A major concern before the States was revenue foregone from loss of fiscal autonomy, as they decided to subsume their taxing powers under GST. The States came on board as revenue compensation was guaranteed in full for five years. As the compensation period is about to end this month, States, especially non-BJP ruled ones, have demanded its extension. The issue is likely to figure at the forthcoming 45th GST Council meeting.
A major argument against extension of compensation is that it would induce a moral hazard problem. Some say there is no sanctity with respect to the 14 per cent protected revenue when subsumed taxes between 2013-14 and 2016-17 grew at 8.1 per cent per annum. Others argue that the guaranteed income provide no incentive for States to explore ways to tap potential GST revenue.
However, there are many reasons why the compensation must continue for some more years. First, many States’ revenue receipts have dried up, expenditure has shot up, and debt has ballooned owing to Covid-19. Since the previous two years were Covid affected, when States had limited space for increasing revenues, extending compensation for two-three years would help stabilise the economy.
A study by Kavita Rao, a professor at NIPFP, shows that 14 States are likely to face a revenue shortfall in 2022-23 if 14 per cent growth is applied. Another study by Renjith PS of Gulati Institute of Finance and Taxation shows that the debt position in most States would be unsustainable in the absence of GST compensation. Thus, failure to extend compensation may worsen the States’ fiscal capacity, which is already in bad shape as a recent RBI Bulletin paper shows.
Second, the technology platform was not ready in the initial years. This resulted in the misuse of input tax credit using fake invoices, which affected revenue collections and tax compliance/buoyancy of States. On the other hand, the complex return filing process through GSTN has also been a significant challenge for small businesses. As the system is still stabilising, an extension of compensation could cushion State finances during the transitory phase.
Third, even if the compensation is extended, it does not imply that all States will require it. Only States falling short of the assured revenue are entitled to it. Given that the recent GST collection figures show promising growth, not many States are going to ask for it. But the very presence of guaranteed compensation gives the States a sense of comfort.
Fourth, some commentators have pointed out that the GST revenue growth has picked up and shown resilience. There are two holes in this argument. First, the growth in 2021-22 came over a low base of 2020-21. Second, the high GST figures are inflated by rising inflation.
Fifth, we still don’t know how the rate restructuring will affect States’ revenue. Going by media reports, it’s likely to happen in the next couple of years. It would be better if this could be finished before three years so that the States, in case they lose revenue, are protected by the compensation guarantee.
Sixth, it is useful to ask who pays the compensation amount. The Centre does not pay from the Union Budget but from a compensation fund paid by taxpayers when purchasing sin and super-luxury goods. Since GST cess has already been extended to 2026 for repaying the borrowings, extension of compensation by proposing a new win-win formula will maintain the spirit of cooperative federalism. Thus, the Center does not lose a penny by extending the compensation period.
Finally, an extended compensation window can be used for a reform agenda such as rate restructuring, pruning exemption, widening the tax base, bringing electricity duty, motor vehicle taxes, fuel items, and the entire real estate supply chain under GST, and streamlining the ITC in the entire supply chain, and so on.
Rework compensation formula
If the demand for extending compensation is reached, both the States and the Center must renegotiate the terms of the new compensation formula. Four issues come before the GST Council. First, by how many years should it be extended? Three years is a reasonable demand by States.
Second, what should be the assured revenue growth? When 14 per cent growth in States’ revenue was guaranteed, the Indian economy was clocking a growth rate of 6.5 per cent per annum. Considering the ongoing inflationary pressures, the protected revenue could equate with the rate of inflation. Third, a new compensation formula could be arrived at by using 2018-19, a normal year, as the new base year.
The new compensation formula must take into account the possibility of moral hazard, on the one hand, and reduce the dependency on compensation, on the other.
Considering the Indianised GST paradigm has been designed to foster cooperative federalism, extending compensation beyond June would be a win-win for the States, the Center and, above all, fiscal federalism. Canada took more than a decade to stabilise its GST system. Failure on the part of the Centre to realise this would lead to non-cooperation by States in the GST Council — more so after the recent Supreme Court ruling that says GST Council only has a recommendatory value.
The writers are on the faculty of Gulati Institute of Finance and Taxation, Thiruvananthapuram. The views are personal