These are the reasons behind the fiscal problem of Indian states

September 21, 2020 7:00 AM

States with steep revenue deficits must address the issue of fiscal responsibility, raised by several Finance Commissions

The Centre’s and the states’ borrowing powers are subject to limits under Article 292 and their respective FRBMs.The Centre’s and the states’ borrowing powers are subject to limits under Article 292 and their respective FRBMs.

By MS Ananth
In November 2016, nine judges of the Supreme Court held that states were ‘…within their right to design their fiscal legislations to ensure that the tax burden on goods imported from other states and goods produced within the state fall equally.’ The judges reiterated federalism as a basic structure of the Constitution and held that the power to levy entry tax under Entry 52 of List II of Schedule VII was not subject to any restriction.

The case was Jindal Stainless Steel Ltd & Anr v. State of Haryana & Ors, and the issue in question was power of states to levy entry tax under Articles 301-304 of the Constitution. But in May 2015, the Lok Sabha had already passed the Constitution 101st Amendment Act which deleted Entry 52 of List II, Schedule VII, while harmonising and consolidating various indirect taxes. The significance of this: Why borrow when you can tax?

The Centre’s and the states’ borrowing powers are subject to limits under Article 292 and their respective FRBMs. The need for fiscal responsibility on the part of states has been identified in successive Finance Commissions. Increasing borrowings of states, with no change in revenue, are bound to adversely affect their commitments under FRBM rules. This would be harsh for states that have practised fiscal discipline and have high GST receipts.

For states, there is no mechanism to resolve which entity is to borrow, and as long as the Centre doesn’t compensate states and directs borrowing, states will have little option but to comply. The Centre acknowledged its obligation to compensate states unambiguously in terms of the GST Compensation Act (Section 19). But the burden of this compensation falls on taxpayers, and not the central government, who pay for goods and services purchased either in the course of interstate trade and intrastate commerce.

This is ironic, because levying compensatory cess on intrastate sales has the effect of a state taxing itself to compensate itself. Disputes with respect to levy of compensation cess would be between taxpayers and central or state governments. If states dispute the computation or lack of payment, state governments would have to litigate on the decision of the GST Council before the Supreme Court under Article 131.

Under the GST Compensation Act, compensation is liable to be paid only for five years from 2017. After 2022, the Centre is under no obligation to compensate states. It is in this context that residuary taxation powers of states are important. The amendment deleted substantial taxation powers but left untouched taxation powers of panchayat, municipality, regional council or district council and taxes on sale of electricity, fuel and alcohol. Entertainment-related levies have been challenged in Madhya Pradesh, Allahabad and Kerala High Courts. These taxes are over and above GST—on entertainment, paid on ticket prices by cinemagoers.

The deletion of Entry 52 may not take away the power of taxation since this power comes from Article 304, which remains unchanged after the amendment. Entries in Schedule VII are only subject matters of legislative powers and the actual power flows from the provisions of the Constitution itself (State of West Bengal v. Kesoram Industries). There’s nothing impermissible or constitutionally illegal in the actions of states imposing such taxes, since (a) there is no equity in taxation and (b) raising finances is a legitimate act of a state. Since federalism is part of the basic structure, states can legitimately take recourse to these powers.

The fiscal problem of Indian states isn’t unique. Provinces in Canada and states in the US are facing a problem with similar consequences—low taxes, revenue, increasing deficits. In the US, there has been talk of states invoking bankruptcy laws to clean the slate and rewrite contracts.

The question whether the Centre should borrow or a state is only a means to an end—fiscal responsibility. The bigger issue of fiscal responsibility raised by the earlier Finance Commissions needs to be addressed by states with steep revenue deficits. Nearly 200 years after Shakespeare advocated fiscal prudence through Laertes, George Washington reiterated this for a new country. His caution of ‘avoiding… accumulation of debt… not ungenerously throwing upon posterity the burthen, which we ourselves ought to bear’ is excruciatingly relevant for Indian states.


The author is a Delhi-based lawyer

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