By Nageshwar Patnaik in Bhubaneswar, September 12, 2020: In early 1990s, legendary leader and former Odisha chief minister Biju Patnaik had sought fiscal autonomy of the resource rich but economically backward state saying that the Centre has neglected the state on all fronts.

Three decades later, his son and the present chief minister Naveen Patnaik reiterated the same demand to ensure faster development of one of the poorest states in India. The record-breaking chief minister’s demand is more relevant in the present context as the fragility of the Indian federal system became overtly wide-open after the outbreak of COVID-19 with a strong trend towards extreme centralization. Never have the fiscal relations between the Centre and States been so stressed as are seen today.

Prime Minister Narendra Modi, a former chief minister himself, initially talked about the governance reform by building a more cooperative form of Centre-state relations. Chief ministers would work together with the Centre as a ‘Team India’ to resolve differences and achieve a jointly defined national interest.

However, Modi’s hype on cooperative federalism now is turning out to be coercive federalism, with the NDA government subtly forcing them to adopt its economic and institutional agenda. The classic example is the controversy over the Goods and Services Tax (GST) compensation payment.

In the current fiscal, economic activities took a battering with massive disruption following the COVID-induced lockdown for more than two months. The economy contracted by 23.9 per cent in the first quarter leading to a sharp downfall in GST revenues and cess collections. The assumed tax growth rate of 14 per cent in either the GST or the cess is unfeasible this year. That leaves either the Centre or states to borrow to make up for the shortfall.

According to an estimate by the GST Council, the shortfall this fiscal will be about Rs 3 lakh crore, out of which Rs 65,000 crore is expected to be generated through cess, but not covering the Rs 2.35 lakh crore loss due to COVID-related hardship.

Now the moot question is where will Rs 2.35 lakh crore come from? Most states, including several BJP-ruled ones, want the Centre to borrow the entire amount and disburse it to them. But the Centre today is unwilling to borrow the required amount and recoup it by extending the period of the cess collection from the stipulated five years to a longer period. Instead, the Modi government has offered two options for the states to choose from and the states have been asked to borrow. This decision came as a bolt from the blue, throwing into disarray the states’ finances, already severely weakened by the pandemic.

Under the first option, states could borrow Rs 65,000 crore through a special window through the RBI at a concessional rate, to be negotiated by the Centre. The principle and interest would be paid out of the compensation cess, so there will not be additional burden on states.

Or else the states will be allowed to borrow the entire amount of the shortfall, estimated to be Rs 2.35 lakh crore. But in this case, there will be no relaxation on FRBM target. Under the second option, the states will have limited borrowing options.

Before GST was put in place, the states depended on two sources for their revenue: their own tax revenues and central transfers. With the implementation of the GST, states have limited freedom in deciding tax rates for goods and services, since these are controlled by the GST council.

In 2017, reluctant states were enticed into the ambit of the GST with an assurance that if collections fell short of a compound growth of 14% during the transition period between July 2017 and June 2022, the shortfall would be compensated for. With the pandemic eroding the revenue base of the states and the Centre withholding the compensation since April, the states are left with no option but to borrow more and survive.

Opposition-ruled states point out this as a violation of cooperative federalism. They have been insisting that the Centre keeps its pre-GST promise regardless of its COVID-emptied coffers.

The Centre’s reluctance to borrow the required amount to fill the gap in GST compensation is attributed to its apprehension of a sharp rise in the interest rate. The other option before the Centre is to monetise the debt which the governments all over the world are doing.

Even former RBI Governor C Rangarajan, who ended the monetization of the debt during his tenure, is in favour of such a move by the Centre. But the Modi government will have none of it on the alibi that this would lead to substantial fiscal deficit. This will be also true if the states are forced to go on a borrowing binge.

It is much more logical for the Centre to borrow to meet the shortfall in the cess fund because the cost of borrowing by states would be higher by 1-2 percentage points. Besides the states’ fiscal deficit ceiling would have to be raised and separately fixed for each state.

Interestingly, in the first two years, there was surplus in the cess fund, which was deposited in the Consolidated Fund of India. Moreover, the undistributed portion of Integrated Goods and Service Tax (IGST) at times was more than Rs one lakh crore, which was deposited in the public account of the central government. Hence at a time when the cess fund is in deficit and requires temporary accommodation, the Centre should adhere to it.

The Modi government must accept the fact that the payment of full compensation is a constitutional right of the states and by not sticking to it is certainly a body blow to public trust, which is essential for any federal system to work smoothly.