GST Compensation issue: analysis

GST Compensation issue

In News: Centre-state friction is growing over pending GST compensation payments issue under the Goods and Services Tax (GST).  The Finance Minister noted that the financial crisis facing the States is a result of an “act of God”.

About GST

The Goods and Services Tax in India is comprehensive, multi-stage, destination-based value-added indirect tax. It has replaced many central and state indirect taxes in India such as the excise duty, VAT, services tax, etc.

GST compensation: As per the GST (Compensation to States) Act, 2017, states are guaranteed compensation for revenue loss on account of implementation of GST for a transition period of five years (2017-2022).

  • The compensation is calculated based on the difference between the current states’ GST revenue and the protected revenue after estimating an annualised 14% growth rate from the base year of 2015-16.
  • Any shortfall has to be compensated from the receipts of Compensation Cess imposed on selected commodities that attract a GST of 28 percent.
  • At present, the cess levied on sin and luxury goods such as tobacco and automobiles flow into the compensation fund.

The solution presented by the government on GST Compensation issue

Two options presented by Centre for borrowing by States to meet the shortfall:

  • Relaxing FRBM limit: States will be able to borrow the final instalment of 0.5% even without meeting the pre-conditions (fiscal responsibility and budget management (FRBM) act).
  • Borrow the entire projected shortfall: The second option is that the entire gap of ₹2.35 lakh crore can be met by the borrowing by the States by an RBI arrangement.

Issues with the options:

  • Inadequate compensation: If states opt for the first option given by the Centre, they would get ₹2.62 trillion, including the compensation cess. That is only 87% of the shortfall.
  • Delayed payment may be a blessing in disguise for states: Under both the options, whatever is not borrowed by states will still be paid to them even after 2022, through an extension of the cess.

Issues between Centre and States over GST compensation:

  • The constitutional mandate not followed: Centre needs to honour the constitutional promise and reimburse the shortfall in tax revenues.
  • Issues of compensation: As per the estimates, the States’ GST revenue gap in 2020-21 will amount to about ₹3 lakh crore, while cess collections are only projected to reach ₹65,000 crore, leaving a shortfall of ₹35 lakh crore.
  • Manufacture and sale of liquor is one of the major sources of state’s revenue: the centre has placed restrictions on bars/liquor sale for long time. Excise duty on alcohol accounts for around 10-15 percent of Own Tax Revenue of a majority of states.
  • Less taxation power with states: Using cess for agriculture such as Krishi Kalyan cess and Swachh Bharat cess, the Union is entering domains that are a part of the state list.
  • Against fiscal federalism: Unilateral decision by Centre without negotiation can jeopardise the future of GST, which was envisaged as a cooperative initiative.
  • Increase burden on taxpayers: The reliance on future compensation means that taxpayers will have to bear the cost.
  • State’s opposition: Finance Minister of Kerala said enforcing a cut in compensation and bringing in a distinction between GST and Covid-related revenue loss is unconstitutional. The Chief Minister of Maharashtra has said that it is time to exit the GST. Punjab, Chhattisgarh and Puducherry have voiced their displeasure.
  • Stress the finances of the states’: If compensation is not paid to states, economy of states will fail because GST accounts for almost 42% of states’ own tax revenues, and tax revenues account for around 60% of states’ total revenues.
  • Role of agencies in slowdown: During tight Monetary policy in 2017 and 2018 agencies showed higher growth than what actually obtained in 2016-17 and 2017-18. This affected structural reforms and the monetary policy of RBI.
Does India need a Fiscal council?

Fiscal Council: It is a proposed independent fiscal institution (IFI) promoting stable and sustainable public finance. It must be composed of non-elected professionals to ensure bipartisan support.


  • Unbiased reporting to parliament.
  • Promoting accountability and transparency
  • Costing of budget, policies and programmes. This discourages populist measures and raises awareness of people about their viability
  • Developing macroeconomic and budgetary projections
  • Raising public awareness on budgetary constraints.
  • Monitoring rules-based policies and this improves the quality of legislative checks on executives. Extra budgetary financing and such practices will be discouraged due to this.
  • Presenting alternative policy options.

Need of fiscal Council:

  • Lack of transparency and accountability in existing budgeting: Fiscal deficit of 2019-20 as per CAG is 4.6% compared to revised estimate of 3.8%.
  • Unrealistic targets of tax revenue and capital receipts.
  • Extra budgetary financing not shown in deficit calculations. Example, Railways financing by borrowing from IRFC (Indian Railway Finance Corporation) and Irrigation financing by borrowing from LTIF (Long term Irrigation Fund) in NABARD
  • Tax Maladministration: A 2017 CAG report found that the tax department had resorted to ‘irregular’ and ‘unwarranted’ methods to meet their tax targets.
  • Coordination between GST Council and Finance Commission: currently there is no mechanism for such coordination.
  • To Limit the borrowings by the Central Government: Article 293 provides a constitutional check over the borrowings by the State government but there is no such restriction on the Central government.
  • To address these fiscal council is recommended by the 13th FC (Finance Commission), 14th FC and N.K. Singh panel of FRBM review. 14th FC suggested such a council should report to parliament and must be autonomous.
  • Moral obligation to compensate states from the Consolidated Fund of India: Centre is morally obligated to pay compensation to States as states gave away their right of taxation.

Way forward:

  • Extend compensation period: Centre can prolong the compensation period beyond July 2022 and offer a greater share of the revenues (the SGST part) to the States.
  • Address trust deficit: The Centre needs to deliberate with the states and bridge the alarming trust deficit.
  • Reconsider FRBM limit: The centre should allow the states to exceed the FRBM limit by more than 0.5 per cent of the SGDP, as a temporary relief.
  • Facilitate borrowing by the states without affecting their debt to GDP ratios.
  • Fiscal decentralisation: 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.
  • Single rate GST: There was an original recommendation of a standard rate of 12%, to be fixed for at least a five-year period. It reduces the need to do arbitrary classification and discretion, reduces litigation and will lead to buoyancy in collection. For example; Australia’s GST rate which has been constant at 10%.
  • Widen the tax base: GST should progressively include all goods (petroleum and alcohol) and services with very few exceptions, such as food and medicine.

Conclusion: GST is a crucial and long-term structural reform which can address the fiscal needs of the future. Therefore, there is need to strike the right and desired balance to achieve co-operative federalism which will lead to enhanced economic growth.

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