The states should give up their stance for a higher rate arising out of revenue neutral rate calculations

The near unanimous passage of the constitutional amendment bill for the goods and services tax (GST), followed by its ratification by 17 state legislatures till now, should warm the hearts of economic reformers, and even of those who were cynical about the ability of the Indian political class to rise above the usual myopia. However, many important challenges remain. They need to be faced with courage and maturity as the states continue the process of discussion and ratification.

While the discussions in state legislatures are likely to revolve around the issue of the revenue neutral rate, and the magnitude of loss or gain that is likely to ensue upon the implementation of GST, there are a couple of points to be made. One, the revenue neutral rate is really a very static way of looking at what can be a Grand Bargain, and a game-changer for the Indian economy at large. After all, the whole point is that the reform will unleash such positive forces of growth that the actual buoyancy in tax revenue for both Central and state governments is likely to be far higher than the current static calculations. In other words, a lower actual rate than the computed revenue neutral rate should be acceptable once the impact on future economic growth is taken into account.

Of course, the growth dividend is unlikely to be available overnight. There is likely to be a lag as teething troubles are sorted out. Yet, a temporary revenue loss is still worth taking in one’s stride. It can be thought of as an investment in a reform that will pay for itself sooner rather than later. In fact, since the Central government has promised a five-year compensation mechanism, the states have little to lose by accepting a lower tax rate. They ought not to hold out for a higher rate for state GST.

Indeed, I propose that instead of a revenue neutral rate, which is the focus of a lot of debate, the states should really be concerned with the budget neutral rate. After all, revenue available is merely a notional amount available for use by the government for providing public goods and services; it is actually the net amount available for expenditure through the budget that is the key and it is this notion that one is referring to when one talks of budget neutrality.

The GST-able component of revenue will increase in an arithmetic sense given the higher rate but there is also the expenditure component that is spent on goods and services that would then be subjected to the higher rate. The net amount available for expending autonomously will thus be less. The argument here is clearly for preservation of such a net amount and on the premise that the real power with the (state) government is not really to raise revenue per se but rather the power to incur expenditure for provision of goods and services. Once again, we reach the conclusion that the states should give up their stance for a higher rate arising out of revenue neutral rate calculations, especially in the context of the assured compensation caveat.

In the case of states such as Maharashtra, there is the ticklish issue of what to do about the significant tax revenue that will have to be passed on to the urban local bodies—specifically Mumbai—when existing taxes such as octroi and local body tax (LBT) are subsumed under GST. Maharashtra is historically not known for showing alacrity in passing on externally allocated funds to cities. The money allocated to it by the Finance Commission is a case in point. The state government has never devolved any funds as per its State Finance Commission recommendations. Whereas political parties on the whole have shown little concern about this lack of decentralization in general, it is likely to become a rather sensitive issue if some political party believes that it would gain power at the local level and be short-changed by the state government.

One way to address this problem would be having a legal contract between the state government and the municipal corporation to define the specific amounts and dates when GST revenue is passed on to city governments. Such a contract can be implemented under the supervision of the Central government for ample sanctity and comfort. This third-party involvement could lend credence to such a contract especially in the context of the historical experience in the state, where there has been no sanctity attached to the notion of devolution (untied grants) from the state to the local bodies.

The modality could be to use the Finance Commission fund via the State Finance Commission route, so that such a transfer to the local bodies in lieu of octroi and LBT could be done outside the normal payment schematics and prior to the funds reaching the consolidated fund of the state. In doing so, computerized banking networks could be used for speed and efficiency. Such an arrangement could then be achieved, perhaps, through an executive order without the legislative voting, keeping to the level of financial transaction modality. The other way would be to pass a generic Bill, complete with procedures and rules that would ensure due compensation to all the urban local bodies, and should provide enough comfort, but at the cost of all the transaction costs of formulating and passing a legislative Bill.

In any case the small tricky steps must be overcome efficiently and with ingenuity so that the Grand Bargain that is promised for all stakeholders is not further stalled.

Abhay Pethe is professor at the Dr Vibhooti Shukla Chair Unit in urban economics and regional development in the University of Mumbai.