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Centre vs states GST row doesn’t matter. What matters is reviving economy & a borrowing plan

Since general government debt will rise regardless of who borrows for GST compensation, a plan to move to a sustained borrowing trajectory should be made.

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The central and state governments are engaged in a dispute to figure out how to make up for the shortfall in the GST compensation cess. In a commitment made in good times, the Centre had promised to make up for the shortfall. But the Centre now wants the states to borrow, and most states, in particular the non-BJP states, are protesting that it is reneging on its promise.

States agreed to implement a nationwide GST only when the central government promised to fully compensate them for any loss in revenue arising from its implementation for the first five years. This was done as GST subsumed a number of taxes which were earlier levied by states.

The growth rate of the states’ GST revenue was pegged at 14 per cent from the amount of collections in 2015-16. According to what was agreed, if the states’ GST collections fall below the trajectory of 14 per cent annual growth, the central government has to compensate for the shortfall, to be paid from a compensation fund financed through a cess on items in the 28 per cent GST slab.

Also read: India’s fiscal crisis can only get worse as tax revenue is seen dropping 12.5% in 2020-21

The Covid disruption

In the current year, economic activity has seen a disruption due to the Covid-induced lockdown. The economy contracted by 23.9 per cent in the first quarter. While there could be some improvement in the subsequent quarters, there is fear of a deep contraction this fiscal. This has resulted in a sharp collapse in GST revenues and cess collections. The assumed tax growth rate of 14 per cent in either the GST or the cess is unachievable this year. Either the Centre or states have to borrow to address the shortfall. The question is who borrows. And, who pays interest.

The Centre has proposed two options to meet the GST compensation shortfall. Under the first option, states could borrow Rs 97,000 crore (the estimated shortfall on account of GST implementation) through a special window through the RBI at a concessional rate, to be negotiated by the Centre. The principle and interest would be paid out of the compensation cess, so there will not be additional burden on states.

Under the second option, states could borrow the entire tax shortfall of Rs 2.35 lakh crore arising on account of GST due to Covid-19 from the RBI. The states will have to bear the interest burden. The compensation fund from the cess levied would be used to pay the principal amount.

If the states choose to exercise the first option, their borrowing limit under the Fiscal Responsibility and Budget Management Act (FRBM) would be raised by an additional 0.5 per cent of gross state domestic product (GSDP). However, the unconditional relaxation of 0.5 per cent in the borrowing limit would not be applicable if states choose the second option.

Also read: Govt finances deteriorating. Postpone fiscal deficit goals, make economics more transparent

Who should borrow to boost the economy?

The Centre says states are better placed to borrow as they have the headroom under the FRBM Act to borrow. Their borrowing limit was enhanced from 3 per cent to 5 per cent to meet the additional expenditure commitments due to the Covid-19 pandemic. Additional borrowings by the Centre would push the yields on government securities, which act as a benchmark for other borrowings, including state government borrowings.

States argue that the Centre should borrow as it is the Centre’s commitment to meet the shortfall in tax revenues of states. The Centre not doing so would be reneging on its promise. The Centre’s view is that it is not in breach of any promise made to states. Its commitment is to compensate states for loss of revenue arising out of GST implementation only, and not for all types of revenue losses.

Additional borrowing, whether by Centre or states, is going to raise India’s overall general government debt burden.

The question is not about Centre or state debt narrowly, but about whether one of these arrangements is better than the other for boosting the economy. The Centre has already enhanced its borrowing target for this year by Rs 4 lakh crore. Additional borrowing could hamper its spending plan to revive the economy.

If states borrow, using the first option, principal and interest would be repaid by extending the GST compensation cess beyond five years. Caution has to be exercised that the cess does not become permanent.

Sustained borrowing trajectory needed

The need of the hour is to bring the economy back on track, so that the GST compensation fund that has hit rock bottom can be used to meet the revenue shortfall of states. Since the general government debt will rise regardless of who borrows, a plan to move to a sustained borrowing trajectory should be made.

At the same time, the Centre needs to take concrete steps towards developing a deep and liquid government bond market, so that states are able to borrow on better terms.

Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.

Radhika Pandey is a consultant at NIPFP.

Views are personal.

Also read: Why India’s bond markets are loving the GST fight between Modi govt and states


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  1. if states borrow, they have to pay the interest which centre will not compensate, hence the disadvantage to states. why not just increase limit of investment under small savings ( post office savings, PPF, kisan patra etc, but do not increase limit under Sec80C). Retired people who do not have pension and other weaker sections will be benefited . Also some part of this collection goes to centre, major part to the collecting state.

  2. Not a convincing argument. If the states go to the market to borrow, interest rates, nevertheless, will go up. The spreads states pay over and above the sovereign federal debt benchmark will also go up; differently for different states. The yields on central government bonds too will also rise in sympathy. Moreover, not all states will be able to borrow. Some will, many may not. This opens up a political minefield. Given the political polarisation, the centre is more likely than not be supportive (by making phone calls to put pressure on the banks – who are the main investors) of the borrowing program of the states partisan to itself leaving the other states in the lurch. Under the public debt act, the centre is as much liable for the borrowings by the states. The centre being the senior partner, it should tale an accommodative stance and borrow in tandem with the states, not shove the onus on states under the pretext of (i) saving its ammunition for its own borrowing program and (ii) not disturbing the benchmark rates in the system by pushing up interest rates in the system. As it is, the interest rate transmission mechanism in India is faulty. The centre’s insistence on the ‘states going first’ will be disastrous.

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