Prime Minister Narendra Modi's crackdown on the cash economy has shattered the consensus needed for a new national sales tax, plunging his boldest reform into limbo and threatening to entrench an economic slowdown.
Modi's government already had its work cut out to finalise a deal with India's 29 federal states to launch a Goods and Services Tax (GST) on April 1 that would transform Asia's third largest economy into a single market for the first time.
But his decision to scrap 86% of the cash in circulation, in a bid to purge the economy of illicit "black money", has caused huge disruption.
A slump in business activity stemming from the cash crunch has caused the revenue of state governments, which collect value-added tax on goods and other duties, to slump by 25-40%.
The states won't risk another setback by rushing the sales tax into force.
"The investment and economic environment in the country is in bad shape," said West Bengal Finance Minister Amit Mitra, who earlier head a panel tasked with building a consensus on the GST. "How is the country going to absorb the dual shock of GST and demonetisation?"
The GST is India's biggest tax overhaul since independence in 1947. It would replace a plethora of federal and state levies with one tax, easing compliance, broadening the revenue base and boosting productivity.
It took Modi more than two years to forge a political compromise on the tax in August. Now, demonetisation "has created a trust deficit," said Kerala Finance Minister T.M. Thomas Isaac. "After this, I am not going to sit and compromise. They don't deserve it."
Left in the lurch
Failure to break the deadlock could tip India into a fiscal crisis: The GST would need to come into effect by mid-September, when the old system of indirect taxation is due to lapse.
The lingering uncertainty is worrying companies needing to understand financial implications of the new tax.
"With so many vital details still missing, they are feeling left in the lurch," said Saloni Roy, a senior director at Deloitte.
Modi's shock move last month to scrap 500 and 1,000 rupee notes was aimed at India's shadow economy. But the ensuing cash crunch has caused job losses, disrupted supply chains and slowed construction activity.
With cash shortages showing no signs of abating, some economists are calling for emergency stimulus to cushion the economy against the impact of demonetisation.
Ambit Capital, a Mumbai brokerage, forecasts growth this fiscal year will be only half of the roughly 7% level many expect. The Reserve Bank of India has shaved its growth outlook by half a percentage point to 7.1%.
To make up for their losses, states are seeking compensation and will press their case at a meeting in New Delhi on Thursday and Friday with Finance Minister Arun Jaitley.
He has already agreed to cover states' revenue losses for five years after the GST's launch, but further concessions would narrow his room for manoeuvre in his annual budget presented in February.
One top finance ministry official dismissed demands for compensation for demonetisation as unreasonable. But states are adamant. "They have brought it upon us," V. Narayanasamy, chief minister of Puducherry, told Reuters. "Now they must pay for our loss."
The quibble is not just over lost revenue. Some states worry about the social and political costs of demonetisation.
Take Kerala, where credit cooperatives that farmers and retired government workers rely on cannot swap old bills or issue fresh notes. The state alleges this has encouraged commercial banks to scout for their deposits, sparking a "run" on them.
Odhisa's chief minister has written to Modi, saying curbs imposed on primary agriculture societies were making it difficult for farmers to access crop loans and procurement payments.
With the states smarting, they have hardened their stance on how to collect the new GST, which will have federal and state elements.
They want sole control over businesses with annual turnover of 15 million rupees ($220,000) and so-called "dual control" over bigger firms. Jaitley opposes this, fearing tax collectors could end up at cross purposes.
"We reached this far because states were willing to compromise," said Isaac, Kerala's finance minister, told Reuters. "If they want the GST, they will have to now concede to the states."
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