7 PM Editorial |Possible Solutions to Compensate States for GST Shortfall|11th August 2020

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Possible Solutions to Compensate States for GST Shortfall


Slow economic growth since 2019-20 has impacted GST(Goods and Services Tax) collections of centre and states. This has made compensation to states for GST shortfalls by the centre, a challenge. This was reflected in delays in such compensation for the FY(Financial Year) 2019-20. COVID 19 pandemic’s economic impact has aggravated this challenge.

Why and how is the compensation given to states?

GST is based on the concept of ‘One nation One tax’. To achieve this, centre and States have shared their powers of taxation. States gave up their powers to levy sales tax, octroi tax etc. This was the reason the 122nd constitutional amendment bill needed ratification by at least 50% of states.

Destination based taxation of GST(tax collected where goods or service is consumed rather than where it is made) had made manufacturing states apprehensive of loss of tax revenues. To convince such states, compensation for any tax shortfalls was provided for 5 years in the constitution. GST(Compensation to states) Act, 2017 was enacted for the same.

Act provides for:

  • Assumption of 14% indirect tax revenue growth rate every year from 2015-16 for states
  • Any shortfall in this revenues will be compensated by centre for 5 years upto June 2022
  • Compensation payments every 2 months and adjustments at end of financial year

Compensation cess fund was created to finance the shortfalls. Additional cess on 28% slab of GST(luxury and sin goods and services), finances this fund.

Slowing economy and challenge of compensation:

In first 2 FYs i.e 2017-18 and 2018-19, cess collected was more than tax shortfalls of states. Slowing economy since 2019-20 has led to:

  • Increased tax revenue shortfalls of states
  • Reduced collection of cess to compensate the states

This is the reason for delays in compensation which has been raised by the states

First quarter GST collections of 2020-21 show that there is 41% shortall in revenues. Hence, it is not possible to achieve a 14% growth rate in revenues or collect enough cess to fund the shortfall.

But the central government is constitutionally obliged to compensate the states. Hence a solution must be evolved.

Possible solutions to address this challenge:

GST council must address the issue of compensation. Following are possible solutions:

  • Constitutional amendment to reduce compensation period to 3 years. This will make 2019-20as the last year and imposes no further obligation on the centre. But states may not agree to this especially considering stressed finances due to pandemic.
  • Funding shortfalls using centre’s revenues: Considering limited fiscal space with centre(expected fiscal deficit of 6-8% of GDP in 2020-21), it is not practical.
  • Raising debt on cess fund: Debt with guarantee of cess fund can be raised to finance shortfall. Cess fund tenure must be extended till such debt is cleared.
  • Revision of 14% tax revenue growth rate target: 14% target for indirect tax revenue growth is unrealistic even without pandemic. It can be renegotiated to a practical growth rate which is linked to nominal GDP growth. Then GST compensation act, 2017 can be amended to make this possible.

Pandemic and its economic impact is an unpredictable shock. Centre and states must recognize the difficult financial situation. Based on cooperative federalism framework, both have to arrive at a practical solution by negotiations in the GST council.

Source: https://www.thehindu.com

Mains question:
  1. Discuss the impact of COVID 19 pandemic on mobilization of resources by the general government? What are the possible solutions for resolving the centre’s obligation to states in funding indirect tax shortfalls? [15 marks, 250 words]
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