While the June GST Council meeting is scheduled in Chandigarh, the initial choice of Srinagar was more apt. The verdant settings and cool climate could have mellowed the mood of the Council members getting ready for a fiery battle over extension of the GST compensation payments beyond the June 30 deadline.

It’s not difficult to see why many States want extension of these payments. The promise made by the Centre to compensate States for shortfall in GST revenue (if it did not grow at compounded rate of 14 per cent annually) in the first five years after transition to the GST regime, has so far worked well in States’ favour. It has helped buttress revenue during the pandemic as well as in the slowdown in 2019-20.

But there are several reasons why it is best to stop these payments. The targeted increase in annual revenue is unreasonably high, going by pre-GST growth rates in tax revenue across States. Uneven tax revenue growth across States has further led to anomalies in GST compensation claims. With some States getting too dependent on compensation payments in recent years, it may be a good idea to wean them from this revenue stream at the earliest.

Faulty design

There are two fundamental flaws in the design of compensation payment. One, expecting that State indirect tax revenue will grow 14 per cent annually in the post-GST period was too optimistic. Annual average growth rate in taxes subsumed by GST between FY13 to FY17 in 28 States was only 8.09 per cent. Data is not available for other States.

If we consider the pre-GST revenue growth in the larger States (see graph), only Bihar recorded growth of over 14 per cent. In fact, the largest States such as Maharashtra, Uttar Pradesh and Tamil Nadu grew their indirect tax revenue between just 5-7 per cent in the pre-GST period.

It’s true that States had to forego their right to tax goods produced and shipped to other States under the new GST regime, which is a consumption-based. But they have driven a hard bargain while transiting to the new system. Pre-GST growth in taxes in Odisha, which is among the States that stood to lose in the transition, was only 8.9 per cent.

Now, the varying rate of growth in tax revenue across States has meant that States with lower revenue growth tend to get higher compensation payments, since the targeted growth is same for all States. Instead of a single growth target, different targets could have been fixed for each State based on the consumption pattern and nature of industrial and infrastructure activity.

With the economy of each State being different — some States such as Punjab have a greater share of agriculture in the economy, which typically grows at a lower rate, while others such as Karnataka have a large contribution from fast-growing services sector — pencilling in a single growth rate has led to a great deal of anomaly. The pre-GST rate of growth in taxes in Punjab was 6 per cent, while it was a more robust 12 per cent in Karnataka.

Some States and Union Territories such as Punjab and Delhi started requiring high compensation payments even before the pandemic set in, underlining the discrepancy due to single growth rate for GST revenue. According to PRSIndia, requirement for GST compensation for Punjab accounted for 13 per cent of tax revenue in FY19 and 20 per cent in FY20. Delhi required 12 per cent and 16 per cent in those years.

A moral hazard

This protected increase in GST revenue could be leading to fiscal profligacy in some States. According to PRSIndia, most States were able to achieve 88 per cent of the targeted increase in GST revenue on their own in FY19. This slipped to 77 per cent in FY20 and further to 64 per cent in FY21. Needless to say that the dependence on compensation cess is higher in some States such as Himachal Pradesh, Punjab, and Uttarakhand while others such as Arunachal Pradesh, Manipur and Mizoram have not required any compensation.

Of concern is the fact that compensation payment accounted for more than 20 per cent of tax revenue in FY22 for States/UTs such as Punjab, Bihar, Delhi and Karnataka. States such as Bihar and Punjab have also been recording high fiscal deficits as per cent of GSDP and their borrowings have also been hitting record levels. The protected revenue could be emboldening them to increase expenditure. Surprisingly, Kerala (5 per cent of tax revenue from GST compensation), which is at the forefront in asking for compensation extension is not too dependent on these payments.

Should the payments continue?

The moot point is whether the compensation payments need to continue. There are several reasons why this is unnecessary. One, all-India growth in GST collections in FY22 over FY21 was a robust 19 per cent. Odisha recorded revenue growth of 42 per cent while Punjab grew its GST revenue 24 per cent.

It’s clear that the GST system is well on the recovery path and the pandemic related travails seem to be behind, at least as far as GST is concerned. States which produce more than they consume have also recorded high growth in collections. As the economy recovers further, there would no longer be any need to hand-hold the States.

Two, States need to be weaned away from the dependence on the compensation payments to meet their fiscal shortfall. Many States have continued to dole out freebies and unnecessary subsidies even during the pandemic, taking their finances to a dire state. Clearly, the committed payments are giving them room to continue in this manner.

Three, States should in fact be nudged to increase collections through plugging of leakages and improved compliance rather than continuing to depend on these payments.

Four, continuation of the payments can require higher borrowing by the government, which has consequences for bond yields and financial markets.

It may be best to bring the compensation payments to an end now, rather than two or three years later, when States will have another set of arguments, for why it needs to be continued.