Corporate Law

Indian Federal Structure – Cooperative or Combative?

Shivankar Sukul and Mudit Burad


Analysing the Failing Cooperative Federalism in Fiscal Matters that we are seeing today

When GST was first introduced in India, it was hailed as the embodiment of pooled sovereignty”. The past experiences of Australia and Canada show that the smooth functioning of the GST System is primarily based on the principle of “cooperative federalism”. The centre and states collectively pool their resources and work for common objectives while allowing reasonable  autonomy to each other.

In the present difficult times, there is an increased need for state and central governments to work in tandem for ameliorating the conditions of the citizens. On the contrary, the prevailing circumstances have strained relations between the two. The allegations by CAG against the centre for diverting the GST Compensation Funds, the obstructionist stand of several state governments regarding the recent GST Compensation Shortfall, and the restrictive debt conditions imposed by the union are a few among many exhibits of this adversarial relation. This article seeks to discuss these  incidents which indicate the failing fiscal cooperation between states and the union and discuss the social and constitutional ramifications of the same.

A Brief Introduction to the GST Compensation Fund

Before we delve into the discussion about the issues regarding GST Compensation, it is important to refer to the constitutional framework on which GST Compensation is based. The 101st amendment introduced in 2016, laid down a mechanism for levying nationwide GST. It attempted to subsume all indirect taxes and octroi fees into one single tax. Hence Clause 18 of The 101st Amendment stipulated to provide compensation to states for a loss of their revenue in the subsequent five years i.e. till July 2022. It read as follows.

“Parliament shall, by law, on the recommendation of the Goods and Services Tax Council, provide for compensation to the States for loss of revenue arising on account of implementation of the goods and services tax for a period of five years” 

Interestingly, this is one of those rare provisions where the word “shall” has been used in reference to the parliament. According to an anecdote shared by the then Finance Minister Arun Jaitley, the words “Parliament.. may” are the usual norm. However, in order to assuage the doubts of the states, this is the only instance where the parliament is mandated rather than requested. 

Stipulations under the GST Compensation Act, 2017

Section 7 of the Act stipulates that the union government shall pay an amount to the tune of difference between the actual revenue collected by the state governments in a financial year and the projected revenue of the state calculated as stipulated under Section 5 of the act. Section 5 lays down that the compensation shall be calculated by assuming the growth of the revenue of the states as 14% and considering the base year to be 2015-16. For Example- If the revenue of the state in the base year (2015-16) was ₹ 100 crore then the projected revenue for the financial year 2019-2020 shall be  100(1 + 114)4=₹ 131.78 crore.

Hence, this act seeks to provide states a certain 14% percentage points growth in the revenue for a period of 5 succeeding years to the implementation of GST. Eg-  If the revenue growth recorded by Uttar Pradesh is 5% in the year 2018 then the remaining 9% shall be paid by the union as compensation.    

The Act also lays down that all the amount collected from levy of cess and surcharges imposed on the products mentioned under Schedule I of the act shall be transferred to the GST Compensation Fund in compliance with Section 10 of the act. The section also stipulated that the compensation to the states shall be paid from the given fund. The section also laid down the formulae for the distribution of the unutilised amount in the said fund. It is provided that the unutilised amount shall be transferred 50% to the consolidated fund of the union and the remaining 50% shall be shared among the states. 

Misappropriation of funds by the Union

The recent CAG report released and tabled in the parliament on 23rd September 2020, flagged the issue of misappropriation of the amount collected under the provisions of cess and surcharges under the

*Figures given in  CAG Report “Accounts of the Union Government” published on 23rd September 2020.

The CAG observed that in the financial year 2017-18, the centre retained around 6,466 crores from the money collected from the extra surcharges and cess levied under the act. It also observed that in the year 2018-19, the union retained around ₹40,806 crores from the money collected through the cesses levied under the act.     

This retention is in clear violation of Section 10 of the Act, which mandates that the proceeds of the cess leviable under section 8 shall be credited into the GST Compensation Fund. This retention also amounts to misappropriating the amount payable to the states as the provisions of the act states that the unutilized amount shall be equally shared between states and the union government. 

Moreover, the retention of the amount collected through levying cess and surcharges in the Consolidated Fund of India also inflates the revenue receipts leading to suppression of the figures of fiscal deficit which is in clear violation of Section 6 of the Fiscal Responsibility Budget Management Act, 2003 which mandates the centre to maintain fiscal transparency. 

The Shortfall in Compensation.

It is expected that the recent pandemic will cause the GST compensation fund to fall short by ₹2.35 lakh crores by the end of the current fiscal year of 2020-2021.  To solve this, the finance ministry gave the states two options, first was that the states can take a loan of GST dues which is around 97 thousand crores, which the centre would refund after 2022 in whole, or second that the states themselves take the loan of 2.35 lakh crore, and pay the interest from their own funds. Most of the states agreed to the first option, but the finance ministry in the next meeting decided to borrow a sum of ₹1.1 lakh crore under the special window from the RBI and further lend it to the states because of the lower borrowing costs available to the central government.  The Finance Minister has also announced that the interest amounts shall be paid from the GST Compensation Funds. The loans will be recorded in the balance sheets of the states as capital receipts, and not in the accounts of the centre so that it would neither increase the government debt nor the fiscal deficit of the country. Moreover, the government has also announced that in order to preserve the interests of states and paying the interests for the loans, it is also planning to extend the term of compensation from 2022 to 2025 which shall require an amendment to Section 2(i)(r) of the GST Compensation Act which defines “transition period” to be five years from the date when State GST was adopted.    

Hence it can be concluded that the centre is currently agreeing to pay only an amount of ₹1.1 lakh crore from the shortfall of ₹2.35 lac crore, this year. Regarding the outstanding payment, it maintains that the amount shall be deferred to subsequent extended years beyond 2022. States such as Punjab oppose this scheme and accuse the centre of evading its constitutional duty. In the same sense, it is imperative to note that Arun Jaitley during the 8th GST Council Meeting had assuaged the doubts of state finance ministers on the issue of deferment and had clarified that compensation to States shall be paid for 5 years in full within the stipulated period of 5 years no matter what. He also clarified that in case of shortfall the centre shall borrow and the loan shall be repaid in the cess collection of subsequent years. Hence the second proposal of the centre where it seeks to defer the payment of compensation is also tantamount to shying away from its constitutional duty enshrined under the 101st Amendment. This assumes even more importance during the pandemic when the state has an increased need for investment in healthcare. 

This adamancy of the centre points a deeper institutional flaw in the GST Council pointed out by Mr. Prasanna Kumar that the manner in which the GST council takes decision is in itself if disruptive of the federal balance, as the centre has 1/3rd of the voting power combined with a requirement of ¾ majority in the council to make a decision effectively grants the centre a veto power to obstruct any decision proposed by a state.  This veto goes against the very concept of cooperative federalism because an equal bargaining ground is imperative to cooperation and coordination, which this veto power fails to provide.  

Conditions Imposed on State’s Borrowing

Estimating the shortfall in revenue and the need to provide financial stimulus to the economy, the central government has recently increased borrowing limits for the states from 3-5%. In response, several states such as UP & Telangana have even amended their FRBM Acts to increase their borrowing limits from 3 to 5 percent of their GSDP (State Gross Domestic Product). 

However, this increased borrowing is not completely unconditional. This borrowing has been divided by the union into several tranches. The first tranche of 0.5% borrowing limit extends a no strings attached borrowing for the states, It has been announced that the second tranche will be extended to the states on the basis of implementation of four criteria which include central schemes and improving ease of doing business. Whereas the last and final tranche of 0.5% will only be provided when the states completely achieve their targets in three out of these four criteria. 

Article 293 of the Constitution provides that the states have the right to borrow however the states have to solicit the prior consent of the central government for borrowing any sum if there is any outstanding loan from the central government. The power of the central government to impose conditions on borrowing is unwarranted as provided in the language of the constitution. On perusal of the past practices, it is evident that conditions on borrowing are imposed only with respect to the financial criteria like GDP to debt ratio and fiscal deficit. The conditions which are imposed on the borrowing of the states are of the nature of administrative control covered under Article 256 of the Constitution instead.  

 However, this is probably the first time an implementation-based condition has been imposed under Article 293. This amounts to unwarranted use of this provision as it was not meant by constitution-makers to be used by the central government for administrative control [1].  Especially considering the fact that the central schemes can be implemented by the centre by providing grant-in-aid to the states as mentioned under Article 275 of the constitution.  

Though a structuralist reading of this provision provides an unwarranted power to the union to impose conditions on states for borrowing. However, the principle of “Pragmatic Federalism” as laid down by the SC in the matters of NCT of Delhi v. Union of India postulates that the provisions which whittle down the powers of states in the federal structure are to be narrowly interpreted. Hence an argument can be made that such a wide and encompassing use of this provision is against the idea of pragmatic federalism and attempts to disturb the federal balance of the nation.  


Cooperative federalism lies at the centre of the GST mechanism and the fiscal relations between union and states. As per the mechanism envisioned by the Indian constitution, the union and the states are complementary parts of a single governmental mechanism. The proper functioning of the GST also requires seamless interaction between the two.

However,  recent events such as misappropriation of GST Compensation funds by the union government, imposition of unprecedented conditions on the borrowing of states by the union, or the stubborn refusal of the states to compromise in the GST Council to reach a solution regarding shortfall, reveal a  failure of India’s cooperative federal structure. The failure of the GST Council to bring all the parties to cooperate and collaborate with each other unveils a probably bigger problem. It shows how the GST regime grossly failed to account for the failure of India’s politics to cut across party lines for the greater common good. The dream of pooled sovereignty where all parties coordinate, collaborate and even compromise can only be achieved if a solution to this political problem is found.   

The authors are III year students at National Law University, Jodhpur.

[1] Granville Austin, “Constitution of India – Cornerstone of a Nation” 9th ed. 2005 at p.233.

3 replies »

  1. Well researched article and I agree to all the points you have made. But dont you think that the centre’s reserve is itself handicapped by the pandemic and putting further load on that might result in economic breakdown. Therefore the decision they made of writing off the loan in books of the states is correct.


    • Hi Dushant
      Thank you for writing in!!
      I feel that though it is fiscally prudent decision of centre to write the loan in the state’s balance sheet but considering the increased need of states to spend in healthcare and allied state subjects it could have at least compensated the states for the shortfall in this fiscal year rather than to defer it above the period of five years


  2. I attended the blog symposium previously organised on thisvtopic but couldn’t understand a thing.
    Thanks for explaining everything in a simple manner.