman said that the covid-19 pandemic was an act of god and that would impact GST collections negatively. An act of god is essentially a natural hazard which is beyond human control, something like an earthquake or a tsunami for that matter. No one can be held responsible for it.

The act of god has led to a situation where the GST collections have nose-dived. This is hardly surprising given that private-consumption has come down over the last few months. Also, by characterising the fall as an act of god, the central government doesn’t want to be held responsible for the fall in GST collections.

Nevertheless, it needs to be said here that GST collections weren’t doing well even before covid-19 struck. Let’s take a look at the growth/fall in GST collections between August 2018 and February 2020, before the covid pandemic struck.

All is well?

   
Source: Centre for Monitoring Indian Economy.

The above chart clearly shows that the growth in GST collections had been falling since early 2019 though it did recover a little since late last year, before stabilizing at half of the peak growth. In November 2018, the growth in GST collections was 16.5%. In February 2020, it was at 8.3%.

The point here being that the growth in GST collections had slowed down since early 2019. It picked up again in late 2019, thanks to a cap on the input tax credit that certain businesses could take. Festival season sales also helped.

This slower growth in GST collections was a reflection of a broader economic slowdown, for which the botched up implementation of GST was also hugely responsible. Of course, the spread of the covid pandemic has only made the situation much worse, with GST collections falling between March and July.

In a normal scenario, a fall in tax collections would mean lower expenditure by the government. But the situation that prevails is nowhere near normal. With private consumption falling, the governments (states and central) are expected to continue spending money, in order to keep the economy going.  Also, state governments are at the forefront of fighting the epidemic and they need money to do that.

The GST collections are split between the central government and the state governments. One of the carrots that the central government had offered to the states in a bid to make GST acceptable and to hasten India’s midnight tryst with GST, was a promise of a compensation if the GST revenues did not grow by 14% from one year to the next. The GST(Compensation to States) Act, guarantees state governments a revenue protection of 14% for the first five years of GST.

Of course, it doesn’t take rocket science to understand that GST revenues will contract in 2020-21, the current financial year. Hence, as per the GST(Compensation to States) Act, state governments need to paid a compensation by the central government.
As per the law, a compensation needs to be paid to state governments every two months. In fact, the compensation due to states for the period April to July 2020, stands at Rs 1.5 lakh crore.

This money comes from the compensation cess which is levied on both sin and luxury goods. The trouble is that like the overall GST collections, the growth in collections of the compensation cess had been falling through most of 2019. This can be seen in the following chart.

To sin or not to sin?


Source: Centre for Monitoring Indian Economy.

In June 2020 and July 2020, the collections of compensation cess fell by 9.4% and 15%, respectively. It needs to be said that even during an economic slowdown or a contraction, the consumption of sin and luxury goods does not fall at the same pace as the overall consumption. But despite that, the compensation cess collected in 2020-21 will not be enough to pay state governments to ensure a 14% growth in overall GST earned.

The shortfall in GST collections as per the central government is expected to be at Rs 2.35 lakh crore. It has said that this shortfall cannot be paid for through the consolidated fund of India, which is a repository for all the money earned by the central government through taxes as well as the money it borrows.

Basically, the central government after promising a 14% growth protection to states on GST, has come back and told them, hey, now that we are in trouble, you are on your own. It reminds me of an old line in buses in North India, sawari apne samaan ke khud zimmedar hai (the travellers are responsible for what they are carrying). The joke, the way the drivers of these buses drove, was, sawari apni jaan ke bhi khud zimmedar hai (the passengers are also responsible for their lives). This is the kind of joke that the central government has just cracked on state governments. This is black humour of the finest kind, which you won’t even see in an Anurag Kashyap movie.

In order to fulfil the gap, the options offered to the state governments by the central government are: 1) To borrow Rs 97,000 crore at a reasonable rate of interest from a special window at the Reserve Bank of India. The Rs 97,000 crore number is an estimate of GST loss due to implementation issues. 2) To borrow the entire gap of Rs 2.35 lakh crore. These options are only for 2020-21. The states can repay the money in the years to come by using the GST compensation cess they receive in the years to come.

This leads to a few points:

1) The central government basically sold the state governments a dummy in promising a 14% growth in GST collections. A narrative was created, it was marketed and then the constituents of the narrative were abandoned.

2) The state governments were also responsible for this to some extent given their resistance to the original law. Also, the central government was in a hurry to ensure India’s midnight tryst with GST, in order to create a narrative.

3) It is easier for the central government to borrow than for the states to do so. It seems here that the central government doesn’t want to spoil its fiscal deficit number any further than it already will this year. Fiscal deficit is the difference between what a government earns and what it spends.

Nevertheless, whatever be the case, the total government borrowing (centre + states) is bound to go up. So, I really can’t understand what is the fuss around the central government borrowing more. Also, with the GST in place, the ability of state governments to tax more is rather limited. Their main taxes on alcohol, real estate, petroleum products and vehicles, have already taken a huge beating this year.

4) It will be interesting to see the legal logic being used by the central government to take this stance. From what I understand, the GST Council and the central government are being considered separate entities (Maybe some lawyer can explain this in simple English).

5) If the state governments borrow from the market, how is it going to impact bond yields?

6) Also, the compensation cess on luxury and sin goods, will now have to be extended beyond 2022 and this will not go down well with businesses, which are already struggling.

7) There is bound to be in increase in compensation cess on some luxury and sin goods during this financial year. That remains the easiest way for the government to increase tax revenues. Also, I sincerely hope the GST Council doesn’t start increasing tax rates on normal goods in a bid to shore up revenues (Governments and government bodies have a tendency to do that).

Of course, the move hasn’t gone down well with state governments. Sushil Modi, the deputy chief minister of Bihar told this to the Press Trust of India, even before the GST Council meet: “It is the commitment of the central government to compensate the states for the shortfall in GST collections. It’s true that it is legally not binding on the Centre, but morally, it is.” Modi belongs to the BJP.

West Bengal finance minister Amit Mitra said: “The question is who should borrow. The Centre… can get a better rate and has more debt servicing capacity.” The finance minister of Delhi, Manish Sisodia, accused the Centre of “betraying” federalism by “refusing” to pay GST compensation to states.

As stated earlier, these options are only for 2020-21. What happens next year? With covid-19 pandemic continuing, the negative economic impact of this might be felt next year as well. The states have a week’s time to get back to the GST Council.

Of course, until then and even beyond, all the confusion will prevail. As I said, the entire scenario now looks like the last thirty minutes of a Priyadarshan movie, where everyone is going after everyone else, and no one knows what is actually happening. The irony is that this is in real life and not something to laugh at. But then when a government talks about an act of god to wriggle out of something that it clearly promised to many other governments, what else can one do anyway but laugh in pain.

There’s has got to be some difference between the government of the world’s largest democracy and an insurance company?

 

Will damages of the 7th Pay Commission be as bad as the Sixth?

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This is the third time this week I am writing a column around the Seventh Pay Commission recommendations. In this column I would like to address the total financial impact of the recommendations of the Seventh Pay Commission.

As I have mentioned in the earlier columns, the Commission has recommended an overall increase of 23.6% in the salary of the central government employees and the pensions of those who have retired from central government jobs. This is likely to cost the government Rs 1,02,100 crore in 2016-2017, the Commission has estimated.

The report estimates that this increase will work out to 0.65% of the gross domestic product (GDP) in 2016-2017.  In comparison, the awards of the Sixth Pay Commission had worked out to 0.77% of the GDP.

The question is how much will it impact the finances of the central government, if the recommendations where to be accepted. First and foremost Pay Commission recommendations are usually accepted. And there is no reason that they won’t be accepted this time around as well.

Further, it is very difficult to estimate by exactly how much the government finances will be affected , given that there is no way of figuring out what the budget makers of the government are thinking. Nevertheless, it is safe to say that the government will have to figure out a way of either increasing its earnings or cutting down on its expenditure, in order to be able to finance this expenditure (as we saw in yesterday’s edition of The Daily Reckoning).

If we look at the budget numbers between 2005-2006 and 2015-2016, the government expenditure has gone up at the rate of 13.4% per year. The government receipts (i.e. the tax and the non-tax revenue of the government less its borrowings) have gone up at the rate of 13% per year. The government expenditure has been going up on a larger base at a faster rate.

Of the extra Rs 1,02,100 crore the government will have to spend, Rs 73,650 crore will have to be borne on the general budget and the remaining on the railway budget. Assuming that the trend of the last ten years will continue in 2016-2017, with an extra expenditure of Rs 73,650 crore, the fiscal deficit of the government is likely to jump to 4.5% of the gross domestic product (GDP) (I will spare you the Maths here).

In 2015-2016, the government has targeted a fiscal deficit of 3.9% of the GDP. Fiscal deficit is the difference between what a government earns and what it spends. And this isn’t a good thing, given that the government is trying to achieve a fiscal deficit of 3.5% of the GDP by 2016-2017 and 3% of the GDP by 2017-2018.

Long story short—the government cannot continue operating the way it currently is. It will have to find out ways to cut its expenditure on other fronts as well increase its revenues. If it does not do that there is no way it will be able to finance the extra spending on salaries and pensions without managing to increase its expenditure as well as the fiscal deficit in the process. And that won’t be a good thing for the Indian economy.

A higher fiscal deficit will have to be financed out of higher borrowing by the government. This will leave lesser amount of money for the private sector to borrow and in effect push up interest rates. And that is something the government won’t want to do.

In fact, the impact of the recommendations of the Seventh Pay Commission don’t end at the central government level. As soon as the central government accepts the recommendations of the Seventh Pay Commission, demands will start for the state governments to increase their salary and pension payouts as well.

That is how things had played out after Sixth Pay Commission recommendations were accepted. The Sixth Pay Commission was due from 2006 onwards, but the Pay Commission report was submitted only in March 2008. The recommendations were accepted in August 2008. Given this, the government had to pay arrears to the employees.

These arrears were paid in 2008-2009 and 2009-2010, with a split of 40:60. This pushed up the fiscal deficit of the central government big time. The fiscal deficit in the year 2007-2008 had stood at 2.54% of the GDP. In 2008-2009, it hit 5.99% and then climbed to 6.46% of the GDP in 2009-2010 (as can be seen from the accompanying table).

There were other reasons as well for this massive jump in the fiscal deficit, from debt of farmers being waived off, to the United Progressive Alliance government getting into the pump priming mode in the aftermath of the financial crisis which started in mid-September 2008, to the expansion of the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) to all districts of the country from the original 200 districts.

YearFiscal deficit of the central govt(% of GDP)Combined fiscal deficit of the state govts (% of GDP)Total
2007-20082.541.514.05
2008-20095.992.398.38
2009-20106.462.919.37
Source: http://planningcommission.nic.in/data/datatable/1203/table_27.pdf

 

After the central government, the state governments also had to start raising salaries as well as pensions. The Seventh Pay Commission had commissioned a study by IIM Calcutta to “ascertain the fiscal impact of the previous Commissions’ awards on the states”.

The study found that: “that a significant number of States follow the recommendations of the Central Pay Commission. Equally, there is significant plurality of States that design their own pay awards based on the recommendations of their own State Pay Commissions, which of course do consider the recommendations the Central Pay Commission.”

Hence, the salaries of the employees of the state government employees also went up after the Sixth Finance Commission recommendations were accepted by the central government. This led to the combined fiscal deficit of the states jumping from 1.51% of the GDP in 2007-2008 to 2.91% of the GDP in 2009-2010.

The combined fiscal deficit of the centre as well as the states jumped from 4.05% of the GDP to 9.37% of the GDP. Things started to improve from 2010-2011 onwards. As the Seventh Finance Commission report points out: “The empirical analysis conducted indicates that the macroeconomic impact on States’ finances tends to taper off in two years in most cases.” So, government finances were impacted for two years.

Will a similar scenario play out this time around as well? While the fiscal deficits of the centre as well as the states are likely to jump up, the quantum of the jump may not be as much, because this time the chances of arrears having to be paid are low (at least in case of the central government).

As the Seventh Pay Commission report points out: “The awards of the previous Pay Commissions, both V as well as the VI, involved payment of arrears…However, Seventh Central Pay Commission recommendations entail, at best, payments of marginal arrears.”

This time around the chances are that the recommendations of the Commission will be implemented from April 1, 2016, onwards, and hence will involve payment of marginal arrears. In case of state governments, the arrears will depend on how soon the state governments agree to salary increases.

So can we safely say that the damages of the Seventh Pay Commission will not be as bad as the damages of the Sixth Pay Commission, which screwed government finances for two years? The fact is that the Seventh Pay Commission has recommended one rank one pension for central government employees as well. And that remains the joker in the pack.

The column originally appeared on The Daily Reckoning on Nov 26, 2015