As the country shifted to Goods and Service Tax, there was apprehension among manufacturing States about a possible loss of revenues. The new system replaced a production-based taxation system with one based on consumption. To assuage this worry, a compensation mechanism was instituted for five years. As per Section 18 of the Constitution (101st) Act, 2016, Parliament “shall, by law, on the recommendation of the GST Council, provide compensation to States for loss of revenue arising on account of implementation of the Goods and Services Tax for a period of five years from the date of its implementation.”

During the transition period, States’ revenue was protected at 14 per cent per annum over the base year revenue of 2015-16. Even at the time of the introduction of Value Added Tax (VAT) in early 2000, there was a compensation mechanism. It did work well, and after a few years, as States’ revenue saw good growth, it was stopped.

To what extent was it called into play during the first five years of the GST regime? 

For the first three years (2017-18, 2018-19 and 2019-20), the system worked, though some States complained that they were not getting compensation on time and dues were piling up. Then came the pandemic, affecting the consumption in a big way and thus the collection of cess and overall taxes. This caused some delay in the payment of compensation, and the Central Government finally borrowed to make good the compensation. As the pandemic-related impact on the economy eased and consumption returned, the situation improved. The financial year 2021-22 has seen good growth with a 19 per cent rise in the collection. So far in FY23, GST revenues have been robust. If this growth continues, the need for compensation may not arise over time.

Why are the States seeking its extension for a few more years? 

Some States have argued that their revenues have not recovered yet, having been battered by the pandemic and the lockdown imposed to contain it. They sought an extension of GST compensation, some wanted it to be extended for another five years, till the situation improved. At least 12 States sought an extension of the compensation mechanism beyond June 30, 2022, during the recently concluded GST Council meeting in Chandigarh. The Centre has listened to their concerns, but no decision has been taken. So, as on date, no compensation is available.

How is this compensation funded? 

For providing compensation to States, a cess is being levied on certain goods, and the amount of cess collected is being credited to the Compensation Fund. Compensation to States is being paid out of the Compensation Fund w.e.f. July 1, 2017. Bi-monthly GST compensation to States for 2017-18 and 2018-19 was released on time out of the Compensation Fund. Since FY20, cess collection did not increase in the same proportion as the 14 per cent guaranteed growth that was promised to the States. Covid-19 further increased the gap between projected revenue and the actual revenue receipt. It also hurt inflows into the Compensation Fund.

To meet the resource gap of the States due to the short release of compensation, the Centre has borrowed and released ₹1.1-lakh crore in 2020-21 and ₹1.59-lakh crore in 2021-22 as back-to-back loans to meet a part of the shortfall in cess collection. All the States have agreed to the above decision. In addition, the Centre has also been releasing regular GST compensation from the Fund to meet the shortfall. 

What are the pros and cons of extending the compensation? 

States say they need compensation as the economy is yet to recover fully from Covid, and now the Russia-Ukraine crisis presents new challenges. Considering this, extension of compensation w.e.f., July 1 will help States fill the resources gap and help rebuild the economy. Development in States will support overall national growth. However, there are disadvantages of extension too. First, it will create a kind of lethargy among State tax officers. Second, it will put more burden on consumers and come in the way of lowering Compensation Cess, and finally doing away with it.