[Answered] The proposed Goods and Services Tax (GST) reforms raise the issue of state compensation for revenue loss. Examine the challenges to fiscal federalism and the importance of ensuring state cooperation in major tax reforms.

Introduction

India’s GST, introduced in 2017 through the 101st Constitutional Amendment, is hailed as the “One Nation, One Tax” reform. Yet, frequent demands for compensation highlight strains in fiscal federalism and cooperative federalism.

Challenges to Fiscal Federalism under GST Reforms

1. Revenue Uncertainty & Compensation Dilemma: Proposed rationalisation from a four-tier to a two-tier (5% and 18%) structure may cause a short-term revenue dip of ₹60,000–1,00,000 crore annually (0.2–0.3% of GDP). States like Maharashtra, Karnataka, Tamil Nadu (manufacturing-heavy) face sharper losses compared to agrarian states, leading to asymmetrical impact. The expiry of the five-year GST compensation cess in June 2022 has aggravated mistrust between Centre and States.
2. Vertical and Horizontal Fiscal Imbalances: According to RBI’s State Finances Report 2023, states’ own tax revenue has stagnated around 6-7% of GDP, while their expenditure responsibilities under the Seventh Schedule have expanded. Disparities exist—industrialised states generate more GST but redistribution via the Finance Commission transfers often disadvantages them.
3. Erosion of Fiscal Autonomy: With the subsumption of indirect taxes like VAT, excise, and octroi, states lost flexibility. Article 279A empowers the GST Council, but voting power asymmetry (Centre has 1/3rd share) raises fears of central dominance.
4. Political-Economic Mistrust: States like Punjab and Kerala have argued that GST compensation denial undermines fiscal space for welfare expenditure. The COVID-19 pandemic exposed the fragility when states demanded additional borrowing under FRBM relaxation to meet shortfalls.

Importance of Ensuring State Cooperation

1. Strengthening Cooperative Federalism: The Supreme Court in Mohit Minerals v. Union of India (2022) clarified that GST Council decisions are not binding, reinforcing the need for consensus-driven policymaking. A permanent GST Compensation Fund or contingency mechanism, akin to Australia’s Horizontal Fiscal Equalisation, can sustain trust.
2. Ensuring Equity and Stability: 15th Finance Commission emphasised balancing equity and efficiency—states with weaker tax bases (e.g., NE states, Bihar) need greater protection to ensure uniform development.
3. Boosting Compliance and Expanding Tax Base: Lower rates encourage formalisation and reduce evasion. Increased compliance (e-invoicing, GSTN data analytics) can expand revenues, benefiting both Centre and states in the long term.
4. Attracting Investment and Ease of Doing Business: Rationalised GST rates (~10% average, close to OECD levels) can enhance India’s global competitiveness and boost Make in India, provided states see themselves as stakeholders in this reform.

Conclusion

As B.R. Ambedkar envisioned, India’s federalism is a “Union of States, not unitary.” Sustained state cooperation, equitable compensation, and fiscal autonomy remain vital to uphold true cooperative federalism in tax reforms.