GST Reforms and Fiscal Imbalances

GST Reforms 2.0 have increased States’ reliance on the Centre, eroding fiscal autonomy. This blog discusses how these changes affect governance and fiscal balance.

Context:

The latest round of GST rate cuts has sparked concerns among the Finance Ministers of Telangana and Kerala, as they warn about the increasing fiscal dependence of States on the Centre. These concerns stem from the significant changes brought about by GST Reforms 2.0, which have altered the fiscal dynamics between the Centre and States, eroded the revenue-raising capacity of States, and placed an unfair burden on them in terms of developmental expenditure. This blog delves into how GST reforms are affecting the financial stability and autonomy of States and challenges the very foundation of fiscal federalism in India.

How are GST Reforms 2.0 Affecting States?

1. Revenue Assurance Not Met
   When the Goods and Services Tax (GST) was introduced, States were promised a 14% annual growth in tax revenue to compensate for any losses in revenue post-GST implementation. However, the reality has been far from the promise. State GST collections have only managed to grow at 7-8% annually, much lower than the expected growth. This has led to a substantial revenue shortfall, putting additional pressure on State finances.

2. Rising Dependence on the Centre
   Prior to the GST system, States had fiscal autonomy, managing their own tax collections through mechanisms like VAT, Entertainment Tax, and Entry Tax. However, with the introduction of GST, tax collections are centralised, and States are increasingly dependent on the Centre for their share of revenue. This centralisation reduces the States’ ability to raise revenue independently, weakening their financial autonomy.

3. Erosion of Developmental Spending Capacity
   Another key concern arising from the new GST system is that although States bear nearly two-thirds of total government expenditure (64%), they now receive a smaller share of the revenue after the GST implementation. This misalignment in revenue collection and expenditure allocation severely limits States’ ability to invest in essential areas such as welfare, infrastructure, healthcare, and education. Consequently, States are left with limited resources for developmental spending, hindering their capacity to promote growth and welfare.

4. Uncertainty in Revenue Projections
   The recent GST rate cuts have further compounded the uncertainty around revenue projections. States like Kerala anticipate losses of ₹8,000–10,000 crore due to the rate cuts, with no clear compensation mechanism in place from the Centre. This lack of clarity and non-commitment to compensation has created budget volatility, forcing States to face financial instability and uncertain fiscal conditions.

5. Process Concerns in GST Rate Rationalisation
   Another point of contention is the GST rate rationalisation process. In the past, rate changes were backed by detailed reports and discussions, involving contributions from both the Centre and States. However, the latest GST rate cut process has been largely led by the Centre, with no consultation or input from the States. This top-down approach undermines the principle of cooperative federalism, where both the Centre and States are supposed to work together in policy formulation. As a result, the decision-making process has shifted to a more centralised model, leaving States with little say in the changes that directly impact their finances.

What Other Factors Are Challenging Fiscal Federalism?

1. Cess and Surcharge Distortion
   One of the key challenges in the current fiscal system is the growing reliance on cesses and surcharges. The 15th Finance Commission mandated a 41% revenue devolution to States. However, approximately 20% of Union revenues are mobilised through cess and surcharge mechanisms, which are not shared with States. As a result, States effectively receive only about 30-32% of Central taxes, despite shouldering a larger portion of national expenditure. This distortion in revenue-sharing further exacerbates fiscal stress on States.

2. Vertical Imbalance in Resource Distribution
   The current fiscal structure shows a vertical imbalance between the Centre and States. While the Centre collects around 60% of national revenues, States are responsible for 64% of total expenditure. This mismatch places an undue burden on States, limiting their ability to meet their financial commitments and exacerbating fiscal imbalances. States face increased pressure as they are expected to spend more, but have limited revenue sources to fund their expenditures.

3. Decline in States’ Fiscal Autonomy
   Over time, States have become increasingly dependent on centrally sponsored schemes and tied funds, which restrict their ability to design welfare programmes tailored to their specific needs. The heavy reliance on the Centre for funding makes States less autonomous in managing their own development agendas. This loss of fiscal autonomy weakens their role in shaping local policies and addressing region-specific challenges.

Conclusion: The Need for a Balanced Approach

The GST reforms 2.0 have exposed the growing fiscal vulnerability of States and their increasing dependence on the Centre. As States continue to bear the brunt of developmental expenditures, the existing fiscal imbalance and misaligned revenue-sharing mechanisms are further exacerbating the problem. To ensure sustainable growth and equitable development across the country, there is a need for reforms that ensure more fiscal autonomy for States, especially in terms of revenue generation and allocation.

Additionally, a more collaborative approach to GST reform, with greater consultation between the Centre and States, will be crucial in ensuring a balanced and fair distribution of resources. States must be empowered to take charge of their economic future, while also being provided with the necessary support to meet the evolving demands of their populations. Only then can India’s federal structure truly thrive in a dynamic and inclusive manner.

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The Source’s Authority and Ownership of the Article is Claimed By THE STUDY IAS BY MANIKANT SINGH