As the Centre and States try to find GST compensation cess monies, it is time to look beyond the present, to see how the future could unfold for State finances.

The financial relationship between states and the Centre has been in news recently. The Fifteenth Finance Commission submitted its report to the president; there have been some delays in payment of the GST compensation cess, and there were some discussions on whether the Centre will honour its commitment of assuring a 14% revenue growth in the agreed-upon transition period.

Constitutionally, Centre-State fiscal relations come up for review quinquennially (once every five years). States have ceded significant taxing powers to the Centre via GST. Earlier, the states had their own tax bases and could manage revenues by juggling taxation policies. This led to a large number of state-specific tax rates, a lack of uniformity in the tax structure in the country, and sometimes, a race to very low-tax regimes to attract investments—and hence, a move towards GST. On the other hand, such flexibility allowed the state governments to create their own fiscal policies which could be more suited to their needs: it also made the states, especially the non-special-category ones, less dependent on fund flows from the Centre.

While the states have a say in GST rates, one-third voting power for the Centre means that it has a casting vote to reach a three-fourths majority in case decisions needs to be taken by voting. The GST Council has, till date, taken decisions by consensus. Large sources of direct funds remaining for the states are non-GST goods, property taxes and stamp duties. Over time, non-GST goods like petroleum, natural gas, aviation turbine fuel, alcohol and electricity may also move into the GST framework to complete the input tax credit cycle.

This can leave states dependent on the Centre for a significant portion of their revenue inflows for funding their expenditure. If there is a slowdown of funds at the Centre, or if there is any misalignment between the priorities of the Centre and the states, the fund-flow situation at the states could become challenging. Since chief ministers are expected to deliver on their promises, the states are face a near-continuous requirement of funds. Note that the states have built-up a lot of “committed expenditure”, mostly on account on salaries (including pensions) and a plethora of social services that belong on the state list. The states also have defined fiscal deficit and debt targets that they cannot breach.

Over time, the states will again seek to build buoyancy in taxation. The only way for the states to keep to deficit and debt targets when expenditures are committed and growing is to increase revenues. Once the five-year GST transition period of committed annual 14% growth in revenues is over (in 2022), states may be required to find themselves new sources of revenues. We look at some possible sources that might come up: citizens and businesses should also remain cognizant about such scenarios.

Better efficiency in tax collection: Better implementation of existing taxing powers of the states by promoting greater compliance, making tax collections more user-friendly, and identifying taxes with large potential, say property taxes. The Economic Survey 2017 had identified that the states (and the cities) do not do a thorough job in identifying, assessing and collecting property taxes—it had mentioned that “Bengaluru and Jaipur are currently collecting no more than 5-20 per cent of their respective potentials for property tax.”

Better collection on state services: The states offer various services to its citizens like transport, water, electricity, schooling, primary health care, etc. User charges (in places which, and for citizens who, have the ability to pay), long recommended by economists, could start to become an important revenue source for state budgets. Many services may see refinement in eligibility criteria to sharpen targeting to genuinely-needy. As average incomes increase, the ability of citizenry to pay increases and requirement for subsidised services could reduce. Many areas which are currently completely in the purview of state governments (say transport services) could partially open up for private sector participation.

Finding new sources of tax funds: Necessity could be the mother of innovation: whatever one state does, it could quickly get copied across other states. Such taxes could be levied on products currently out of tax-net, or on goods and services that may be perceived to be luxury or ‘sin goods’, or be based on new ideas (like say congestion pricing). State-backed lotteries or similar new products/services can create a revenue potential for the state. There are very few state PSUs that could be disinvested for meaningful sums of monies—in any case, these ‘receipts’ will be one-time and only available to a few states which may have such PSUs. Possibly, the states could start their own social-security collections?

Land sales or value-capture: Chinese cities created a significant revenue base for themselves by selling land in the city and on its periphery. Whether by issuing TDRs, or by allocating higher FSI near public infrastructure creation (like a metro station), or by charging a well-documented premium for converting agricultural land to non-agricultural (NA), states can come up with new solutions on these.

Debt: Along with all the cash flow initiations/optimisations that we discussed above, states could look at their debt-raising ability and its profile—after all fiscal accounting in India is cash-based and not accrual-based. A recent OpEd in FE highlighted that Telangana is now borrowing more long-term to avoid the short-term roll-over pressures. Over time, many other states could come to similar conclusions: long-dated papers of state government could start to come to the markets.

These trends will emerge not only because of the current news flow on Centre and state fiscal relations but also because as India prospers, its tax-to-GDP ratio could increase to the levels of OECD countries—this will require both the Centre and the states to come up with new ideas, reasons and methods of collecting the monies.

The author is Head, Strategy and New Initiatives, Axis Bank. Views are personal.

Originally published in The Financial Express.

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