GST is good economics, but is it good politics?

A constitutional amendment proposed by the Centre to give teeth to the goods and services tax (GST) will have serious consequences for centre-state relations. The amendment, reported by Mint newspaper, suggests that every decision of the proposed GST Council, the supreme decision-making body on GST comprising central and state finance ministers, will have to be ratified by the Union finance minister to become law.

The GST, India’s biggest fiscal reform to date, is supposed to come into force next year. It seeks to unify both the value-added tax and the service tax into one goods and services tax. Once in force, tax evasion will become difficult each GST assessee effectively polices tax payments by his input providers.

This is how it is supposed to work. If I am a car manufacturer, I get a rebate on GST to the extent my suppliers have paid GST. Else, I pay the full rate on my factory price of the car. Over a period of time, the GST will have a moderating influence on prices because it ensures that there are no taxes on the tax component in factory-gate prices. In short, the tax is self-policing and anti-inflationary, and will make India a truly common market with few internal trade barriers.

The ideal GST is one where both centre and states have one common rate for all products. But the current consensus is that there will be two GSTs, one by the centre, and the other by states. There is also a possibility that both centre and states will levy two different rates — a concessional one and a regular one. Recent discussions suggest that some goods may be totally left out of GST — petroleum products, booze and power, among them. This means, we will have an entire thicket of GST rates, and some existing levies like excise and sales taxes may be retained. The shift to GST is going to be a messy affair.

The main reason for this is clear: the centre-state tussle over financial autonomy. Once GST comes into force, states lose financial flexibility because they can’t unilaterally alter rates. The tug-of-war over petro-products and power is happening precisely because states want to retain some tax levers with themselves.

This is where the finance minister’s ability to veto any GST decision taken by the council — as proposed in the constitutional amendment — will become a major bone of contention. No state can politically afford to put all its revenue eggs in the GST basket, because this reduces its own political flexibility. The finance ministry’s veto, if enacted, will enhance the power of the centre vis-a-vis states.

The most obvious flaw in the proposed arrangement is that it flies completely in the face of political reality. Regionalism is a strong force and the cry is for greater financial autonomy. Whether it is Kashmir or Telangana, Gujarat or Tamil Nadu, politics is driven from the regions. If, inspite of this, states have been rather muted in their demands for greater autonomy, it’s because the coalition era has enabled state-level actors to get power by proxy.

During the NDA regime, Chandrababu Naidu wangled concessions for Andhra Pradesh even without joining the government. The DMK is able to practically “own” the ministries it runs at the centre (telecom, textiles), just as Trinamool has a lock on the railways (never mind the accidents). However, this is a fundamentally unstable situation and sooner or later state-level economic decisions will have to be pushed down to the states.

This calls for more fiscal federalism, and GST may be a move in the opposite direction.

There is also another reason why states need more fiscal legroom. Take the case of Greece. The reason why its problems have threatened the entire architecture of the European Union is simple: as a member of the common monetary and currency union (the eurozone), it could run up huge debts because the markets thought it had the whole of the European Union behind it.

Today, Greece’s bankruptcy has forced European leaders to put up a $1 trillion rescue package, and Germany itself has announced austerity measures to finance the unity of Europe. If Greece was not part of the eurozone, the markets would have seen the risk they ran by holding on to Greek loans and bonds, and Greece would have been forced to tighten its belt much earlier. Autonomy engenders greater discipline and prudence.

A similar logic applies to Indian states. The more they lose their fiscal flexibility, the less politically controllable they will be as they lose the incentive to stay financially solvent. India is too big an economy to not be truly federal in character. GST is an economically sound idea, but there are some things that should be left out of it to give states some elbowroom on fiscal autonomy.

A finance minister’s veto is avoidable. Good economics should not be made a reason for bad politics.