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The GST compensation imbroglio
June, 17th 2020

How can the gap between fund requirement for GST compensation to states and availability in the Compensation Cess Fund be bridged?

The impact of the pandemic on the revenue receipts of the Central and state governments has been devastating. The total average collection of GST revenue in April and May is only Rs 94,323 crore, just 46 per cent of the previous year’s average bimonthly receipts. The states have been guaranteed 14 per cent annual growth in GST revenue over 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 per cent .

The Compensation Cess Fund had already been under severe stress as the GST revenues have been far from buoyant. The increase in revenue in 2019-20 has been a meagre 3.8 per cent compared to the previous year. The result is that even after paying Rs 1.2 lakh crore as compensation, the payments were three months in arrears at the end of the financial year. And now with the pandemic, the fund requirement for compensation has dramatically increased. The payments are in arrears by more than Rs 1 lakh crore already.

If fund requirements have been ballooning on the one hand, fund availability has been shrinking on the other. The collection of Compensation Cess in the months of April-May is only Rs 7,332 crore. The total balance is just Rs 8,013 crore. This raises a fundamental question: How can the gap between fund availability and fund requirement be bridged?

Hypothetically, there are three solutions. One is to revise the compensation formula. From the start of deliberations on GST, the states had made it clear that they would support constitutional amendment and the GST legislation only if they were given iron-clad guarantees of compensation enshrined in the Constitution itself. Accordingly, the Constitution was also amended and Parliament passed the GST (Compensation to States) Act.

It was after much deliberation that the 14 per cent growth was guaranteed to the states. But the optimistic mood regarding the buoyancy of GST prevailing then has not been borne out by the actual outcome even after three years. The implementation has been lacklustre, with the IT backbone yet to be completed and tax administration handicapped by too many impediments. Further, the pre-election sharp reductions in tax rates without serious examination of the revenue implications have also contributed to the fall in revenue. The current rates are not revenue neutral.

It is in this context that the 15th Finance Commission Chairman formally proposed in the GST Council that it should revisit the formula. The Council refused to even consider the proposal and was unanimous in rejecting it. The response would not be different even now.

The second option is to increase the Compensation Cess rate or bring additional commodities in its net. However, there is very little chance for any proposal to increase tax rates to be approved during the pandemic slump period. Even the proposal for resolving the inverted duty structure of cloth, footwear and fertiliser, which is creating serious problems for the manufacturing sector, was rejected by the Council because it involved an upward shift of the final products to a higher tax bracket.

Therefore, we are left with the third option. The GST Council or the Compensation Fund must be empowered to borrow funds from the market and compensate the states. The period of the Compensation Cess can be extended for a year or an additional period long enough for repayment of the funds borrowed. The advantage of the third option is that it would not affect the Centre’s finances. Since the loans are not taken by the Centre, it has no fiscal deficit implications. And the liabilities would be liquidated automatically from the collection of the Cess during the extended period. This proposal is not anything new.

The issues related to compensation were discussed in the fifth to eighth council meetings. In response to these discussions, the then chairperson and Union finance minister had given the following assurance: “The Hon’ble Chairperson assured that compensation to states shall be paid for five years in full within the stipulated period of five years ...”. He added that “... in case the amount in the GST Compensation Fund fell short of the compensation payable in any bimonthly period, the GST Council shall decide the mode of raising additional resources including borrowing from the market which could be paid by collection of cess in the sixth year or further subsequent years”. States were assured that compensation would not be restricted to the compensation cess collected. Section 10(1) of the Compensation Act reflects this position. The alleviation of the apprehensions paved the way for a federal consensus to introduce GST in the country.

However, in para 107 of the Union Budget speech 2020–21, the Union finance minister unilaterally announced the decision that, hereinafter, transfers to the fund would be limited only to collection by way of GST Compensation Cess. This declaration is against the federal consensus between the Centre and states, and the constitutional guarantee enshrined after an elaborate process. However, an understanding has been reached in the Council to have a special session to discuss and resolve the imbroglio in July.

Yet another partial solution would be to revisit the rate of apportionment of the GST between the Centre and states. Many states had adopted a consistent position during the discussions in the empowered committee that the apportionment of rates of GST should be 60:40. The basis of this argument was that the proportion of state taxes subsumed was 44 per cent as against 28 per cent in the case of the Centre. This logic for the apportionment in a 60:40 ratio between the states and the Centre had been recognised by the Government of India committee on Revenue Neutral Rates, headed by the then chief economic advisor. The present crisis may have provided us an opportunity to correct the historic mistake of equal apportionment of GST rates.

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