7 PM Editorial |Issue of GST Compensation to states and suggested reforms|1st September 2020

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Issue of GST Compensation cess to states and suggested reforms

The issue of centre refusing to provide for GST compensation cess to the states.


GST was conceived with the idea of providing frictionless trade across borders, buoyant and leakproof tax compliance and to remove the ills of cascading “tax on tax”. Three years ago, the Centre and the States of the Union of India struck a grand bargain resulting in the launch of the unified Goods and Services Tax (GST) era. The States gave up their right to collect sales tax and sundry taxes, and the Centre gave up excise and services tax.

However, the states had apprehensions of revenue loss arising out of implementation of GST which had to be addressed.

The promises by the centre to address this issue of revenue loss:
  1. Centre promised to reimburse the shortfall in tax revenues for 5 years to the states, which was to be funded by GST Compensation Cess.
  2. The tax year on year growth for the states, upon the base, was promised as 14%.

Now, the Centre is abdicating its responsibility of making up for the shortfall in 14% growth in GST revenues to the states, which makes the position of states perilous.

Why the Centre should not deny States the Compensation Cess:
  1. In comparison to states, the centre has multiple recourse to revenue generation. Eg. The centre can raise money by issuing sovereign bonds which the states cannot.
  2. States, if borrowing from markets, will have to shell out more because of higher interest rates for them. This will put the collective government debts higher.
  3. Rating agencies also do not take individual central debt as the base to reduce ratings. So, the centre should not fear the agencies for a sovereign downgrade.
  4. Fighting this recession through increased fiscal stimulus is basically the job of macroeconomic stabilisation, which is the Centre’s domain.
  5. Breaking the promise of compensation by using COVID-19 as the reason, causes a serious dent in the trust build up between centre and states.
Along with the responsibility of centre to provide for compensation, the GST structure, overall, also requires changes: The Grand Bargain 2.0
  1. There should be a fixed rate of 12% for 5 years with minimum exceptions: This has been done by Australia, which started the GST implementation on the same date as India. It has a single rate of 10%. This encourages better compliance, reduces the need to do arbitrary classification and discretion, reduces litigation and will lead to buoyancy in collection.
  2. The Revenue Neutral Rate (RNR), which occupied much of the pre-GST debate need not be emphasised as long-term changes in consumption patterns, production configurations and locations, which cannot be anticipated, makes RNR non-viable.
  3. The local governance system, the 3rd tier of government, have had issues with transfer of funds, functions and functionaries. Of the 12% GST, 10% should be equally shared between the States and the Centre, and 2% must be earmarked exclusively for the urban and rural local bodies, which ensures some basic revenue autonomy to them. This will establish a tighter link between the governed and government and will ensure democratic decentralisation.
  4. The current system is complex leading to higher transaction costs. Zero rated exports should also be explored.

GST is a crucial and long-term structural reform which can address the fiscal needs of the future, strike the right and desired balance to achieve co-operative federalism and also lead to enhanced economic growth. The current design and implementation has failed to deliver on that promise. A new grand bargain is needed.

Mains Question:

Why should the Centre not go back on its promise of GST compensation cess to the states? Discuss in light of the stressed revenue situation of the states because of COVID-19 pandemic.

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