The Union government is endowed with more tax powers than the States, while the States are assigned more expenditure responsibilities than the Union government. This gives rise to a vertical fiscal imbalance (VFI) between the Union and State governments. The main responsibility of the Finance Commission is to correct this, but this task remains unaccomplished. We look at this issue in the context of the Goods and Services Tax.
The Union and State governments concurrently levy GST on commodities with 50% as Central GST (CGST) and 50% as State GST (SGST). There is an Integrated GST (IGST) on inter-State trade, so that 50% of it goes to the final destination State. The GST is a harmonised tax on commodities across the country. Individual States have little power to unilaterally change this tax. Though conceptually, the Union government could not do so either, the GST Council gives the Union government a veto to thrust its preferences on the States.
The simplest of the many empirical measures of VFI is ‘VFI equals one minus the ratio of the State’s own revenue to own expenditure’. If this VFI ratio is zero, the States have enough own revenue to meet their own expenditure and there is no need for financial transfers.
We can calculate the VFI ratio for each State and for all the States put together. If we look at the data for all the States over the periods of the last three Finance Commissions (2005-06 to 2020-21), the VFI ratio shows an increasing trend. For the latest period of 2015-16 to 2020-21, the ratio was 0.530, which means that only 47% of the States’ own expenditure was financed by their own revenue in that period. In this period, four major changes took place. First, the divisible taxes of the Union government expanded from two to all the Union taxes, thus enlarging the revenue base to be shared with the States. Second, fiscal responsibility legislation was implemented to constrain the fiscal deficits of the States. States directly borrow from the market subject to limits imposed by the Union government. Third, the Union Planning Commission was dissolved, leading to the withdrawal of Plan grants. Fourth, GST was introduced in 2017. These changes have considerably altered the States’ revenue structure. States have little revenue autonomy and are more dependent on the Union government. For instance, if we consider the withdrawal of the Union government’s plan grants and loans to the States and their effect on States’ combined budget, the VFI ratio increased for the same period to 0.594 from 0.530, indicating that only 40% of the State’s own expenditure is financed by their own revenue.
Reassigning of tax powers
We propose a solution to correct the VFI by reassigning the tax powers between the Union and the States. The Union government has exclusive power to levy excise duty on petroleum products, and the States have exclusive power to levy excise duty and sales tax on liquor. All other commodities fall under the GST. We propose that the CGST and the excise duty on petroleum products be assigned to the States so that the entire GST is assigned to the States.
This should be conceived as follows. One, we should bring all commodities, including petroleum products, under GST. Two, the Union government should continue to collect IGST only to settle revenue on destination basis. This will ensure harmonisation of GST across States. GST shall continue as a tax determined by the GST Council. However, the veto power of the Union government should be removed. Then, the GST Council will truly become a body by the States to settle tax issues among themselves, with the Union government facilitating the arrival of consensus among the States on tax issues. This may once again require some constitutional amendments. Commodity taxation should be moved to State List II of the Seventh Schedule of the Constitution, with a rider that harmonisation of commodity taxation should be maintained.
The assignment of excise duty on petroleum products to the States will hasten the process of integrating taxes on petroleum products into GST and remove the cascading effects of the current excise duty on petroleum products. This will reduce the tax potential of the States, but higher buoyancy of GST should compensate for this revenue loss. The positive aspect of this reassignment of tax will be the increase in own tax revenue of the States. This will also improve accountability of the States to their people on fiscal matters.
We assume that once GST is assigned to the States, VFI will come down to zero. Assuming this reassignment and revenue effect, we recalculated the VFI ratio and found that it stands at 0.005 (2015-16 to 2020-21), indicating that all the States’ own expenditure can be financed by their own revenue resources. The need for assigning share in Central taxes and grants in aid to address VFI does not arise.
Though the financial transfers to the States to address VFI may not be needed if the entire GST is assigned to the States, the tax base of the GST, namely consumption, is not equally distributed among the States. The unequal tax base with unequal expenditure requirement between the States creates horizontal fiscal imbalance among the States. Therefore, the Union government should effect equalisation transfers to address this issue of horizontal fiscal inequality. Our calculations show that the revenue surplus of the Union government after this tax reassignment should be enough to provide for this equalisation transfer to the States.