Turbulence ahead for fiscal federalism

June is a watershed moment in the history of fiscal federalism in India. It marks the end of the five-year period for which state governments were entitled to a guaranteed 14% growth in their revenues after the implementation of the Goods and Services Tax (GST). It can be said with some degree of confidence that GST would have not seen the light of day without this incentive. How much will states lose in terms of revenue once the mandatory compensation comes to an end? That’s not clear, although it is undisputed that state finances are bound to come under further pressure. Some states could suffer larger losses, as GST is a consumptioncentric tax and penalises states which are hubs of manufacturing activities.

However, the long-term implications are more difficult to predict. For example, tax receipts are enjoying inflationary tailwinds at the moment. However, revenue growth could turn tepid if nominal growth comes down. Low nominal growth driven headwinds to revenue collections were a major problem in the pre-pandemic period. To be sure, the end of the compensatory period could also generate tailwinds for inflationary pressures. As long as the states were guaranteed assured revenue growth, they were always arguing for tax cuts in the GST Council. Many experts have pointed out that average weighted tax rates have come down in the GST regime since its inception. Now that states will have a bigger stake in actual GST collections, they will have an incentive to ask for rate hikes. The fact that the compensation cess period is not coming to end – its proceeds will be used to pay off the debts incurred during the pandemic period – will add to inflation pressures. To surmise, the fiscal federalism framework will require greater vigilance after June.