In 1773, the British Parliament passed the Regulating Act, appointing a governor general to oversee all of British India. This law marked the beginnings of the Central government of the British Raj, the single most significant institution to shape the Indian subcontinent for the next two centuries. It continues till today in independent India in the form of the Union government.

For an institution with such a long history, however, it is today facing a rather prosaic problem: a cash crunch. The main driver for this is falling tax revenue due to an underperforming Goods and Services Tax.

The Centre is contracting

The Union government in India is a behemoth, employing lakhs of people and responsible for collecting a lion’s share of the taxes that India’s people generate. However, this juggernaut is now slowing down. Total Union government expenditure as a proportion of the Gross Domestic Product fell from 13.9% in 2013-’14 to 12.2% in 2018-’19.

Not only is this fall significant, it is also abrupt: the Union government itself has been unable to predict it. On February 1, 2018, for example, the Union government estimated that total Union government expenditure for 2018-’19 would be 13% of the GDP, an increase from the previous year – and one that would break the falling streak.

The government’s estimate, however, was completely off the mark. Expenditure as a percentage of GDP actually fell in 2018-’19. The actual expenditure of the Centre was lower by Rs 1.31 trillion than the budget estimates.

New Delhi’s tax revenue is falling

What is driving this slowdown of the Union government: poor tax collection. The Centre’s share of taxes was 7.3% of the Indian GDP in 2013-’14. By 2018-’19 that number had dipped to 6.9%.

Like in the case of expenditure, there is also the problem of unpredictability. The estimated central government share of taxes as a percentage of GDP at the start of 2018-’19 was 7.9%. But it fell by a whole percentage point when actual taxes were counted up at the end of the financial year. This gap between estimates and actuals was the highest ever in India’s tax history and sent alarm bells ringing in the Union government.

The largest ever gap between estimates and actuals points to a fairly disconcerting state of affairs. How did things come to such a pass? To understand that, take a look at the chart below:

Taxes broadly fall into two buckets: direct or indirect. The former is a tax on incomes, either individual or corporate. Indirect taxes, on the other hand, are paid when goods or services are purchased.

As we can see from the above chart, direct taxes are doing okay. However, something is clearly wrong with indirect taxes, which plummet after 2016-’17.

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Failing GST

What happened to cause this sudden drop? On July 1, 2017, in a special midnight session of Parliament, Prime Minister Narendra Modi introduced the Goods and Services Tax. The new tax subsumed nearly all indirect taxes – state or Union – and was a fundamental change in the way India’s fiscal federalism works.

At the time, the Union government as well as most commentators hailed the move. The Union finance minister even claimed it would lead to an increase in GDP by 2%.

However, these forecasts turned out to be more pollyannaish than prescient.

As the chart above shows, the GST collections fell alarmingly short of the estimates set out by the Union government at the start of the year.

Even more worryingly, the GST is mopping up less taxes than India’s earlier tax regime, which had been derided for being too complex and clunky – problems that the sleeker “one nation, one tax” system was supposed to fix.

For the year 2017-’18, the Centre’s GST collection was 10% less than the pre-GST indirect tax collection for 2016-’17. Rather than fix the earlier tax regime’s problems, the GST was performing worse than it.

And things are not looking to get much better. India’s gross tax collection growth for the ongoing financial year was at a 10-year low for the April-June 2019 quarter.

To make matter worse for the Centre, it is bearing the entire load of the GST shortfall. As part of the deal-making that saw the states give up their powers of taxation and adopt the GST, the Modi government had promised them a 14% year-on-year growth in revenue. Any shortfall on this figure would be made up by New Delhi.

Scramble for money

This fiscal crunch means that the Modi government is now adopting some rather unorthodox ways to collect money. The 2019-’20 budget speech saw a move to raise credit from foreign investors in US dollars – a move almost universally criticised by experts as extremely dangerous.

Moreover, a number of industry leaders have raised complaints that the Union government is coming down hard on companies in order to raise taxes. Infosys director Mohandas Pai even went so far as to call it “tax terrorism”. The Modi government has also tightened the rules on Corporate Social Responsibility rules which mandate that companies spend at least 2% of their average net profit on CSR activities – and transfer any unspent funds to the government.

The Centre has also concentrated hard on taxing the rich and the middle class – even inviting some flack from this demographic, who are otherwise Modi’s strongest supporters.

The cash crunch is impacting Indian federalism significantly. The Centre wants the Finance Commission to create a separate mechanism in order to fund defence and internal security. This, if accepted, would be an unprecedented move and will result in a significant fall in state revenues.

The Union government is now also relying increasingly on cesses and surcharges – taxes that, as per the Indian Constitution, it need not share with the states. [More on this in the second part of the series.]

Till (and if) these moves deliver results, however, New Delhi is making do with fudging its books in order to reign in the fiscal deficit (the gap between expenditure and revenue). The government is pushing down its food subsidy bill by transferring less money to the Food Corporation of India – the entity that buys foodgrains and runs the Public Distribution System, providing subsidised food rations.

Of course, any shrinkage in the FCI’s operations would be political suicide in India’s democracy. As a result, FCI is kept going by granting it loans from the National Small Savings Fund, a pool of small savings run by the Union government.

This jugglery keeps some expenditure out of the budget and manages to, on paper, keep the fiscal deficit manageable. Of course, there is no free lunch. This fudge is only temporary and the Union government will have to, one day, pay off those loans.

This is the first in a two-part series on Central Finances. The second part looks at how a cash-strapped Union government is increasingly relying on taxes that need not be shared with the states, thus damaging India’s fiscal federalism.