Fiscal Federalism Under Strain: States Decry Centre's Policy Shifts on GST and Funding

New Delhi: A deep rift is widening between the Union government and several states, with a growing number of Chief Ministers and Finance Ministers voicing strong objections to proposed changes in the Goods and Services Tax (GST) compensation mechanism and the introduction of new centrally-sponsored schemes. States, particularly those ruled by opposition parties, are increasingly asserting that the Centre's moves amount to a significant overreach, threatening the principles of cooperative federalism and eroding their financial autonomy, sparking a political and economic firestorm ahead of crucial deliberations.

Key points

* States are vehemently protesting the Centre’s decision to phase out the assured GST compensation regime and seeking a review of its financial implications. * Concerns are mounting over the Centre's increasing use of Centrally Sponsored Schemes (CSS) in subjects traditionally under state jurisdiction, often with stringent conditionalities. * Chief Ministers and Finance Ministers from several states accuse the Union government of encroaching on state fiscal space and diluting the spirit of cooperative federalism enshrined in the Constitution. * The opposition-ruled states are attempting to forge a united front, demanding greater dialogue, transparency, and a re-evaluation of the Centre-state financial relationship. * The escalating friction is set to dominate the agenda of upcoming inter-state council meetings and potentially impact the implementation of key national development programmes.

At the heart of the current dispute lies the Centre's clear signalling of its intent to fully discontinue the GST compensation cess beyond the originally stipulated five-year period, which ended in June 2022, and its reluctance to extend the mechanism despite persistent demands from states facing revenue shortfalls. While the Centre did release pending arrears, the future of compensation remains a contentious point. Compounding this, the Union government has unveiled a new flagship 'Ayushman Bharat – Swasthya Samvardhan Yojana' (ABSSY), a health sector initiative, and 'Pradhan Mantri Shiksha Sarathi' (PMSS) focused on skilling, both designed as centrally-sponsored schemes but with enhanced central shares and often specific implementation guidelines that states argue impinge on their legislative and administrative domains in health and education.

“The very fabric of our federal structure is being stretched thin by these unilateral decisions,” asserted Dr. K. N. Balagopal, Finance Minister of Kerala, speaking to Toofan Express News. “The GST compensation was a solemn assurance given to states to offset revenue losses during the transition to a uniform tax regime. To withdraw it completely, especially when states are still grappling with post-pandemic fiscal pressures, is not just unfair but a betrayal of trust. Furthermore, these new CSS schemes, while laudable in intent, come with a design that dictates terms to states, making us mere implementing agencies for Delhi’s agenda, rather than partners in development.”

Echoing similar sentiments, Tamil Nadu Chief Minister M.K. Stalin highlighted the constitutional implications. “Health and education are subjects squarely in the state list. While we welcome central assistance, it cannot come at the cost of surrendering our autonomy to decide on local priorities and implementation strategies. The Centre must engage in genuine consultation, not just present us with faits accomplis. Our ability to manage our finances and tailor policies to our unique demographic needs is being systematically undermined.”

Official data reveals that GST collections have shown robust growth, with monthly gross GST revenue consistently exceeding ₹1.6 lakh crore in recent months, hitting a record high of over ₹2.0 lakh crore in April this year. However, states argue that this aggregate growth doesn't always translate into commensurate growth in their own shareable pool of revenue or account for the specific pre-GST revenue growth rates they were guaranteed. During the five-year compensation period (July 2017 – June 2022), the Centre disbursed approximately ₹8 lakh crore as GST compensation to states, including arrears. States like Punjab, Kerala, West Bengal, and Tamil Nadu have consistently highlighted persistent revenue deficits post-GST implementation and have been vocal about the need for an extended compensation mechanism or an alternative revenue-sharing formula that is more equitable.

A senior official from the Union Finance Ministry, speaking on condition of anonymity due to the sensitive nature of the discussions, defended the Centre's position. “The GST compensation mechanism was always meant to be temporary, a hand-holding exercise for five years. The Constitution itself stipulated this timeframe. Prolonging it indefinitely would go against the very spirit of fiscal discipline and self-reliance that states need to foster. Regarding the new CSS, these are designed to address national priorities, ensuring a uniform standard of development and welfare across the country. The Centre provides a significant financial contribution, often 60-75% of the total project cost, easing the financial burden on states, and aims to leverage economies of scale and expertise.”

Dr. Pronab Sen, a distinguished economist and former Principal Adviser to the Planning Commission, offered a nuanced perspective. “The initial GST compensation was critical to build trust and facilitate the biggest tax reform in independent India. While a perpetual compensation regime is unsustainable, the Centre must acknowledge that some states still face structural revenue challenges. A more robust, transparent, and perhaps performance-linked grant mechanism could be explored in consultation with states, rather than a unilateral withdrawal. On CSS, while national goals are important, the design needs to allow for greater flexibility to states. Otherwise, it risks creating parallel administrative structures and inefficient resource allocation, particularly in sectors like health and education where local nuances are paramount.”

Industry bodies have also weighed in, concerned about the potential impact on economic stability. “Any friction between the Centre and states, particularly on fiscal matters, introduces an element of uncertainty for businesses and investors,” stated Mr. Anand Mahindra, Chairman of Mahindra Group, in a recent address. “Clarity on tax regimes and stable policy environments are crucial. While reforms are necessary, they must be implemented in a manner that fosters confidence and maintains a collaborative federal spirit, avoiding undue disruption to state finances which fund essential services and infrastructure.”

Background

The Goods and Services Tax (GST) was introduced in India on July 1, 2017, as a landmark indirect tax reform. To allay states' concerns about potential revenue losses stemming from the transition from a complex system of multiple indirect taxes to a unified GST regime, the Constitution (One Hundred and First Amendment) Act, 2016, included a provision for compensation. This guaranteed states a 14% annual growth in their GST revenue, with any shortfall being compensated by the Centre for a period of five years, using funds collected through a GST Compensation Cess levied on certain luxury and sin goods. This compensation period concluded on June 30, 2022. While the Centre has cleared all pending dues for this period, including an extension to cover the Covid-19 pandemic induced shortfalls through special borrowing mechanisms, it has firmly indicated no further extension of the compensation cess. This stance has been a consistent point of contention in GST Council meetings, with several states repeatedly pushing for an extension or a new formula.

Concurrently, the proliferation of Centrally Sponsored Schemes (CSS) has been a long-standing point of friction. These schemes are funded jointly by the Union government and states, but are designed and largely controlled by the Centre. While intended to achieve national objectives, states often argue that CSS dictate priorities, come with onerous conditionalities, lead to funding mismatches, and infringe upon their policy space, especially in social sectors like health, education, and rural development, which are primarily state subjects under the Seventh Schedule of the Constitution. The NITI Aayog had previously attempted to rationalise CSS, but new schemes continue to be introduced, often with enhanced central shares and greater central oversight, further escalating states’ concerns about their shrinking fiscal and policy autonomy.

What it means

The deepening discord carries significant implications for India’s federal structure, economic stability, and the delivery of public services. For states, the loss of assured GST compensation means increased fiscal uncertainty, potentially forcing them to either curtail expenditure on welfare schemes and infrastructure projects or resort to higher borrowings. This could exacerbate existing inequalities between fiscally strong and weaker states. The new CSS, with their prescriptive nature, could lead to a 'one-size-fits-all' approach, potentially misaligning with local needs and priorities, and creating implementation challenges due to different state capacities and socio-economic contexts. It risks turning states into mere appendages of central policy directives, undermining their role as independent centres of governance responsible for their citizens’ welfare.

Politically, the issue is galvanising opposition-ruled states, potentially leading to a more unified front against the Centre on matters of federal rights and financial devolution. This could translate into increased legislative gridlock in Parliament and state assemblies, as well as a more confrontational approach in bodies like the GST Council. Economically, prolonged uncertainty or state fiscal distress could dampen investor sentiment, particularly if states are forced to raise their own taxes or delay capital expenditure, impacting overall national growth trajectories. Ultimately, it tests the spirit of cooperative federalism, which is essential for a diverse and large nation like India to function effectively and equitably.

Reactions

Beyond the initial strong reactions from Kerala and Tamil Nadu, several other states have also weighed in. Punjab’s Finance Minister, Harpal Singh Cheema, highlighted the disproportionate impact on agrarian states. “Our revenue streams are inherently different, and a blanket approach to compensation or scheme design fails to recognise these ground realities. We need a fairer share of the national pie.” West Bengal Chief Minister Mamata Banerjee has consistently criticised the Centre’s “weaponisation of funds” to pressure states, citing delays in releasing funds for various existing central schemes. The Chief Ministers of Telangana and Andhra Pradesh have also voiced concerns regarding the imposition of central schemes without adequate state consultation and financial flexibility.

Conversely, some BJP-ruled states have adopted a more conciliatory tone, acknowledging the need for fiscal discipline while subtly urging the Centre to consider states’ individual fiscal positions. However, even within these states, there is a quiet apprehension among bureaucrats about the increasing centralisation of decision-making in sectors traditionally managed by states. Opposition parties nationally have seized on the issue, with leaders like Rahul Gandhi calling for a restoration of “true federalism” and accusing the Centre of systematically weakening state governments.

What happens next

The immediate future will likely see intensified negotiations within the GST Council, where states will press their demands for either an extension of compensation or a revised revenue-sharing formula. The upcoming Inter-State Council meeting, if convened, will be another critical platform for these discussions. States might explore legal avenues, challenging the Centre’s unilateral imposition of scheme conditionalities or interpretations of fiscal devolution, although such moves are often seen as a last resort due to their politically charged nature and lengthy judicial processes. Politically, expect opposition-ruled states to continue to forge stronger alliances on federal issues, potentially leading to joint representations to the President and larger public awareness campaigns.

The Union government, while publicly firm on its stance, might consider offering some concessions or alternative financial mechanisms – perhaps performance-linked grants or sector-specific aid with slightly more flexible terms – to de-escalate tensions, especially as national elections draw closer. The ongoing dialogue between the Centre and states will be crucial in determining whether this current friction evolves into a prolonged crisis of cooperative federalism or finds a path towards renewed collaboration and mutual understanding.