Why Is GST Compensation To the States a Complicated Affair

Three years after the implementation of GST, centre and states have yet to reach a solution; perhaps the formula for compensation cess needs to be reconsidered

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Since the Goods and Services Tax (GST) was implemented, the GST Council had promised the states that they would be compensated for the loss of revenues, for an initial period of five years. In FY 19-20, the centre could not live up to that promise as compensation cess collections saw a shortfall. This led to discord between the centre and the states since states are dependent on the compensation receipts from the central government.


Let’s unpack why compensation is an important issue to be solved for in the overall design of GST. Compensation cess was introduced by the Goods and Services Tax (Compensation to States) Act, 2017, with a view to compensate the states from losses, resulting from the implementation of GST. As GST is a consumption-based tax, manufacturing-heavy states would end up losing out on revenue. Also, several state levies such as entry tax were abolished. Hence, the GST Council recommended that the states be compensated according to an agreed formula for a period of five years from the date of implementation of GST.

Compensation cess is only levied on certain items, mostly luxury and sin goods. However, due to decreased economic activity in FY 2019-20, and the financial year closing with the outbreak of the COVID-19 pandemic, the centre saw a shortfall in collections. The centre disbursed a total compensation cess of INR 165,302 crore for FY 2019-20, against a collection of only INR 95,444 crore. The difference was made good utilizing the balance from FY 2017-18 and FY 2018-19, in addition to INR 33,412 crore being transferred from the Consolidated Fund of India.

Unfortunately, this cannot be a long-term or sustainable solution. The overall compensation mechanism seems to be somewhat flawed. It was introduced to compensate for the revenue deficit, arising from the states giving up their powers to charge and collect taxes. However, three years after the implementation of GST, centre and states have yet to reach a solution; perhaps the formula for compensation cess needs to be reconsidered.

GST was introduced with the hope that the revenue collections would spiral. A seemingly utopian expectation, but not unwarranted as GST was expected to boost supply chain benefits and remove the cascading effect of taxes. In hindsight, the compensation formula should have used actual collections as the basis. But back then, who would have thought three years down the line, the Union government would be battling an economic crisis caused by COVID-19.

In the midst of a pandemic, the imbroglio is even more apparent. With economic activities having slowed significantly the states need the money more than they did before. The pandemic calls for aggressive healthcare measures, especially among the economically weaker sections of society. Having a compensation deficit would result in the states cutting back on affordable healthcare facilities, with the poor suffering the worst.

Market borrowing to close the deficit has been a measure discussed for a long time. It has turned out to be a bit of a farce though, with neither the centre nor the states willing to take on the guarantee. The 41st GST Council meet will discuss this option, though it is a bit early for the states to exhibit any optimism. The GST Council may be empowered to borrow as has been suggested by some states that would be a good middle ground, as it would avoid fiscal deficit implications. The cess collections arising in future years can be used to pay back the borrowing, with the council possibly looking at bringing more luxury and sin goods under its ambit.

Borrowing is not the only solution, however, the most plausible one at the moment. In the long run, the states also need to look at more aggressive means to boost their revenues. States should work with the centre to actively prevent tax evasion. With the administration of indirect taxes taken over by the centre, the states cannot get complacent. Measures ought to be taken to curb the wrongful availment of the input tax credit and the timely filing of returns. E-invoicing is a good start, and the states need to put in an equal effort in its implementation and the introduction of other such reforms.

A change in the law to revise the compensation cess formula should be considered. A 14 per cent hike year-on-year on revenue collections seemed justified back in 2017. Now, with the economic slowdown and the pandemic, perhaps a reduction in the percentage should be discussed. It is doubtful that the states will accept this unless coupled with an equitable benefit for them. Another option would be to include more items under the scope of compensation cess. Since it applies mostly to luxury and sin goods, it would not affect the average consumer. At this point, it is about reaching a mutual compromise, until the states are able to fend for themselves.

Archit Gupta

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