The contentious issue of extending compensation payable to States by the Centre will occupy centre-stage in the upcoming GST Council meeting on Tuesday and Wednesday. Compensation payments will cease on June 30. . The Centre had promised to compensate the shortfall in revenues to States and Union Territories that failed to record 14 per cent annual growth in GST for five years beginning July 1, 2017, as part of implementation of the landmark tax reform. The compensation payments were made despite the economic slowdown in 2019-20 and the pandemic that followed, taking States’ GST revenue growth far below the target. With the compensation cess collection proving inadequate to meet the shortfall in FY21 and FY22, the Centre borrowed ₹2.69-lakh crore to make the payments, thus necessitating an extension of the cess until March 2026..

Some States now demand that compensation period be extended as their revenues have suffered due to the pandemic-induced lockdowns. This issue was debated in depth at a GST Council meeting in September 2020. The decision arrived at then was that the Centre would compensate for the shortfall arising from GST implementation issues and not for the Covid-related deficit. While it is tempting to argue in favour of an extension of the cess given the perilous fiscal position of some States the fact is that doing so will not help solve the fiscal problem. The States’ debt issues have more to do with fiscal profligacy that predates the pandemic. The benchmark of 14 per cent revenue growth on which compensation is pegged is too high when the rate of growth in taxes subsumed under GST between FY13 and FY17 — of just 8 per cent — is taken into account. The uniform protected growth of 14 per cent for all States has meant that States (for example, Punjab and Delhi) that had lower rate of growth in tax revenue pre-GST became eligible for higher compensation cess. There is also a moral hazard of States becoming too dependent on these payments to bridge their fiscal gap. GST compensation receipts accounted for more than 20 per cent of tax revenue in FY22 in States such as Bihar, Karnataka, Himachal Pradesh and Delhi.

With the original guarantee fulfilled by the Centre, it is time to end compensation payments. In fact, there cannot be a better time than now to wean States away from an assured payment as GST revenues are growing strongly — they grew 27 per cent in FY22.. Around 24 States/UTs saw GST revenue growth of over 20 per cent and 11 recorded over 30 per cent growth in this period. These numbers show that the GST system is well established and there may not be any need to hand-hold States and Union Territories anymore. The Centre also needs to keep in mind the negative impact of compensation cess on consumers and industries, especially the automotive sector. The funding of compensation payment will have to come from consumers which means that the cess collection will extend well beyond 2026, and that would be more than a decade after launch of GST. This is unfair on consumers and industry and will also have a cascading effect on inflation. Assuming that the Council concedes the demand for extension now, there is no guarantee that a demand for further extension will not arise again in future, especially if the economy under-performs then. With GDP set to grow at 7-7.5 per cent this year, this is the best chance to end compensation. Buoyancy in GST revenues will by itself compensate the shortfall that some States may experience from the ending of compensation payment.