Fixing the GST compensation imbroglio

Lokeshwarri SK | Updated on September 09, 2020

Despite their problems, States can be more flexible, given that the country is going through severe economic distress

There is quite an uproar on the GST compensation issue, with many States up in arms over the Centre not giving them their rightful dues. The Centre, on its part, is seeking refuge in ‘the Act of God’ argument to show that this is an unprecedented situation that calls for a different approach.

The predicament of the States is not difficult to understand. According to the RBI, GST collections accounted for 43 per cent of States’ own tax revenues in 2018-19. A sharp fall in these collections, especially when other sources of revenue have dried up and healthcare spends are rising, does create enormous difficulties.

The Centre has its own set of problems to deal with — expanding fiscal deficit, growing pile of debt, bond yields that are refusing to be tamed and rising inflation. The situation is quite tricky with the Centre fighting with its back to the wall. The States can be a little flexible here, in giving due consideration to the solutions offered by the Centre.

How did the shortfall arise

As we all know, making all States agree to the GST was no mean task. One of the ways used to cajole the States was through the promise of minimum increase of 14 per cent in GST revenue every year, from the base year of 2015-16, in the first five years after implementation. The States were to be compensated for any shortfall through the compensation cess levied on luxury, sin and demerit goods.

Though the first two years were marred by technical glitches and problems in filing returns, collections from GST were not too bad. In 2017-18 and 2018-19, the compensation cess collection was adequate and even after disbursing to the States, some amount remained unutilised.

The trouble began in 2019-20, when consumption was impacted due to the liquidity crunch triggered by the IL&FS crisis. GDP growth had declined from 8.2 per cent towards the beginning of 2018 to 3.1 per cent by March 2020. Not only did this create a shortfall in GST collection, the compensation cess mop up also fell, mainly due to a decline in auto sales.

The total compensation released provisionally in FY20 was ₹1,65,302 crore while the cess collected in the year was ₹95,444 crore. In order to bridge the gap of ₹69,858 crore, the IGST balance in the Consolidated Fund of India and the carried-forward compesation cess balances from previous years were used.

The situation has become quite dire in 2020-21. While the June quarter has been a total disaster for the country, forecasts of GDP contraction for the entire year are now being expanded to beyond 10 per cent by research houses. With consumption taking the sharpest knock as people prefer to stay at home, SGST collections have dropped precipitously in April and May.

While collections in June, July and August were around 80 per cent of the mop up in the previous year, it needs to be remembered that GST collections were quite weak in 2019.

Behind the numbers

The Centre is projecting the shortfall in GST revenue of States at ₹3-lakh crore for FY21. This number is based on the original promise made to States about 14 per cent annual increase in collections. Based on the total own tax revenues of the States of ₹8.4-lakh crore in 2015-16, the protected revenue for States from GST collections comes to around ₹7-lakh crore for FY21.

Extrapolation of the trend in GST collection between June and August 2020, pegs the shortfall for States at around ₹3-lakh crore. This gap can be higher if growth stutters in the coming quarters and vice versa if things look up.

In order to arrive at the impact of the pandemic on collections, the Finance Ministry assumed a 10 per cent increase in GST collections in the first 10 months of FY21 (year on year) and deducted the sum from the protected revenue for the period, to arrive at the gap, which is ₹1,65,178 crore. By deducting the compensation cess, projected until March 2021 at ₹68,700 crore, the Centre has arrived at ₹96,477 crore, which it says is due to GST implementation.

The better option

Let’s examine the two choices that the Finance Ministry has given the States. In the first option, out of the total shortfall of ₹2,35,000 crore, ₹97,000 crore (the shortfall due to GST implementation) can be borrowed by States through a special window coordinated by the Ministry. Both the principal and interest of this borrowing will be paid from the compensation cess, which will be extended beyond 2022.

Under option 1, States have to take care of the remaining ₹1,38,000 crore through market borrowings. States’ borrowings will increase to that extent and they have to take care of both the principal and interest on this portion.

Under the second option, the entire shortfall of ₹2,35,000 crore may be borrowed by States through issue of market debt. The Centre will repay the principal of such debt while the interest will have to be borne by the States.

A back-of-the-envelope calculation shows that the second option is more conducive as it involves only payment of interest, although on a larger amount of ₹2,35,000 crore.

A few States have accepted the first option, perhaps with the intention of using the special window immediately without worrying about the balance in shortfall, for now.

Many are refusing to accept either option, stating that both the principal and interest on the entire ₹2,35,000 crore have to be borne by the Centre.

The impossible 14% increase

There is no doubt that the States are legally correct in their demand. But there are two reasons why they need to bend back a little. One, while the ‘Act of God’ argument was subject to much ridicule, it has its merits.

The pandemic resulted in a sharp fall in GST collections in the June quarter and revenue is going to be subdued for the rest of the year, too, due to movement restrictions. Hypothetically, if we were still in the pre-GST era, the States would have had to bear the decline in revenue through borrowings. They can, therefore, shoulder at least a part of the borrowing cost.

Two, the protected revenue assumes a steep revenue growth, of 14 per cent. With nominal GDP growth in FY20 dipping to around 7 per cent, the shortfall was bound to expand. The Covid-led contraction has further exacerbated the situation.

The GST Council needs to deliberate on the growth figure of 14 per cent pencilled into the statute. A little flexibility on that, against the light of the ongoing economic turmoil, will go a long way in resolving this logjam.

Finally, it’s in the interest of all States to together iron out the issues.

The GST Council has so far worked quite efficiently, in the true spirit of cooperative federalism. This needs to be continued.

Published on September 09, 2020

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